Risk Management: How Regional and Community Banks Can Survive and Win in the Credit Cycle Game

Article excerpt

In May 1998, the authors participated in a panel discussion on risk management at a conference on emerging issues for bank examiners, sponsored by the Federal Financial Institutions Examination Council. Loretta Fansler addressed changes in underwriting at the community bank level and Dev Strischek addressed these changes at the regional bank level. This article, based in part on that presentation, also shares excerpts from two recent RMA-sponsored studies, Winning the Credit Cycle Game: A Road Map for Adding Shareholder Value through Credit Portfolio Management and Beating the Odds: A Community Banker's Guide to Risk Management. The article emphasizes the latter study, to draw on both studies' observations of best practices in risk management that could and should be implemented now. While the article focuses on the needs of the community and regional banks, the observations are applicable to banks of all sizes.

RMA and First Manhattan Consulting Group surveyed 64 banks with more than $5 billion in assets to learn the best traditional and advanced risk management portfolio practices in use today. Some specific practices revealed by the survey and published in Winning the Credit Cycle Game: A Road Map for Adding Shareholder Value through Credit Portfolio Management (WCC) are in the following areas:

Business strategy. The more successful banks set more flexible risk limits and tend to develop solutions for poor market pricing. They give more proactive guidance to relationship managers on credit exposures that are to be retained in the portfolio.

Risk grading. The better practitioners grade more quantitatively, and even subjective factors, such as management quality, are scored and weighted in the final mix. These bankers assign more pass grades, some as high as 19, with reference to external models. The wider grade range allows them to assign credit costs to each risk grade more precisely.

Risk pricing. Eighty percent of the more advanced banks systematically calculate required risk-based prices, compute line-of-business and customer risk-adjusted returns on capital, and then use the information in organization and customer sourcing.

Portfolio grooming. Advanced practitioners diversify risks among loans they hold on the basis of correlation-adjusted, portfolio wide measurements. They frequently buy loans that diversify their portfolio or create a better return on the risks assumed.

Management. Better banks replicate bond market credit processes. A lender advocates a loan to the portfolio manager, who then purchases the loan for the bank's portfolio, facilities its sale to others, or declines the loan. The credit group oversees the process to ensure it is appropriate and that the credit grades are accurate. A credit committee organization emerges that approves and reshapes strategies recommended by portfolio managers.

The Community Bank

Beating the Odds: A Community Banker's Guide to Risk Management (BTO) is the result of an RMA/Verrone Consulting Group survey of 126 U.S. community banks. The OCC definitions for risk management (Figure 1) and those of a community bank were used. Community banks generally have less than $1 billion in assets. Banks with total assets of $1 billion to $5 billion, possessing community bank risk profile and designating themselves as community banks, also were included in the survey. Risk management practices were gauged and some how-to's for community banks were developed. Eleven of the observations made arc shared here.

Risk grading and state of risk. Most community banks (70%) assign one single grade for commercial and industrial (C&I) and commercial real estate (CRE) loans to a borrower that reflects both the risk of the obligor and the risk of the facility. Further, community banks have relatively few pass grades, and these usually are concentrated in one or two grades [ILLUSTRATION FOR FIGURE 2 OMITTED]. …


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