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What is effective challenge?

Thomas Curley
July 12, 2018
Read Time: 0 min
Alison Trapp

By Alison Trapp

Senior Consultant, Sageworks Advisory Services

Effective challenge is a framework for providing critical analysis, and it is a critical component of risk management for an institution, model or practice. Effective challenge involves utilizing objective, informed parties who can identify limitations and assumptions and who can produce appropriate changes. The goal of effective challenge is to ensure that key risks are not ignored. This does not mean listing every possible thing that could go wrong, but rather identifying what could put the organization at risk.

How can effective challenge support growth?

At financial institutions, there are three roles that provide lines of defense for the loan portfolio that enable the effective challenge: loan officers, credit analysts, and loan review. Each staffer plays an important role in creating a culture that balances risk and growth.

The first line of defense is the lending function. A loan officer’s mindset generally leans toward growth, making it all the more important for her to understand which loans fit the institution’s credit profile. Knowing how potential loans fit into the institution’s overall goal helps her not spend time on transactions that are very unlikely to be approved.

The second line of defense is the credit function. Credit analysts are more focused on risk management than growth. This alignment makes it more difficult to see how their role can support asset growth. However, growing the portfolio prudently can be just as valuable to a financial institution. By taking a judicious approach to lending, growth is more stable and there is more of a long-term return.

The third line of defense is the loan review function and is clearly more on the side of risk management on the scale of growth vs. risk. Effective challenge in this context means helping the bank manage its portfolio risk. Supervisory entities recognize that financial institutions must take risks and expect them to manage those risks. Done well, the third line of defense looks like healthy debate around risks inherent in individual transactions and the portfolio strategy as a whole.

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When does effective challenge happen?

Ideally, effective challenge is embedded into the bank’s mindset such that there is not a “challenge phase.” It should be part of how business is done. This ideal can be difficult to achieve. Organizations can encourage this behavior through roles and responsibilities, proper incentives for different roles, and company values that highlight partnership while maintaining healthy debate.

How can information systems promote effective challenge?
  • Make approval more efficient to allow time for challenge
  • Provide regular reporting to monitor policy and underwriting exceptions
  • Evaluate portfolio data to determine samples for targeted exams (See more info here.)

Growth is easy. Prudent growth, however, relies on a combination of lines of defense to ensure that the loans a financial institution makes are grounded in the principles of safety and soundness. An organization run solely by lenders likely would have losses beyond its capital adequacy within a fairly short time period. One led solely by credit or loan review likely would never make loans at a high enough risk level to be able to make profits and stay in business. Both sides are needed and can be used to support growth. While it can be difficult to develop an environment that supports effective challenge, the benefits make that effort worthwhile.


About the Author

Thomas Curley

Senior Marketing Manager

Full Bio

About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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