Part 2 Reason one Unfortunately, there is a management issue regarding their transparency with the investment community and/or client base.  Regrettably for the managers and leaders choosing this approach, if this problem persists too long, the organization may choose to rectify with a change in the management and leadership Reason two The solution is both simple and complex.  In simplistic terms, the financial institution must evolve its portfolio risk management reduction techniques and take a more proactive stance.  Both internal and external data exists that can provide significant insight to the portfolio, its trends and potential future loss. Such data sources include: Internal behavioral characteristics (negative changes outside of just delinquencies) High line usage Non sufficient funds frequency & severity (for those borrowers who also have a deposit account with the institution) Deposit account closuresExternal data Regular rescore of the borrowers (both small business and consumer) Derogatory payment trends with other creditors (the borrower may be current with you but for how long?) Judgments or liens Such data can be used to create models for portfolio performance calculating: Delinquency trends by score (as the portfolio trends up or down in the score ranges we can adjust the expected loss rates, delinquency rates, etc.) Within score ranges and based upon other behavioral characteristics, what is the likelihood for charge-off or recovery. The biggest takeaway is that these portfolio management techniques are not new and untested.  Your data provider (such as Experian), has used these techniques and has the data to support the effectiveness.  While we are in trouble, we may find ourselves wanting to keep the “dirty secrets” to ourselves.  Too often such an approach leads to one’s demise.  Seek information, seek help, get control and truly start to move in a positive direction.

“Unprecedented times”, “financial crisis”, “credit crisis” and many other terms continue to be buzzwords that we hear every day.  We are almost becoming desensitized to the terms, yet we feel the impact on a daily basis.  Everyone is waiting for some positive news in the financial services industry and more bad news keeps coming. Each quarter we continue to read about financial institutions claiming that the worst is over. They have recognized the risk in their portfolios through risk assessment, set aside adequate reserves or loan loss allowances and are now ready to turn the corner.  Yet we continue to read about these same institutions coming back with more bad news, more credit losses and a restatement of the assurance that the problems have been recognized. As a result, this financial risk management has brought to light all of the high-risk accounts and the trend will begin to change. Why does this story keep repeating itself? Reason one  Management assesses to what extent the market (both stock market and the client base) will tolerate the level or degree of bad news, recognize losses to that extent and will then work hard to try to correct any known issues before we actually have to report the next quarter.  Unfortunately, this approach simply delays the inevitable and brings into question the risk management practices of the particular institution.  Like the boy who cried wolf, the more times you make a statement and it proves to be false, the less likely you will be believed the next time. Reason two The financial institutions are actually surprised each quarter with a new batch of credit losses.  The institution, its credit management team and workout areas are diligently trying to address the current problem. But, just when they start to see the light at the end of the tunnel, a new batch of credit problems arise.  For the most part, the credit issues still persist in the high-volume, low-dollar credits such as residential mortgages, home equity loans, automobiles, credit cards and small business loans.  Due to the sheer volume of clients/loans, it becomes more difficult to assess what issues may be brewing in the portfolio.  For the large volume, small dollar portfolios, the notion of a pending credit issue comes when the delinquency starts to rise to a delinquency of 60 or 90 days. The real issue is identifying those accounts that are likely to go 60 or 90 days past due and then assess the likelihood that they will go into charge-off. Regardless of the reason, we have a “credibility” problem in addition to a “credit” problem.

It seems to me that there remains quite a bit of dispute and confusion around the inclusion of healthcare providers under the umbrella of "creditors." This would, in turn, imply that a physician's office would need to have a Red Flags Identity Theft Prevention Program in place.  Yikes!  My guess is that this will not be fully resolved by May 1, 2009.  I see too many disparate opinions out there to think otherwise.  I certainly see both sides.  On the one hand, the definition of "creditor" to include "deferred payment of debts" does make the case for most physicians’ offices to be covered under the rule.  On the other hand, to what extent will each and every physician's office be able to have a verification process in place by May 1, 2009?  Certainly, those offices integrated with third party processing will have an easier go of it, but the stand-alone practices are facing a tough challenge.    There is no doubt that the healthcare space is, and should be, covered under the Red Flags rule, I just have to wonder how comprehensive and enforceable compliance will be.  Let me know your thoughts!

During a recent real-time survey of 850 representatives of the financial services industry: only 36 percent said that they completely understood the new Identity Theft Red Flags Rule guidelines and were prepared to meet the deadline. 60 percent said that they had just started to determine their approach to Red Flag compliance.

By: Tom Hannagan Part 3 This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. I mentioned before that the second general major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial. I thought it might help put this into perspective by offering rough numbers that relate to risk-adjusted profit performance, bottom line earnings and expand on the premise that risk has a cost. Lending, in the leveraged/banking sense, involves credit risk, market (interest rate) risk and operational risk. The fourth area, the risk of unexpected loss, is covered by capital. Unmitigated risk will eventually impact earnings and common equity.  The question is when and by how much? It’s important to understand that the cost of risk mitigation efforts depend on the various risk characteristics of the bank’s loans and loan portfolio. The differential cost of market risk As an example, a floating rate loan that reprices every month involves little market risk, requiring little if any expense to offset. Compare it to a five-year fixed rate, interest-only loan that involves greater exposure to market risk. That risk costs something to offset. The difference in annualized marginal funding cost ranges widely depending on the steepness of the yield curve on the date the loan is closed. The difference between Federal Home Loan Banks 30-day rates and five-year bullet funding today, for instance, is close to 200 basis points. If risk-based loan pricing models don’t reflect this difference by using a matched marginal funding cost, the bank is voluntarily assuming some or all of the market (or interest rate) risk. Multiply an implied 200 bps risk-based funding cost difference by $100M in average loan balances and the implied annualized additional risk-free funding expense is $2,000,000. Multiply that by the average life of the portfolio to get the full risk-adjusted cost difference that the bank is assuming. And that’s just for the market risk. The implied cost of credit risk A loan with a pass risk rating of ‘2’ involves a lower likelihood of defaulting than a loan with a pass risk rating of ‘4.’ The lower risk (grade 2) loan, therefore, involves less of an Allowance for Loan Lease and Losses reserve requirement and an implied lower provisioning expense than the higher risk (grade 4) loan. Depending on the credit regimen and net loss experience of a given bank, the difference in the implied annualized expected loss due to credit risk could be 40 bps or more. Multiply the implied 40 bps credit risk cost difference by $100M in average loan balances and the implied annualized additional risk-adjusted credit expense is $400,000. Multiply that by the average tenor of the portfolio to get the full risk-adjusted cost difference to the bank. The implied difference in administrative (or operations) expenses These expenses include all mitigated (insured) operational risk. An owner occupied commercial mortgage is normally much less expensive to monitor than a line of credit backing a construction project. Those cost differences often range into several thousand dollars per annum. If, in our example of the $100M portfolio, our average credit is $400K, then we have around 250 loans. These loans multiplied by $3,000 in fully-absorbed annual non-interest expense differences would amount to $750K. A competent risk-adjusted loan pricing effort would take this cost difference into account. Again, multiply that yearly amount by the average life of the portfolio to get the full cost difference that the bank is incurring. In reality, the three sample portfolios above would not overlap perfectly. The total actual assets from the above examples would lie between $100M and $300M. However, the total pretax cost difference of these three sample risk-based costs adds up to $3.15M per annum. The after-tax negative impact on risk-adjusted earnings is therefore about $2M yearly. So, the impact on ROA would be between 2.00% (if the three portfolios overlapped perfectly, for $100M in total assets) down to .67% (if there was no overlap, for $300M in total assets). This is a huge difference in earnings, on a risk-adjusted and fully cost-absorbed basis. Finally, the amount of risk-based capital needed to back loans with differing risk characteristics, for purposes of unexpected loss, can be substantially different. This can be looked at as a difference in the implied cost of capital or in the performance ratio of ROE. In a simple application, the implied required equity might range from say 6% on the lower-risk loans up to 8% for moderate risk (average pass grade risk rating). If the portfolio in question is earning 1% ROA, the difference in risk-based equity would result in an ROE of either 12.5% for the higher risk loans versus 16.7% for the lower risk loans. The differences in fully risk-based ROE, or RAROC, could easily be more dramatic than this. As stated before, if these differences are not “priced” into the loans somehow, the bank is not getting paid for the risk it is incurring or it is charging the lower risk borrowers a rate that pays for the added risk expenses of the higher risk borrowers. The business risk to the bank then becomes losing the better clients over time rather than attracting the riskier deals. An economic look at performance We are not talking in terms of “normal” accounting practices or “typical” quarterly reporting periods. We do use general ledger numbers to start the analysis process by relying on actual balances, rates and maturities. But, GAAP doesn’t address risk. So the risk adjustments are a more “economic” look at performance. Eventually, the risk reduction approach and the GL-based results will even out. The question is not “if” risk will eventually surface, but when and how it will manifest itself in GL results. We’ve seen a lot of this in the news the past eighteen months – and there’s likely more to come as the economy is in a downturn phase. Going through the effort is worth it Once risk is created by making a loan or placing a bet, someone owns it. The reason to go through the effort to price loans (and relationships) on a fully risk-adjusted basis is to understand the impact of risk at the only point in time when you can do something about getting paid for it – at the time the loan is agreed upon. After that, the bank is pretty much along for the ride. Risk-adjusted pricing is smart banking. It not only puts some teeth in the bank’s already existing risk management policies, it is justifiable to the client and it makes sense to most lending officers.

Stephanie Butler, manager of Process Architects, in Advisory Services at Baker Hill, a part of Experian continues from her last post by adding how to get back to the risk management basics. With all that said, what is next?  You’ve learned the lessons and are ready to begin 2009 fresh.  How do you make sure that history does not repeat itself?  Simply get back to the basics by: • Refocusing your lenders The lenders are your first line of defense.  Make sure they understand the importance of accurate, complete information.  Through their incentives, hold them accountable for credit quality.  Retrain them, if necessary, on credit policy, financial analysis, business development, etc. • Creating or enhancing your loan review staff A strong, internal loan review staff is crucial.  They are your second line of defense.  By sampling the entire portfolio on a regular basis, loan review can see trends that an individual loan officer cannot.  Loan review can aid in the portfolio management concentrations,  policy adherence and portfolio growth.  By reporting to either the holding company or credit administration, loan policy review can give an unbiased opinion on the quality of lending and the portfolio. • Bring back the credit department and formally-trained credit analysts For larger commercial loan underwriting requests, it is important to bring back the use of credit analysts and the credit department for in-depth financial analysis, loan write-ups and the discussion of strengths and weaknesses.  Don’t forget to train the credit analysts!  If you don’t feel you have the skill set within your institution for training, there are many good courses that your credit analysts can take.  Remember, this is your bench for future lenders. • Bring accountability back Everyone in your organization is accountable for a specific job or task.  You must hold your entire team, including senior management, accountable for their tasks, roles and the process of risk management. Remember, a lot of lessons were learned in 2008.  The key is not to waste this knowledge going forward.  Don’t keep doing what you have been doing!  Embrace the potential to improve your lending practices, financial risk management, training opportunities and customer satisfaction.  2009 is a new year!

This post is a feature from my colleague and guest blogger, Stephanie Butler, manager of Process Architects in Advisory Services at Baker Hill, a part of Experian. Are you tired of the economic doom and gloom yet?  I am.  I’m not in denial about what is happening -- far from it.  But, we can wallow or move forward, and I chose to move forward.  Let’s look at a few of the many lessons that can be learned from the year and some action steps for the future. 1. Collateral does not make a bad loan good  Remember this one? If you didn’t relearn this in 2008, you are in trouble.  Using real estate as collateral does not guarantee a loan will be paid back.  In small business/commercial lending, we should be looking at time in business, repayment trends and personal credit.  In consumer lending, time with an employer, time at the residence and net revolving burden are all key.  If these are weak, collateral will not make things all better. 2. Balance the loan portfolio  Too much of a good thing is ultimately never a good thing.  First, we loaded our portfolios with real estate because real estate could never go bad.  Now, financial institutions are trying to diversify out of real estate and move into the “next great thing.”  Is it consumer credit cards, commercial C&I, or small business lines of credit?  It’s anyone’s guess.  The key is to balance the portfolio.  A balanced portfolio can help smooth the impact of economic trends and help managing uncertainty.  We all know that policy requires monitoring industry concentrations.  But, balancing the portfolio means more than that.  You also need to look at the product mix, collateral taken, loan size and customer location.  Are you too concentrated in unsecured lending?  How about lines of credit?  Are all of your customers in three zip codes? 3. Proactive vs. reactive The days of using past dues for portfolio risk management are gone.  We need to understand our customers by using relationship management and looking for proactive markers to anticipate problems.  Whether this is done manually or through the use of technology, a process must be in place to gather data, analyze and anticipate loans that may need extra attention.  Proactive portfolio risk management can lessen potential charge-offs and allow the bank to renegotiate loans from a position of strength. Be sure to check my next post as Stephanie continues with tips on how to get back to risk management basics.

Part 2 My colleague, Prince Varma, Senior Client Partner -- Portfolio Growth and Client Management, shares his advice on the best practices for portfolio risk management in these trying times. Boy; this is an interesting time. Banks today are at a critical threshold -- the biggest question that they are trying to answer is, "How do we continue to grow -- or at least avoid contracting -- without sacrificing profitability or credit quality?” The urge to overcompensate, or engage in ultra conservative lending practices, must be resisted.  That said, we are already seeing a trend in which mid-sized and regional lenders are abandoning mid-tier credit. This vacuum is being filled by community banks and credit unions which are implementing aggressive risk-based pricing programs in order to target the small business market. These organizations are also introducing "safe and secure" campaigns that specifically target existing clients of banks in the news -- and attempting to entice those clients to switch over. We are strongly urging banks to engage in an analysis of their existing portfolios in order to pinpoint opportunities for expanding their relationships with existing key clients. Many senior executives are expressing apprehension about undertaking new projects given current levels of uncertainty.  Our best advice is two-fold.. First, focus on identifying those areas where process remediation will have long term and sustained value. Second, do not allow uncertainty to paralyze your internal improvement efforts.  Strong business cases lead to good decisions; don't let fear and apprehension cloud what you know needs to be done.

By: Tom Hannagan Part 2 This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. For the discussion of the key elements involved in risk-adjusted loan pricing, please visit my earlier posts. In my last blog we discussed reason number one: good corporate governance. Governance, or responsible and disciplined leadership, makes a lot of sense and promotes trust and confidence which has been missing lately in many large financial institutions. The results can be seen in the market in multiples now and are associated with both the struggling companies and, through guilt by association, the rest of the industry.  But, let’s move beyond the “soft” reason. The second major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial. Profit performance By financial, we mean profit performance or bottom line earnings. This reason relies on the key belief that risk has a cost. Just because risk can be difficult to measure and/or is not addressed within GAAP, doesn’t mean it can’t ultimately cost you something. If, for any reason, you believe you can get away with taking on any unmitigated risk without it ever costing anything, do not continue reading this or any of my other posts. You are wasting your valuable time. Risk will surface The saying that “risk will out,” I believe, is true. The question is not if risk will eventually surface, but when, how and how hard it will bite.  Risk can be transferred (hedges, swaps and so on), but it doesn’t disappear from the universe. Once risk is created, someone owns it. The news headlines of the past 18 months are replete with stories of huge writedowns of toxic assets. The securitized assets and/or their collateral loans always contained risk – from the moment the underlying loan was closed. The loans and their payment streams were sliced a dozen ways, repackaged and resold. The risk was also sliced up, but like mercury, it all remained in the system.  Another familiar casino saying that brings this to mind is: “If you don’t know who the ‘mark’ at the table is, it’s you.” There are now several world class examples of such marks. Some have now failed completely and many more would have without federal intervention. Lending, in the leveraged/banking sense, involves all major types of risk: credit risk, market risk, operational risk and business risk. And, beyond the identifiable and potentially insurable portions of these risks, like any business, it includes the risk of unexpected loss, which needs to be covered by capital. Banks have developed policies and guidelines to mitigate, identify and measure many of their risks. These all fall under the world of risk management and these efforts all cost something. There is no free way to offset risk – other than not doing the loan at all. But lending is the business of banking, isn’t it? Further, the risk mitigation efforts cost more or less depending on the various risk characteristics of the bank’s loan portfolio each loan. For instance, a floating rate loan involves little market risk and requires little if any expense to offset. A five-year fixed rate, interest-only loan involves a lot of market risk and that costs something to offset. Alternatively, a loan with a pass risk rating of ‘2’ involves a much lower likelihood of defaulting than a loan with a pass risk rating of ‘4’. The lower risk loan; therefore, involves less of an ALLL (Allowance for Loan and Lease Losses) reserve and provisioning expense.  Also, an owner occupied commercial mortgage is normally much less expensive to monitor than a credit backing a floor plan or construction project. Those cost differences could be reflected in the pricing. Finally, for today, the amount of risk capital needed to back these kinds of differing loan characteristics, for purposes of unexpected loss, is substantially different. If these kinds of differences are not priced into the loans somehow, one of two situations exists: Either the bank is not getting paid for the risk it is incurring; or, If it is, it is charging the lower risk borrowers a rate that pays for added risk-adjusted expenses of the higher risk borrowers. The business risk to the bank then becomes losing the better clients over time in lieu of attracting the riskier deals. This process has a name: adverse selection. The ongoing expenses of risk mitigation and the negative impact of unexpected losses on retained earnings, over time, materially hurt the bank’s earnings. Someone is paying for all of the risks of being in the business of lending and it’s usually one of two groups: the customers or the shareholders. In the worst of cases, it’s also the taxpayers. The idea of risk-based pricing, at the loan level, is to have the clients pay for the risks the bank is incurring on their behalf by pricing the loan appropriately from the beginning. As a result: This tends to protect, and often enhance, the bank’s financial performance; It is clever; It puts some teeth in the bank’s already existing risk management policies; It is justifiable to the client; and It even makes sense to most lending officers. Fortunately, loan pricing analysis is a scalable activity and possible for most any size bank. It is a smarter way of banking than a one-size-fits-all approach -- even without considering the governance improvement.  

By: Tom Hannagan Part 1 In my last three posts, we have covered the key parts of how risk-based loan pricing works. We have discussed how the key foundational elements involved in risk-adjusted loan pricing can and should relate to the bank’s accounting results and strategic policies. We went from the pricing analysis of an individual loan on a risk-adjusted basis to solving for a bank-wide target or guideline return. We also mentioned how this analysis can be expanded to the client relationship level, both producing a relationship management view of any existing loans and the impact of pricing a renewal or new credit to impact the client-level return. Finally, I mentioned that although this capability can exist (and does in more banks than ever before), it isn’t an easy undertaking in an industry that is historically keyed to volume goals rather than transaction profit (let alone risk-adjusted profit). So, why go through the effort? Moving to a risk-adjusted view of lending and relationship management requires serious thought, effort and resolve. It involves change and teaching lenders a new trick. It even suggests that the lending executive (perhaps the next president of the bank) hasn’t been doing the best job possible to protect and advance the bank’s margins. Any new undertaking involves management risk. And, accurate or not, bank executives are not generally viewed as terrific change agents. Is this concept of risk-based pricing worth all the time and trouble? We think so – for two general reasons. Corporate governance Almost any business, if not any undertaking of any kind, involves risk to some degree. Finance in general, and commercial banking, specifically, involves several kinds of risk. The most obvious risk is repayment or credit risk. Banks have been lending money successfully for a long time. The funny thing is that often, when we’ve studied the actual loan rates of a bank’s portfolio versus the bank’s own risk ratings (or risk grades), we see almost no difference in loan pricing. The banks have credit policies that discuss the different ratings in some detail. And, the banks usually have some sort of provisioning process or ALLL (Allowance for Loan and Lease Losses) logic that uses these differences in risk rating. Loan review guidelines often use the differences in risk rating to gauge the review frequency and depth. So, the banks know what’s going on. They know that a higher risk borrower/loan is less likely to be repaid in full than a lower credit risk borrower/loan. But, the lending operation goes on as if they were all about the same. There seems to be a disconnect (kind of like when my arms and brain disconnect when I swing a golf club). I know if I slow down I’ll hit a better shot, but I still swing way too fast. It seems to me that since the bank has all of these terrific policies in place dealing with credit risk, that good governance would require that credit risk be reflected more fully when loans are marketed, negotiated and agreed to – rather than just when they go awry. I would make the same general argument for management consistency associated with other risk types. If the loan duration is longer, good governance would reflect (pay for) a realistic marginal funding cost of the same duration. This would help to align the loan pricing effort with the guidelines or policies associated with ALCO or Asset and Liability Policy Committee and Interest Rate Risk (IRR) management. If a loan involves higher or lower risk of unexpected loss based on loan/collateral type and risk rating, then the risk capital associated with the loan should vary accordingly. The risk-based allocation of capital will then require different pricing in order for the loan to hit a targeted return. This protection of return, on a risk-adjusted basis, is the final step in good governance – in this case, to protect the shareholders specific contribution (of their equity) to funding the loan in question. Finally, if I were a director, regulator or an auditor (again), and I reviewed all of these fine policies related to risk management, and did not see them reflected in deal pricing, I would have to ask “why?”.  It would seem that either executive management doesn’t really believe in their own policies, or they are willing to set them aside when negotiating deals for the added business. Maybe loan management doesn’t want to be bothered by the policies while they’re out there in the “real world” fighting for added loan volume. Either way, there seems to be a governance disconnect. Which I know on the golf course, leads to lost balls and unnecessary poor scores. My second major reason will follow in my next blog.

By: Tom Hannagan Part 1 Risk-based pricing starts as a product-level reflection of a bank’s financial and risk characteristics. In my last few posts we have covered the key parts of how risk-based loan pricing works. In doing so, we have discussed how the key foundation elements involved in risk-adjusted loan pricing can (and should) relate to the bank’s accounting results and strategic policies: Loan balance, rate and fee data relates to the bank’s actual general ledger amounts; The administrative costs are also derived from actual non-interest expenses; The cost of funds is aligned with the policies used in the ALCO operation and in the IRR management processes; The statistical cost of credit risk used in pricing (providing sensitivity to the loan’s risk rating) is derived partially from the bank’s credit and provisioning policies; The taxes are the bank’s actual average experience; and For banks using ROE/RAROC, the equity allocation is related to the bank’s overall (unexpected) risk posture and its capital sufficiency policies. Once a bank understands risk-adjusted pricing and can calculate the risk-adjusted return (ROA or ROE/RAROC) for a given loan, what more can we do to help the lender close the deal? And, what can we do to help lenders assist the bank with meeting profit goals? The answer to both questions is: “quite a lot”. First, bank management and lending executives can set various risk-based goals or guidelines that are based on the same data and foundation logic that was used to create the risk-based profit calculations. This analytical form of targeting helps take the profit (and therefore pricing) process out of the realm of “blue sky” numbers or simply wishful thinking on the part of management. The risk-based targeting guidelines benefit from the same analytical processes that went into the logic behind creating the profit calculations. The targets should be as well-founded as the analysis that went into the profit calculations. Then the fun begins. First at the loan level: Once we have the ability to calculate risk-adjusted loan profit and we have similarly founded targets or guidelines, we can easily use the profit calculations in reverse to solve for a required loan rate and/or origination fee that will meet the target profit. The lender can change a structural aspect of the loan under consideration and quickly see the impact on risk-adjusted profit. More importantly, they can see how these changes relate to the guidelines or target. In fact, the lender could look at any number of changes to the loan amount, tenor, amortization rate, moving the risk rating up or down, and changing the rate from fixed to floating impact to see what relative impact the change has on risk-adjusted profit. Because knowledge is one key to successful negotiation, the lender is in a substantially stronger position to conduct the sales and negotiation phases of landing the deal. There is a substantially higher likelihood the resulting loan will be a better risk-adjusted return for the bank than would take place by ignoring such pricing practices. Add up all of the loan and lines done in the course of a year and you see a significant impact on the bank’s overall performance. In my next post, I’ll expand this concept to the relationship management level.

So here it is!  The moment you all have been waiting for--the top ten hot topics of 2009 (in no particular order of importance). 1. Portfolio Risk Management – You should really focus on this topic in 2009.  With many institutions already streamlining the origination process, portfolio management is the logical next step.  While the foundation is based in credit quality, portfolio management is not just for the credit side. 2. Review of Data (aka “Getting Behind the Numbers”) – We are not talking about scorecard validation; that’s another subject.  This is more general.  Traditional commercial lending rarely maintains a sophisticated database on its clients.  Even when it does, traditional commercial lending rarely analyzes the data. 3. Lowering Costs of Origination – Always a shoe-in for a goal in any year!  But how does an institution make meaningful and marked improvements in reducing its costs of origination? 4. Scorecard Validation – Getting more specific with the review of data.  Discuss the basic components of the validation process and what your institution can do to best prepare itself for analyzing the results of a validation.  Whether it be an interim validation or a full-sized one, put together the right steps to ensure your institution derives the maximum benefit from its scorecard. 5. Turnaround Times (Response to Client) –Rebuild it.  Make the origination process better, stronger and faster.  No; we aren’t talking about bionics here -- nor how you can manipulate the metrics to report a faster turnaround time.  We are talking about what you can do from a loan applicant perspective to improve turnaround time. 6. Training – Where are all the training programs?  Send in all the training programs!  Worry, because they are not here.  (Replace training programs with clowns and we might have an oldies song.)  Can’t find the right people with the right talent in the marketplace? 7. Application Volume/Marketing/Relationship Management – You can design and execute the most efficient origination and portfolio management processes.   But, without addressing client and application volume, what good are they? 8. Pricing/Yield on Portfolio – “We compete on service, not price.” We’ve heard this over and over again.  In reality, the sales side always resorts to price as the final differentiator.  Utilizing standardization and consistency can streamline your process and drive improved yields on your portfolio. 9. Management Metrics – How do I know that I am going in the right direction?  Strategize, implement, execute, measure and repeat.  Learn how to set your targets to provide meaningful bottom line results. 10. Operational Risk Management – Different from credit risk, operational risk and its management, operational risk management deals with what an institution should do to make sure it is not open to operational risk in the portfolio. Items totally in the control of the institution, if not executed properly, can cause significant loss.   Well, that’s it.  We encourage your feedback on this list.  Let us know which of these ten topics is a priority for your institution and what specific areas in each topic you would like to see addressed.

I’m speculating a bit here, but I have a feeling that as the first wave of Red Flag rule examinations occurs, one of the potential perceived weak points in your program(s) may be your vendor relationships.  Of particular note are collections agencies.  Per the guidelines, “Section 114 applies to financial institutions and creditors.” Under the FCRA, the term “creditor” has the same meaning as in section 702 of the Equal Credit Opportunity Act (ECOA), 15 U.S.C. 1691a.15 ECOA defines “creditor” to include a person who arranges for the extension, renewal or continuation of credit, which in some cases could include third-party debt collectors.  Therefore, the Agencies are not excluding third-party debt collectors from the scope of the final rules and “a financial institution or creditor is ultimately responsible for complying with the final rules and guidelines even if it outsources an activity to a third-party service provider.” A general rule of thumb in any examination process is to look closely at activities that are the most difficult for the examinee to control.  Third-party relationship management certainly falls into this category.  So, make sure your written and operational programs have procedures in place to ensure and regularly monitor appropriate Red Flag compliance -- even when customer (or potential customer) activities occur outside your walls. Good luck!

By: Tom Hannagan Part 2   Return on Equity (ROE) ROE is the risk-adjusted profit divided by the equity amount associated with the loan in question.   ROE =      Risk-adjusted profit Equity amount of the loan   There are two large advantages to using ROE. One, you can use it to compare profit performance across asset-based and non-asset-based products. This can’t be done with ROA – if there’s no “A”, you can’t create the ratio. This seems to be a crucial consideration if you are serious about cross-selling non-asset-based products (such as deposits and a long list of non-credit financial services) and if you are serious about being a truly client relationship oriented organization.   Second, by using ROE you have the possibility of risk-adjusting the amount of equity used in the denominator of the calculation.  Adjusting the equity amount based on risk, in a credible manner, creates risk-adjusted ROE, or what is referred to as risk adjusted return on capital (RAROC). The equity amount applied to the loan represents all of the remaining risk or unexpected loss (UL).instance that we did not account for in the steps that got us to the risk-adjusted profit result. RAROC, or risk-adjusted ROE, is a fully risk-adjusted representation of relative value. This level of risk-based performance measurement also has the advantage of relating pricing and relationship management activities to the bank’scapital management process.   So far, we have covered several of the key parts of how risk-based pricing can work. In doing so, we have discussed how the various elements involved in pricing relate to the bank’s books and policies. The loan balance, rate and fee data relates to the banks actual general ledger amounts. The administrative costs are also derived from actual non-interest expenses. The cost of funds is aligned with the policies used in ALSO and in IRR management processes. The cost of credit risk is related to the bank’s credit and provisioning policies. The taxes are the bank’s actual average experience. And, for banks using ROE/RAROC, the equity allocation is related to the bank’s overall risk posture and its capital sufficiency policies.   I stated earlier that “Risk-based pricing analysis is a product-level microcosm of risk-based bank performance”. It is that and more. In addition to pricing’s linkage to financial figures and results, risk-based pricing should also be a reflection of the bank’s most critical risk management policies and governance processes.

By: Tom Hannagan Part 1 In my last post about risk-based pricing, we started a discussion of the major elements involved in the risk adjustment of loan pricing. We got down to a risk-adjusted pre-tax profit amount. Not to divert the present discussion too much, but we often use pre-tax performance numbers for entity level comparisons to avoid the vagaries of tax treatments. Some banks are sub-S corporations, while most are C corporations. There are differences in state tax levels and, there may be other tax deferral strategies such as, leasing activity and/or securities adjustments that can affect these after-tax numbers. So, pre-tax data can be very useful.   After-tax profit and profitability ratios For internal comparisons across loans, client, lenders and other lines of business; and to better understand how the risk-adjusted profit from a loan or a relationship relate to overall bank performance, we prefer to get to an after-tax profit and profitability ratio. This is also necessary to compare loans or portfolios involving tax-exempt entities to loans with taxable interest income. To do this, we apply the bank’s average effective income tax rate (including federal and state) to the pre-tax result, with the exception of tax exempt loans. This gives us risk-adjusted net income (or profit) at the loan level.   By arriving at risk-based profit estimates at the product level, we then have the opportunity to accumulate these for multi-product client relationships, or at lender or market segment levels. Clients can then go on to analyze the profit results in comparison to their distribution of risk ratings and break the risk-adjusted returns down by loan/collateral type, client geography or industry. Some banks have graphical displays of these results.   In addition to profit level, and to assist with comparative capability, we continue to one or more profitability ratios. You can divide the profit amount by the average loan balance to get a risk-adjusted return on assets (ROA).   ROA =        Profit amount Average loan balance   This is very helpful for looking at asset product performance and has been used historically by the banking industry for risk-based pricing. Many banks have moved beyond ROA and now focus on return on equity (ROE). For a more comprehensive discussion of ROA and ROE see my post from December 6, 2008.   I will continue in my next post about Return on Equity.