Business Analytics is Part of the Full Lending Performance Cycle

On several occasions I’ve spoken about the “Full Lending Performance Cycle” (FLPC). This cycle is comprised of several steps aligned with the origination process and aftermath when evaluating a portfolio. One tool for evaluating the portfolio is business analytics. As CECL adoption comes closer to reality, the lending process becomes even more interconnected. For simplicity purposes, the FLPC is comprised of several disciplines.

Underwriting

In order to maintain a sound credit portfolio, a financial institution (FI) must have an established formal transaction evaluation and approval process. Approvals should be made in accordance with the FI’s written guidelines and granted by the appropriate level of management. The FI could utilize specialist credit groups or individuals to analyze and approve credits related to significant product lines, types of credit facilities, and industrial and geographic sectors. FI’s should invest in adequate credit decision resources so that they are able to make sound credit decisions consistent with their credit strategy.

Monitoring

FI’s should have in place a system for the ongoing administration of their various credit risk-bearing portfolios. Credits to related companies and individuals must be monitored with particular care and other appropriate steps taken to control or mitigate the risks. An effective credit monitoring system will include measures to:

• Understand the current financial condition of the borrower or counterparty
• Monitor compliance with existing covenants
• Assess collateral coverage relative to the obligor’s current condition
• Identify contractual payment delinquencies and classify potential problem credits on a timely basis
• Direct any problems for remedial management
• Risk Assessment

FI’s should consider a wide range of data when applying CECL accounting models. Information considered should be relevant to the assessment and measurement of credit risk to the particular lending exposure being assessed. This data should be reasonable, supportable, and include information about past events, current conditions and forecasts of future economic conditions. FI’s should use their experienced credit judgment in determining the range of relevant information.

Forward-looking information, including macroeconomic factors, is a distinctive feature of CECL accounting frameworks and is critical to the timely recognition of risk. FI’s will have to employ sound judgment consistent with generally accepted methods for economic analysis and forecasting. As credit risk management is a core competence of FI’s, they must now consider forward-looking information which can be supported by a sufficient set of data. The extent to which forward-looking information, including macroeconomic factors, has been integrated into existing methodologies meaning a broader range of data will need to be considered.

Pricing

Systematic loan pricing is primarily driven by the FI’s profitability objectives outlined by management. In a competitive environment, these profitability objectives have become more difficult to obtain or there has become a willingness to accept less in order to fill balance sheet demands. As products become more commoditized, spreads will continued to narrow.  If you consider the key drivers in pricing, invariably one of those drivers have been compromised to the benefit of added production. Those drivers include: interest rate, cost of funds, G&A expenses, and risk applied. Risk as defined in the incurred loss method invariably has been compromised. That will no longer be the case with the introduction of CECL. While the incurred loss rate did relate to credit performance in the past, the performance cycle defined in the valuation could be narrowed and/or widened to allow for more aggressive pricing.  CECL will force the FI to not only look at past performance cycles but now must look through the life of the loan based upon reasonable and supportable projections. Once implemented and full adopted, the ongoing adjustments from CECL to the credit risk parameters will be automated and the ability to circumvent pricing will be lessened.

Analytics

Analytics can be designed to address portfolio trends through analysis. An FI can gain a deeper understanding of its customer portfolio and what characteristics drive their profitability. As noted earlier, the transitioning criteria from the incurred loss method to CECL will include evaluating new originations based upon macroeconomic indicators. These indicators can be imbedded into the analytics criteria and provide insights of a portfolio’s health. By identifying what products and services should be promoted and applying sound analytics, the institution can align strategic decision making and by more accurately targeting the combination of products and services with the greatest potential to improve profitability and mitigate risk. Analytics can provide the framework for assessing the risk to be applied as a key driver when pricing a loan and a guide for strategic direction.

With the adoption of CECL while evaluating the full lending performance cycle, each discipline within that cycle become more inter-connected. Analytics becomes a critical piece that financial institutions will be using to assist in identifying performance and profitability. Where in the past, analytics may have been considered primarily for marketing purposes, strategically leveraging analytics can prepare the financial institution for future profitability and avoid severe downturns.

Author Bio

John Robertson is part of the Advisory Services team at Baker Hill, specializing in pricing and profitability. With 26 years of experience in the banking industry, Robertson assists banks in developing and implementing technology for commercial lending that improves the efficiency of the lending process and the productivity of the lending officers. As a Senior Business Process Architect for Baker Hill’s Advisory Services, Robertson provides guidance to Baker Hill’s clients on profitability, specifically with strategies involving risk-based pricing and relationship profitability.

Prior to joining Baker Hill, Robertson served in various roles related to cash management, treasury, and asset/liability management. Previously, he served as assistant treasurer for three banks and was a member of various asset and liability committees. Additionally, Robertson has developed and implemented several programs during his banking tenure including a pricing and profitability system, a secondary marketing department and a treasury management group.

Robertson received his bachelor’s degree in business administration and accounting from the University of Houston.