Lending environment changes, room for a PD Model
Starting with the financial crisis, there has been a decided shift in the lending environment. Banks and credit unions with commercial lending have turned away from Commercial Real Estate loans (CRE) in favor of Commercial and Industrial Loans (C&I). If the C&I portfolio is well managed, it can be a lucrative opportunity since demand for this type of loan is increasing and due to the risk that was exposed among CRE portfolios during the financial crisis.
Given increasing demand, financial institutions might be tempted to loosen credit terms so that they can remain competitive in the aggressively competitive market. If standards are relaxed, or even if they aren’t, regulators are concerned that financial institutions that enter into or expand their C&I portfolios will do so without ensuring that they have the appropriate credit risk management processes in place. The result could be inefficient covenants or analysis at origination or improper monitoring during loan review.
In order for banks to approach C&I lending conservatively, there are few processes they should revisit:
1. Review existing underwriting policies to ensure they incorporate appropriate commercial standards. What financial statements are required for review, how often? What expectations are there for a global cash flow analysis?
2. Update your board, lenders and credit analysts so their expectations align and so they understand your recently reviewed commercial underwriting policies. Sound policies are only sound when the involved parties understand what is involved and can execute.
3. Reevaluate concentration limits and your institution’s risk appetite. This is a banking strategy discussion that needs to happen at the board and executive level. Ideally the bank will stress the portfolio so management can accurately assess what will happen given a change in certain parameters. With that information, bank management can appropriately change concentrations or behavior to ensure that risk remains within a reasonable threshold.
4. Invest in technologies or experience. If your lenders or analysts are less experienced with this type of loan analysis, consider investing in either a software program that will standardize credit analysis or outside training. For example, a spreading software could simplify analysis and get analysts out of a spreadsheet-based program. Or, a probability of default model that identifies private-company risk could help analysts acquaint themselves with new segments or industries. Similarly, a PD model that can be used at the portfolio level can augment the strategy discussions mentioned in (3). A PD for the portfolio can be systematically stressed to make objective risk tolerance decisions.
For more tips on evaluating the risk of C&I loans and navigating the changing future of the lending environment, check out this free whitepaper: Shifting Credit Concentrations: 6 Ways to Prepare