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Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
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The 8 Steps of Credit Risk Management

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Safeguard your lending program by learning about the 8 steps of credit risk management. Learn about nonfinancial risks, structuring the loan, and more.

Published in: Economy & Finance
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The 8 Steps of Credit Risk Management

  1. 1. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 1 JOIN. ENGAGE. LEAD. THE 8 STEPS OF CREDIT RISK MANAGEMENT Safeguard your lending program by learning about the 8 steps of managing credit risk.
  2. 2. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 2 JOIN. ENGAGE. LEAD. MANAGING CREDIT RISK Elements of Credit Risk Management Know your customer Analyze nonfinancial risks Understand the numbers Structure the deal Price the deal Present the deal Close the deal Monitor the relationship
  3. 3. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 3 JOIN. ENGAGE. LEAD. 1 KNOW YOUR CUSTOMER • Knowing your customer is the foundation of the credit process. • You must operate on pertinent, accurate, and timely information.
  4. 4. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 4 JOIN. ENGAGE. LEAD. KNOW YOUR CUSTOMER (CONT.) • The information you gather and the relationships you establish are critical to positioning yourself as a valued financial consultant and provider of financial products and services. • Establishing a good relationship can bring a long stream of equity to your institution.
  5. 5. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 5 JOIN. ENGAGE. LEAD. • Find out as much as you can about the company and its industry prior to meeting with the customer. • This up-front exploration allows you to: – Make the most of the time that you have with the customer. – Set up an effective calling plan to guide you through the interview process. KNOW YOUR CUSTOMER: PRE-CALL PLANNING
  6. 6. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 6 JOIN. ENGAGE. LEAD. KNOW YOUR CUSTOMER: THE INITIAL INTERVIEW Elicit key information. Listen for verbal cues and watch for non-verbal cues to help establish a customer’s needs. Establish your credibility as a knowledgeable professional and friendly businessperson. Ask questions about the company’s products and services, customers, suppliers, facilities, management, ownership, and history. Develop your initial observations about management’s behavior. Start to evaluate management’s qualifications and abilities to carry out the company’s business strategy. Investigate competition, market share, and the probable impact of economic conditions on the business. Identify the company’s business strategy and what the company must do to succeed.
  7. 7. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 7 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS • Understand your customer’s business by analyzing nonfinancial risks. – Information gathered in this step is critical to positioning yourself as a financial consultant to your customer and a valued member of your financial institution’s lending team. 2
  8. 8. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 8 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) An understanding of the economic and industry factors that influence a company’s financial stability and financing requirements is necessary before evaluating the numbers.
  9. 9. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 9 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) There is risk to every line item on the balance sheet and income statement. Learn how to evaluate those risks, which fall into the broad categories of: • Industry • Business • Management
  10. 10. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 10 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS: MICRO AND MACRO LEVELS • The concept of risk management can apply to a single loan or customer relationship (micro) or to an entire loan portfolio (macro). – At the micro level, a loan is a risk. – At the macro level, a portfolio of loans is a risk.
  11. 11. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 11 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS: MICRO AND MACRO LEVELS (CONT.) • Your credit policy department will identify risk factors and query the entire loan portfolio (macro) to judge whether the particular risk is relevant to other customers of your institution. Identifying Risks • How does this identified risk affect a company’s ability to repay debt? The Key Question
  12. 12. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 12 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) Evaluation • Evaluating industry, business, and management risks enables you to ask questions of customers and prospects in order to fully identify, quantify, and possibly mitigate key risks. Critical Thinking • Evaluation develops your critical thinking skills, integrating economic, political, and market issues into the overall underwriting process. Risk Analysis • Properly analyzing these risks gives you information to help structure the loan in a fashion that will ensure the highest probability of repayment.
  13. 13. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 13 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) The focus of risk analysis is not to eliminate risk, but to understand its effect on your client’s ability to repay. Certain fundamentals of risk management have emerged as classic, time-proven strategies.
  14. 14. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 14 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) Financial institutions that have (or want to gain) a significant exposure to a particular industry usually have industry experts on both the lending and credit analyst teams. Industry experts provide an intimate knowledge of an industry and will: • Identify, understand, evaluate, and mitigate risk. • Provide expertise in the event of a loan workout situation with a customer. • Provide efficient marketing strategies in acquiring creditworthy and profitable clients within a particular industry.
  15. 15. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 15 JOIN. ENGAGE. LEAD. ANALYZE NONFINANCIAL RISKS (CONT.) The Process of Understanding Risk Identify the risk. Analyze the risk. Quantify the risk. Mitigate the risk. Monitor the risk. Anticipate unidentified risks.
  16. 16. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 16 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS There are many benefits and risks associated with establishing a banking relationship. As a lender, you should know: • How the requested funds are going to be used and how they are anticipated to be repaid. • How to identify, categorize, and prioritize all of the risks inherent with the customer that are known at the time of the analysis as well as those that are anticipated to be in existence over the period of the relationship. 3
  17. 17. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 17 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS (CONT.) Before beginning any financial analysis, it is important to understand why companies and individuals borrow money.
  18. 18. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 18 JOIN. ENGAGE. LEAD. New Clients • It is doubly important to probe into how and why the loan request originated. Established Relationships • Your assessment of the loan will be guided by your knowledge of the changes in your customer’s asset structure as it goes through its business cycle. UNDERSTAND THE NUMBERS: THE REASON FOR BORROWING
  19. 19. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 19 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: REASONS FOR BORROWING Support increased level of sales, necessitating increased funding for inventory and accts. rec. Finance inefficiencies in working capital asset management, i.e., slow down in accounts receivable or inventory turnover. Purchase of long-term operating assets or investment assets, including purchases related to merger and acquisition strategies. Make personal investments. Show more cash balances. Repay trade creditors, other bank debt, “friendly” debt, taxes, or any other liability that has come due. Repay long-term debt. Make payments for dividends and stock repurchase programs within the equity account. Pay expenses, but hopefully not unplanned operating losses.
  20. 20. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 20 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: REASONS FOR BORROWING The reason for borrowing provides you with insights into the company’s ability to repay. • A complete understanding of the historical and projected financial performance of your customer is key to your analysis. Once you are comfortable with the nature of the loan request, the process of understanding the numbers can begin.
  21. 21. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 21 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: THE PROCESS To understand the numbers: • Focus on the financial capacity of the company as evidenced by the information provided. • Examine the accuracy of the information. • Examine the quality and sustainability of financial performance.
  22. 22. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 22 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: THE PROCESS (CONT.) Balance Sheet Quality Analysis Analyze the balance sheet along with relevant liquidity and leverage ratios. Accounting Fundamentals Review the auditor’s Engagement Letter, Financial Statements, and Management Letter, as well as accounting fundamentals and generally accepted auditing principles (GAAP). Knowing the Auditor Analyze the competency and reputation of the firm or individual preparing your customer’s financial reports.
  23. 23. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 23 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: THE PROCESS (CONT.) Analyzing Financial Efficiency Cash Flow Drivers Use profitability ratios and turnover ratios to analyze a company’s cash flow drivers. Cash Flow Statement Analysis Analyze operating cash flow, investing cash flow, financing cash flow, and cash flow ratios. Income Statement Quality Analysis Analyze revenues and costs along with income statement ratio analysis.
  24. 24. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 24 JOIN. ENGAGE. LEAD. UNDERSTAND THE NUMBERS: THE PROCESS (CONT.) Company Financial Statements Analyze the company’s financial statements and provide an overview. Obviously, a small company will have a simpler chart of accounts, while a large domestic or international corporation will be more complex. Personal Financial Statement Analysis Analyze the personal financial statement and tax return in the event that you are lending directly to or seeking additional credit support from an individual. Developing Projections Determine the reasonableness of assumptions behind business fundamentals and swing factors.
  25. 25. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 25 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL: UNDERSTAND THE BUSINESS Areas to Study The nature of the business. The nature of the industry. The impact of economic conditions. The business strategy. The competencies or deficiencies of management. Before completing a financial analysis, identify the characteristics that influence a company’s success. 4
  26. 26. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 26 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL (CONT.) • Having completed the analysis of the business, you can then move to analyzing the financial reports: historical and forecasted. • Understanding profitability and cash flow, liquidity, and leverage are key to structuring the facility.
  27. 27. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 27 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL (CONT.) Once you have identified the underlying borrowing cause(s) and understand both primary and secondary repayment sources available, the next step is to structure the loan.
  28. 28. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 28 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL (CONT.) Loan structure depends on the nature of your customer’s business and how your institution intends to provide financial services to the company.
  29. 29. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 29 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL (CONT.) • Loan structure is important because your customer needs to clearly understand the boundaries within which it can operate and continue to depend upon your institution for its financial services needs. • The structure of the deal appropriately establishes your customer’s expectations for how your institution will perform during the term of the relationship. • Your customer needs this assurance in order to run the business efficiently, i.e., if they operate in accordance with the terms and conditions of the loan agreement, your customer can expect funding from your institution.
  30. 30. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 30 JOIN. ENGAGE. LEAD. STRUCTURE THE DEAL (CONT.) Structuring a Customer Relationship Project how the company will perform in the future, including likely primary and secondary repayment sources. Anticipate challenges and problems that may arise. Match an appropriate type of loan to both the loan purpose and the likely repayment sources.Develop a set of covenants that protects your institution for the duration of the relationship. Secure the credit facility with collateral. Consider requiring additional loan support, such as guarantees.
  31. 31. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 31 JOIN. ENGAGE. LEAD. PRICE THE DEAL Determining the appropriate pricing is critical. It ensures that your financial institution will be adequately compensated for the risk of the deal. 5
  32. 32. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 32 JOIN. ENGAGE. LEAD. PRICE THE DEAL: COMPLEX FACTORS DETERMINE THE FINAL RATE Interest rate risk may be managed through the use of financial futures and options. Interest rate risk mgmt. and loan pricing are highly interrelated through the pricing models. As the major source of profitability for many banks, loan interest income plays an important role in shareholder return. Commonly, loan pricing systems are based on floating rates. This pricing tactic ties the loan rate to a base rate that responds to movements of money market rates. In addition to company- specific variables, factors that affect pricing include: Marketplace in which the bank operates. General economic conditions. Matching the pricing and maturity of the bank’s assets and liabilities.
  33. 33. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 33 JOIN. ENGAGE. LEAD. PRICE THE DEAL (CONT.) Your financial institution’s finance and lending divisions, in conjunction with the ALCO, will set loan pricing and service fee strategies.
  34. 34. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 34 JOIN. ENGAGE. LEAD. PRESENT THE DEAL Communicating your findings in a cogent and professional manner is a critical step in getting your proposal approved. Credit decisions should not be made on financial statement analysis alone. A credit review would not be complete without an equally significant emphasis on the qualitative issues such as the ability of management, the competitive business environment, and the economic issues relating to the business. 6
  35. 35. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 35 JOIN. ENGAGE. LEAD. PRESENT RE THE DEAL (CONT.) Key Credit Elements Summaries & Recommendations Financial Analysis and Projections Economic & Competitive Environments Management Assessment Sources of Repayment
  36. 36. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 36 JOIN. ENGAGE. LEAD. CLOSE THE DEAL Closing the deal takes place after the analysis, structuring, and pricing have been completed. 7
  37. 37. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 37 JOIN. ENGAGE. LEAD. CLOSE THE DEAL: BEST PRACTICES • Prepare a closing memorandum or detailed loan documentation checklist.1. • Provide sufficient time for the borrower and other involved parties to gather documents.2. • Provide instructions on how to complete your standard documents to the borrower and other parties; ensure that the forms are returned to you for review prior to the closing. 3. • Prepare drafts of loan documents and deliver them to the borrower or other involved parties prior to the closing with sufficient time for the recipients to have the documents reviewed by their own legal counsel. 4.
  38. 38. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 38 JOIN. ENGAGE. LEAD. MONITOR THE RELATIONSHIP By having an appropriate structure to the relationship, agreeable to both parties, you have established a mechanism for monitoring individual transactions within a relationship. 8
  39. 39. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 39 JOIN. ENGAGE. LEAD. MONITOR THE RELATIONSHIP (CONT.) Monitoring can be accomplished in two ways: 1. Have a loan covenant checklist that routinely tracks your customer’s adherence to covenants. 2. Require that an officer of the company regularly (e.g., quarterly) certify as to the company’s compliance with all of its outstanding agreements. Note: Failure to notify your customer of a covenant default may make your institution’s future enforcement of the covenant difficult.
  40. 40. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 40 JOIN. ENGAGE. LEAD. MONITOR THE RELATIONSHIP (CONT.) Periodic reviews, ratings, and audits can ensure that the client is one that will create long-term profitability for your bank.
  41. 41. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 41 JOIN. ENGAGE. LEAD. For additional information about the credit process, visit www.rmahq.org where you can: • Find many related articles in the Credit and Lending Studies Packs. • Enroll in The Lending Decision Process for an in-depth look at the lending process and learn how to accomplish the best practices discussed in this white paper. • Subscribe to eMentor to make smarter, faster credit decisions. • Apply for the Credit Risk Certification exam. LEARN MORE
  42. 42. Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending 42 JOIN. ENGAGE. LEAD. SHARE THIS PRESENTATION Visit http://www.rmahq.org for information on risk management. RMA is a member-driven professional association whose sole purpose is to advance sound risk principles in the financial services industry. RMA helps its members use sound risk principles to improve institutional performance and financial stability, and enhance the risk competency of individuals through information, education, peer sharing, and networking. Become a member today.

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