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How to Outrun the Grim Reaper
by Jay Brew & Kyle Kuster |April 2010
Contributions by Michelle Gula
Overseeing a bank’s loan portfolio has always been a managed strategy. For many banks, the
recent experience has called attention to this issue. The balance between risk and return within
the portfolio should be established in a credit philosophy and credit culture, while closely
monitoring exceptions and loan mix.
During the mid-2000’s boom period, many banks rode the wave of rapid and contestably
irrational growth by making excessive exceptions or alternative loans to customers that would
otherwise not be originated under stricter loan guidelines. This in mind, your bank should be
monitoring loan performance against your historical trends and industry benchmarks.
Proactive Monitoring is Key
Knowing the customer and maintaining relationships are vital to providing the best financial
service experience possible for your customer. Neither the customer nor the bank wants to be
put into the situation where payments are unable to be met. When issues have occurred, many
banks have seen a move from relationship banking to recovery banking.
Rather than having a monthly contact point (the payments) and a positive relationship that
allowed the customer to achieve their financial goals, some banks are now attempting to collect
on past due loans, which is cast as antagonistic. However, there are methods to make this
process significantly less abrasive.
Proactive monitoring is key. Being proactive in monitoring your troubled loan customers will
allow you to take action as early as possible and make efforts to help the customer. Identifying
the problem earlier allows for the bank to take a variety of actions to prevent much larger
issues that may have occurred, as well as save the relationship.
Front-End Credit Analysis
Identifying problem loans should be an area of strength for community banks. Community
banks place strong emphasis on the relationship, the contact, and the desire to give back to the
community. These banks, and more specifically, their branches, have an innate ability to better
understand their local market than many of their competitors.
With this knowledge base, oversight committees and management should be able to integrate
a credit philosophy, becoming more proactive in loan origination.
Become more proactive in loan analysis and origination with front-end credit analysis. The best
practice is to have the entire relationship, including all deposit relationships. The current
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customers provide you with the greatest detail and transparency for monitoring their loans.
Having the relationship at the bank will allow for loan officers to look for patterns that may
prove as a red flag that otherwise could not have been detected.
Closely Monitor Exceptions and Loan Mix
Generally speaking, it is not the policies put in place creating the problems, but the exceptions
and failure to produce a loan mix that is in line with the strategic direction of the bank and its
desired level of credit risk. For example, a bank may originate a loan with a loan to value of 85%
rather than the stated policy of 80%, or allow origination of a loan with limited documentation.
These examples of exceptions may be perfectly reasonable, but should be monitored closely. It
will also be important to weight the exceptions based on the volume of each loan rather than
the total number of exceptions.
The other main issue is found in the loan mix, which may have shifted from a conservative
balance. Currently, the national benchmark group of community banks has an 11.35% level of
construction and development loans on their portfolio. This risk did not provide the proper
level of return. To mitigate the risk within construction and development loans, much of the
industry will need to shift this mix to a lower level going forward. We believe that a 5% level of
construction and development loans should be the target for the future, based upon past
historical performance of this loan type.
Impact of Proactive Loan Management Strategy
The graph below shows the national average of net charge-offs as a percentage of total loans.
The other two lines show what a reduction of 25 and 50 percent in charge-offs would look like.
As you can see, the effects to the bottom line can be significant during periods of high loan
delinquency.
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Considering all things equal, the graph depicts the impact of a more proactive loan
management strategy and the establishment of a credit philosophy. The graph also could
represent an institution’s ability to move from one NCO level to another. A shift down from the
national average could show that a particular institution learned from previous lending
practices. The opposite may be true for a bank that felt they were comfortable taking on new
risks, which resulted in loan charge-offs.
Take a look at your loan portfolio, and it is easy to see the potential costs from the nearly 150bp
spread in the fourth quarter between what could be considered a more proactively monitored
loan portfolio and the national average.
The following graph shows industry-wide loan loss reserves as a percentage of total loans, while
comparing those results with the net charge-offs. Banks have consistently had to balance the
demands of regulators and auditors. While regulators wish to see reserves increase, auditors
feel banks are “shoring up” their balance sheets when boosting levels of reserves. The key is to
manage the loan portfolio to reduce net charge-offs and let loan loss reserves remain
untapped. This keeps the protective buffer of reserves, reducing overall risk.
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The key to your credit philosophy is tied heavily to the level of proactive management as well as
properly mitigating origination risks through sound research, analysis, building total
relationships, and documentation.
Re-evaluate Credit Philosophy
So, the time has come to re-evaluate your credit philosophy and culture. It is important to view
yesterday’s and today’s issues as an opportunity to learn and to adjust policies and credit risk. It
is important to use the lessons learned to mitigate future risk through a review of the bank’s
credit philosophy and how it could be improved.
It is also important to carry through this credit philosophy by constantly and consistently
announcing that the bank is lending to your community in a safe and sound manner.
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