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Building a strong credit culture

Feb 19, 2023

Building and maintaining a strong credit culture at your financial institution is no easy task. But that culture will go a long way in affecting the long-term success, or lack thereof, of your organization.

The COVID-19 pandemic brought with it plenty of stresses as lenders navigated various challenges and solutions. However, banks are coming out of a period in which credit losses are at historic lows, and problem loan reports and watch lists are about as small as they ever were.

Most lending institutions ended 2022 in a strong capital position (notwithstanding unrealized losses in the securities portfolio) with minimal credit issues, regardless of the strength of the institution’s credit culture.

However, current economic uncertainties are a reminder of the need to revisit your lending approach. Your institution needs a strong credit culture to weather volatility in market conditions and the economy going forward.

Here are the key components of a strong credit culture and some changes you may need to adopt to build yours.

An effective loan policy

It starts with an effective, well-defined loan policy. This is not a one-size-fits-all document. The policy should be tailored to the institution based on the local area and economy, as well as the characteristics of your institution: size, strength, expertise, types of lending offered and the borrowing needs in the local economy.

This policy document should provide for effective supervision by senior management and the board of directors. It should not be a static document and should be reviewed and approved on an ongoing basis as the circumstances of borrowers, the economy and the institution itself change. The policy also provides guidance and outlines expectations for loan officers and staff.

Careful underwriting

Gone are the days of the handshake loans with minimal to no underwriting. Effective loan underwriting is critical in understanding the risks in a borrowing relationship. Detailed underwriting and risk analysis will help management determine whether the level of risk in each credit application is acceptable given the expected reward.

Effective loan underwriting analyzes and discusses the five Cs of credit: character, capacity, capital, collateral and conditions (and some also add control and common sense). In most instances, underwriting is performed by the credit department, providing a view independent from loan production — although in some smaller institutions this may not be possible due to limited staffing.

Credit personnel should be knowledgeable and well-trained to provide the proper analysis and uncover the risks lurking within a credit and loan request and be able to effectively articulate any concerns held by internal staff, the credit committee, board of directors or others.

A grading matrix

To determine and quantify the level of risk in a credit application, a clear, measurable and objective-based loan grading system should be used. A grading matrix is a great tool to assist in determining the proper loan grade and helps provide consistency in grading throughout the organization.

While a perfect grading matrix does not exist, these key objective criteria carry the most weight:

  • Debt service ability
  • Collateral coverage
  • Leverage
  • Liquidity

Other criteria — including industry, type of collateral, guarantor strength and payment history — also matter but are typically weighted less.

Once the matrix determines the score, consider whether it seems appropriate. If it doesn’t, an adjustment to the weightings or risk factors should be considered, and an adjustment may be appropriate.

Possible reasons for an adjustment might be the sudden loss of a significant customer or the untimely death of an owner or key employee.

A grading matrix is not a one-size-fits-all tool. The expectations for a commercial real estate credit may be different than a commercial and industrial credit. Underwriting and grading an agricultural borrower would not be the same as it would for a construction or development borrower. An institution may want to consider having three or four (or even more) different grading matrices in its arsenal.

A diligent credit committee

The credit committee reviews new credit requests as well as previously approved and funded loans not just for approval but also to ensure the depth and detail of the credit underwriting and analysis is commensurate with the subject request. Is the type and structure of the loan appropriate and within policy parameters as dictated by senior management and the board? 

If there are exceptions to policy, are they appropriately mitigated so the level of risk in the credit is reasonable given the risk appetite of the institution? The credit committee is also frequently a learning opportunity for junior personnel to become further immersed in the credit culture of the institution.

Proper credit administration

Another important but often overlooked part of the credit process is loan documentation and administration. This effort includes pre-lien searches, proper titling, approved terms and conditions and accuracy of documentation. Proper checks and balances and review of loan documents are needed prior to closing. It is too easy for something to slip between the cracks due to pressure from a loan officer, borrower or attorney, as well as myriad other distractions that administrators must face.

After the loan is properly booked and funded on the system, there may be follow-up filings and post-lien searches.

Thorough portfolio management 

Effective loan portfolio management is imperative. More than just monitoring payment performance, it involves keeping in touch with the borrower performing a site visit, if appropriate. The institution may need to obtain and review periodic financial reporting from the borrower and/or guarantors as required in the loan agreement.

Check whether the financials raise any red flags or trip any covenant requirements. If so, investigate and find out why. Do not wait until a loan becomes past due to raise concerns with the borrower.

Effective loan portfolio management goes beyond individual loan monitoring. Is the level of risk in the portfolio changing and, if so, why? Stress testing is an important tool in determining the potential risk in individual credits as well as the portfolio.

Concentration levels need to be monitored. Are the various loan types within the concentration parameters outlined in the loan policy? If not, what is the plan to return to the policy threshold? Are those threshold levels still appropriate? If exceptions are made to the policy, consider whether the level is appropriate and be sure the exceptions are being tracked and reported to senior management and the board.

Another important aspect of loan portfolio management involves the management of problem loans. Even an institution with a strong credit culture will have the occasional hiccup. The question becomes how does the lender deal with the hiccups. The earlier the loan officer can identify a potential problem, the easier it is to consider more potential solutions.

Many pieces must come together to build a strong credit culture. For management to be diligent in its oversight, having the right people in place is critical. The quickest route to financial decline for a lender is to allow complacency to take hold in any critical aspect of the lending process.  While every loan is a good loan at the point of origination, a strong credit culture improves the chances it remains so.

How Wipfli can help

At Wipfli, we are tuned into the concerns of financial institution clients on underwriting risks. The appropriate policies help build lasting relationships and create a positive impact. Our team’s seasoned lending professionals are ready to provide guidance on best practices and help your organization achieve its goals.

Contact us today, so that we can help gain confidence in the integrity of your loans.

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Eric E. VanDoren, CRC
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