Enhancing Credit Decisions with Risk Data
This article shows how incorporating risk data elements improves origination workflow by providing a higher degree of accuracy in decisions, better assessment of total risk exposures, improved compliance, and greater control over pricing – both from a data consolidation and monitoring perspective.
In striving for higher operational efficiencies and tighter alignment with regulatory compliance needs, lenders are seeking end-to-end origination solutions with a high degree of automation. As spreads remain tight for most lenders, ensuring a low cost of ownership and future longevity play critical roles in determining any investment in origination platforms. These platforms must support increasingly dispersed and complex business organizations.
The first step is to provide standard business functionality with configuration capabilities for different business lines, products, counterparty group structures, and legal entities. This helps to standardize data throughout the process and cuts costs by streamlining operations and eliminating redundant systems. Use of this approach alone, however, fails to consider the shift in focus of lending activities from purely credit decisions to a credit risk-based decision, and thus prevents credit managers from becoming risk intelligent.
As banks become more complex and diversified, aggregating information and total exposures for their borrowers also become increasingly complex. Pressed by the need to monitor and mitigate risks across boundaries – both for compliance and profitability targets, banks look to push through the risk strategy decisions made at head offices to their front lines, where loan applications and borrowers are routinely assessed. Positioning risk as the overseer and gatekeeper for every step of the origination process may afford credit and business teams with higher levels of efficiency, by ensuring that the right people make the right decisions at the right time.
In a 2013 CEB Tower Group poll of Commercial Banking, 79% of executives reported that it is critical or highly important to maximize their credit application, approval, and booking rates. A similar proportion reported that it is equally important to protect the credit portfolio from balance runoff and underutilization.1
LOAN ORIGINATION PROCESS PHASES
Commercial loan origination is comprised of several steps that require seamless transition and a built-in approval and monitoring mechanism. Segmenting the activities into three phases helps explain how incorporating additional risk data into each phase improves the transparency, accuracy, and timeliness of credit decisions. It also ensures that a loan portfolio is diversified in accordance with the level of risk undertaken.
Figure 1. Loan origination incorporating risk elements
Source: Moody's Analytics
- Counterparty management
- Risk profiling
- Limits & exposures
- Concentrations & diversifications
- Risk-based pricing
- Decision routing
- Compliance checking
- Monitoring & alerts
- Mitigants & collateral perfection
Phase 1 – Counterparty, Portfolio, and Account Monitoring
Risk plays a critical component in the first phase of the origination process. A thorough examination of the existing and potential future borrower relationship, limits, and exposure is required not only from a sound business and economic perspective, but also to satisfy various regulatory guidelines (e.g., the Risk Data Aggregation principals as issued under BCBS 239). Introducing pre-qualification risk data such as pre-scoring, minimum acceptance criteria, and risk filters early in the process allows a bank to vet the borrower as meeting initial credit policy and regulatory acceptance criteria. Similarly, the incorporation of rating tools that require minimum spreading will further complete the borrower picture.
Enhancing risk helps to ensure compliance with the bank’s credit policy in terms of loan portfolio concentrations in, for example, particular industries, geographies, currencies, borrowers, or loan types.
As banks reinforce the organization’s risk policy on the front line, it is important they introduce risk data as early in the origination lifecycle as possible to confirm that each loan passing through each phase in the process is qualified. This will guarantee the accuracy of the sales pipeline, and reduce the cost and time of origination by ensuring that the maximum number of loans that start origination reach booking.
In a 2013 CEB Tower Group poll of Commercial Banking, 79% of executives reported that it is critical or highly important to maximize their credit application, approval, and booking rates. A similar proportion reported that it is equally important to protect the credit portfolio from balance runoff and underutilization.
Phase 2 – Origination and Credit Analysis
The origination, underwriting, and credit analysis steps provide ample opportunity for risk management to enhance the loan origination process. A traditional credit-based approach determines a borrower’s potential to default through financial analysis, and calculates risk metrics, such as debt service coverage. However, borrowers are interconnected through a maze of financial and legal relationships. A better approach would take into account the borrower hierarchy, relationships, exposure, covenants, financials, and risk metrics to aggregate total risk. Armed with this comprehensive view of the borrower risk profile, lending banks have the opportunity to streamline operations by routing different loans to different work queues (e.g., auto-decisions, level one decisions, credit committee decisions), while still understanding the risk implications of each new loan.
Banks further need to adopt pricing mechanisms that allow them to realize competitive advantages and avoid disadvantages based on the credit policy of the bank. Portfolio risk-based pricing enables banks to price their loans by taking into account the loan portfolio concentration and diversification strategy they would like to achieve. In the highly competitive loan market with tight margins, portfolio risk-based pricing would also help financial institutions acquire new customers from targeted sectors at competitive rates other banks could not afford. The banks’ risk-diversified portfolio composition would ensure that the new transactions meet minimum performance metrics like risk-adjusted return on capital (RAROC) and Sharpe Ratio at both transaction and customer levels.
Phase 3 – Credit Decision and Due Diligence
In Phase 3, banks analyze and verify the credit and risk data gathered throughout the origination process. At this stage, banks must reinforce their understanding of the proposed risk in terms of subordination, covenants, collateral, and off-balance sheet liabilities. Collateral valuation and allocation must be monitored throughout the life of an exposure and any insufficiency immediately alerted. Similarly, ongoing exposure management and limit checking must ensure that the proposed structure is in line with the overall portfolio allowable limit structure and notify of potential breaches at any level. Automated tracking processes must be natively linked to financial statements to detect early warning signs about the borrower. Covenant conditions that have been defined during the origination process must be included in loan documentation and checked against new facilities. Credit decisions must be transparent and auditable at all stages.
Enabling risk alerts throughout the end-to-end origination process will allow rejection indicators early in the process, which saves banks time and money. Overlaying risk alerts also secures a higher conversion rate of successful opportunities progressing through the origination process.
Improving origination workflow with risk data
This article discussed how incorporating risk data elements improves the origination workflow by providing a higher degree of accuracy in decisions, better assessment of total risk exposures, improved compliance, and greater control over pricing – both from a data consolidation and monitoring perspective.
As banks become more complex and global, aggregating global information and total exposures for their borrowers becomes increasingly challenging. Banks must monitor and mitigate risks across boundaries to meet compliance and profitability targets. They look to push risk strategy decisions made at their headquarters into locations where loan applications and borrowers are routinely assessed. A risk-based approach to credit decisions provides this capability.
“We’re seeing a shift from focusing on cost reduction to improving efficiencies and better portfolio and risk management,” confirms Joanne Pollitt, Practice Manager CEB TowerGroup Commercial Banking.2
Many banks rightly invest in origination system consolidation and upgrades in order to reap the cost and other benefits discussed in this article. By overlaying risk as the gatekeeper and overseer of the loan origination process, these banks can make the right decisions at the right time.
A CASE STUDY
A top 50 US regional bank implemented a Commercial Loan Origination (CLO) solution to address several challenges arising from the complexity of its commercial lending process. As with many institutions today, it wanted to improve the overall risk management of its portfolio by creating consistency in the underwriting processes and achieving better overall credit quality in the loan portfolio. For customer management, the bank focused on reducing the loan processing turnaround time and increasing the time relationship managers spent on customer-facing business development activities versus loan processing activities. Improving the efficiency of loan processing and reducing associated costs through the use of automated workflows, as well as triggers and analytics, were also primary objectives of the initiative to modernize their commercial lending lifecycle. The bank was able to achieve improvements that included:
- A 24-hour turnaround time for new small business credit applications.
- 80% reduction in paper used in the loan application.
- Lower costs and more standardization and consistency of the documentation. The centralization of loan documentation to a back office function eliminated the need for relationship managers to process loan documentation.
1 CEB TowerGroup, Commercial Banking Survey, 2013.
1 CEB TowerGroup, Strategies to Address Risk Management in Commercial Lending, 2013.
Creates credit assessment and origination strategies and supports commercial loan origination and risk management objectives.
Develops analytic and empirical models, and trains and advises clients worldwide on enterprise risk management, asset and liability management, and stress testing.
Across 35 years in banking, Blake has gained deep insights into the inner working of this sector. Over the last two decades, Blake has been an Operating Committee member, leading teams and executing strategies in Credit and Enterprise Risk as well as Line of Business. His focus over this time has been primarily Commercial/Corporate with particular emphasis on CRE. Blake has spent most of his career with large and mid-size banks. Blake joined Moody’s Analytics in 2021 after leading the transformation of the credit approval and reporting process at a $25 billion bank.