Balancing the Risks & Rewards of Lending with Effective Credit Policies

Balancing the Risks & Rewards of Lending with Effective Credit Policies

Credit risk is a significant source of risk for banks, and there’s no doubt that effective credit risk management is critical to minimize losses, protect customer trust, and ensure compliance.

While measuring and mitigating credit risk is nothing new to the financial services industry, the trends impacting this function are constantly evolving. Between developments in machine learning and AI, to expanded data sources that can be used for underwriting, the landscape of credit risk is changing.

While the technologies and resources will certainly evolve over time, the basics of credit risk management and enforcing effective credit policies remain the same. In this blog, we'll revisit the basics and explore the key considerations that should inform a financial institution’s credit policies in 2024 and beyond.

Balance Growth Goals with Risk Tolerance

Mitigating risk while driving growth can feel like walking a tightrope. Managing these two essential functions is an exercise in balance. After all, the goal is to maximize the financial institution’s risk-adjusted rate of return while maintaining risk exposure within pre-defined, acceptable parameters.

An institution’s credit risk strategy should give recognition to the goals of credit quality, earnings, and growth. This might also include the identification of target markets and the overall characteristics that the bank would want to achieve in its credit portfolio, including levels of diversification and concentration tolerances.

Consider CRE lending for example. A bank may choose to pursue certain deals under certain parameters because they know their market and which projects are likely to succeed. This requires a thorough understanding of the market a bank is lending in.

Are there too many businesses of the same type? What types of business have done well in that market? Beyond business types, dig deep into the financials of any potential customers.

For riskier loans, the financial institution can seek more collateral. The financial institution can also make deposits part of the deal. When financing a project, a bank can require that the customer’s operating account be held at their institution, which not only helps generate deposits, it also offers the bank greater visibility into the customer’s cash flows.

Know the Difference Between Policy & the Process

Policy is what needs to be enforced and the process is how it is enforced. A policy document should avoid getting too specific about how rules or thresholds are enforced and should instead focus on the specifics of what the rules and thresholds are.

Many policies contain detailed “how-to” instructions for routine procedures, resulting in lengthy, cumbersome documents that can become outdated. While various procedures might change over time, particularly as automation eliminates some manual processes, credit and other policies should be changed less frequently.

It’s also important that credit policies use clear language to avoid misinterpretation. Avoid using vague or ambiguous terms, which can lead to confusion among staff and makes enforcement of policies that much more difficult.

Communicate for Compliance

To be effective, credit policies must be communicated throughout the organization, implemented through appropriate procedures, monitored and periodically revised to take into account changing internal and external circumstances, such as higher interest rates. According to the Basel Committee, “This includes ensuring that the bank’s credit-granting activities conform to the established strategy, that written procedures are developed and implemented, and that loan approval and review responsibilities are clearly and properly assigned.”

While senior management is responsible for implementing the bank’s credit policy and risk strategy, managing credit risk is a team effort. By effectively communicating the policies and framework, financial institutions can create a culture focused on sound risk management practices and ensure compliance.

While financial institutions are eager to add new business to ensure growth, any new credit must be extended prudently. While additional collateral can help secure some higher-risk credit, some potential loans are too risky regardless of additional collateral or other business that a potential customer may bring in.

Credit policies and procedures should be adhered to by everyone involved with lending. You don’t want to waste time and effort starting the process of extending credit to a potential customer who clearly presents too much risk. This is where technology can empower staff to apply consistent processes and workflows that support the bank’s overall credit policy. The right tools can help all team members involved in a deal – from the relationship manager to the credit analyst – balance growth opportunities with solid credit decisions that are aligned with their institution’s risk tolerance.

Topics: risk management