Effective Credit Risk Management with ErmsCo Dual Risking Rating System

Transcription

1 Executive Brief Effective Credit Risk Management with ErmsCo Dual Risking Rating System ErmsCo Inc Intellectual Property. All Rights Reserved. 103

2 Introduction to ErmsCo About ErmsCo ErmsCo is a consulting and training firm that focuses on assisting financial institutions with optimizing their enterprise risk management (ERM) processes. Our mission is to help our clients optimize the resources and controls used to manage risk. At the same time, we work with clients to fine-tune risk management resources to the performance objectives of the financial institution. Using proven methods and solutions to achieve targeted results, ErmsCo consistently delivers outstanding value to our clients. Our Team The ErmsCo team includes experienced banking professionals who have strong expertise in enterprise risk management. Our areas of expertise include risk management in governance, credit, operations, information technology and markets. Our professionals fully understand the challenges that bankers face with managing risk and we approach each client with careful consideration of the demands on time, resources, and pressures bankers face to deliver results. We are lead by Mr. John Drew, a 31 year banking veteran who has served as the EVP/Chief Risk & Credit Officer with large regional banks. In addition, he has been engaged to provide risk and credit management practices training at the national, state and local levels for the Risk Management Association, MIT Sloan, Office of the Comptroller of the Currency and numerous banking entities. As a founding member of the RMA Enterprise Risk Council and serving as a member on the National and State Boards of the RMA, his thought leadership in the ERM arena has been instrumental. Malvern National Services Malvern National Services represents ErmsCo with business development activities. In conjunction with ErmsCo, Malvern National Services works closely with its clients to optimize performance with a proven set of solutions and services ErmsCo Inc Intellectual Property. All Rights Reserved. 2

3 Need for Better Credit Risk Methods The common credit risk management practices used by banks during the past decade have had challenges in predicting credit loss and tracking accurate risk migration in the loan portfolio. Over the past several years, we have observed the following challenges associated with banks credit practices. Credit Practices Speed & Complexity of Credit Analysis Approval Overrides Risk Based Pricing Competitive Pricing Strategy Risk by Loan Types Risk Rating Reliability Risk Migration Benchmarking Credit Culture Common Challenges Pressure to win business can cause short-cuts to analysis process due to time required to compete High override rate usually shows weakness in credit rating system Accounting for the cost of risk is often not included in the pricing of a loan agreement Understanding risk exposure by markets/business lines is not always included in pricing strategy Differences in risk exposure between loan types lacks appropriate levels of risk differentiation Quality and reliability of risk ratings can become unreliable without back-testing and analysis Granular visibility to changes in risk patterns is usually too narrow in comparison to a statistical bell curve Adequate factors that can produce meaningful and actionable results are difficult to model Risk culture lacks sufficient support due to inconsistent measures and confidence in ratings At ErmsCo, we believe these challenges can be overcome with a more effective credit risk methodology. Specifically, the credit rating systems used by banks in support of their commercial loan portfolio has room for improvement. The following pages review how ErmsCo address these challenges with our 2D Credit Management program. 3

4 ErmsCo 2D Credit Risk Management Service After the recent credit challenges experienced by most banks, there is a need to further improve credit scoring methods for commercial lending. Most banks today use a single grading system that is subjectively derived based on a combination of purpose, collateral and financial capacity of the borrower. ErmsCo Dual Risk Rating Solution At ErmsCo, we believe there is a better approach to building a more reliable risk rating methodology. We refer to this methodology as ErmsCo s 2D Dual Risk Rating methodology. This methodology uses a dual risk rating that calculates the a risk rating for the borrower known as Probability of Default (PD) and a risk rating for the loan facility known as Loss Given Default (LGD). Both PD and LGD are used in the. The calculation of Expected Loss (EL) which over time will enable management to better control loss as well as plan for loss reserves. The 2D Credit Risk Model can be used to create specific line of business scorecards that further refine the unique characteristics found within individual market segments. The creation of the 2D model/scorecards is done with the full participation, local market knowledge and input of the bank s lending team. The models are further tested and aligned with the use of a historical loss information. Our dual risk rating methodology is Basel II aligned. The methodology produces superior results in the both the quality of the risk rating at time of origination and over the life of the loan as credit scoring is updated on a regular basis. The insight to changes in risk migration becomes more granular and reliable. 4

5 Position for Improved Performance With ErmsCo 2D, the yield of the credit portfolio will improve due to the use of including each dimension in the calculation of the overall credit risk of the loan. Each dimension is described in further detail below. Probability of Default: Differentiating Between Risky Borrowers Using Probability of Default (PD), the underwriting process examines borrowers by risk and the probability to meet the obligation of repaying the loan. The rating assigned to a borrower is methodically calculated with objective factors. Lenders often mistakenly assign the same ratings to borrowers with different levels of risk and can produce loan grades that either underestimate or overestimate risk. The consequences can lead to incorrect capital allocations and incorrect pricing for risk. The bank may not be getting paid for taking on extra risk and may also be driving good business away if other institutions that can accurately price risk. Loss Given Default: Differentiating the Risk of the Facility Many banks do not adequately distinguish between differences in the quality of loan facilities. Not only should the facility be rated separately from the risk of the borrower, but also the bank should use distinct and differentiated facility rating grades. This rating method is known as Loss Given Default (LGD). Using LGD, the underwriting team can structure loan facilities to improve its repayment due to appropriate covenants, collateral and security. At the outset, facility rating system will initially expose significant gaps in facility pricing and risky concentration of collateral but will provide better insight into loan loss through the life of the loan. Expected Loss: Provisioning for loan loss By combining the borrower (PD) and facility (LGD) risk ratings, the bank can refine the way it provisions for expected losses. Accurate borrowerspecific and facility-specific risk information will give management a clearer view of both promising and less attractive facilities within the loan portfolio. Over time, the Expected Loss should produce an accurate estimate of actual loss that will be realized in the loan portfolio. 5

6 Key Results with ErmsCo 2D Credit Risk Management Faster Process and Approval Times Our clients have found their process and approval time has improved significantly because they have come to rely on the risk ratings produced from ErmsCo s 2D methodology. Loan officers are able to quickly evaluate the credit risk score for a prospective borrower/loan facility and determine whether the borrower/loan facility meet minimum requirements for loan approval. Improved Yields with Risk-based Pricing An important improvement from refined provisioning is the immediate impact on loan pricing. Over the long term, as loans in the portfolio are re-rated and re-provisioned, the general provision will guide management to the risk level assumed by the bank and in business units. Risk-based pricing provides a framework to identify earlier those revenue sources that appear attractive until subsequent risk outcomes wipe out the nominal revenues. A risk-based pricing also allows the bank to demonstrate to customers, and to management, that the price being offered on a loan is reasonable given the inherit risk involved. Greater Visibility Into Risk Migration and Potential Loan Loss With ErmsCo s 2D methodology, portfolio managers are empowered with better visibility to risk migration of the loan portfolio. The 2D methodology uses objective factors in the risk model to provide a more accurate distribution of risk migration through the life of each loan. The net result is the ability to become far more proactive in taking appropriate measures to mitigate loan loss. Credit Risk Culture Strengthened With increased confidence in the ErmsCo 2D methodology, banks have found their overall credit culture becomes stronger. As an example, the rate of credit approval overrides has dropped to minimal levels with our clients due to the greater reliance on the risk ratings produced by the ErmsCo 2D methodology. With incorporation of the 2D methodology added to credit training, the entire lending organization is able to speak a common language of credit analysis and review. Competitive Strength Using the ErmsCo 2D methodology, management will be able to take advantage of business opportunities where informed decisions about market segment risk can be included in the market strategy process. The net result will be capital can be applied to the best market opportunities that are aligned with management s appetite for levels of risk. 6

7 Learn More About 2D Credit Risk Management We would like the opportunity to be of further service to you and would be glad to schedule an executive session to review in detail how our program could perform for your bank. We will take the time to understand your current your credit risk management practices and determine in a collaborative manner how the 2D Credit Risk Management could help to enhance and/or expand the depth and breadth of the bank s credit risk management practices. ErmsCo also offers other risk management services that are available to assist banks with various consulting and advisory services on all forms of risk management. In addition, we have an excellent program to assist banks with enhancing their enterprise risk management practices with the use of our ERM Foundations program. Contact Brian Blair, Malvern National Services, is the sales and business development contact for ErmsCo and can be reached via the contact information listed below. John Drew, President of ErmsCo, welcomes all inquiries as well. Brian Blair President Malvern National Services ErmsCo Strategic Business Partner bblair@malvernnational.com Office: Website: John Drew President Director of ERM Services ErmsCo, Inc. john@ermsco.com Office: Website: Offices Philadelphia & Houston ErmsCo Inc Intellectual Property. All Rights Reserved. 7

8 Our Business Philosophy The ErmsCo operating model embodies these concepts to ensure effective relationships and results Common Sense: balanced approach to business decisions and judgment Candor: professionally state the question or call the point as needed Courage: take actions needed to optimize risk management and create value Communicate: professionally, fully and concisely Commitment: to our clients and completing our charge everyday