Legacy of the 1980s: changes in credit risk management

RMA Journal, The, Feb, 2003 by Irene Oleksiw

The observations of 15 senior credit risk managers who experienced the late 1980s credit downturn attest to a new wave of banking practices that have surfaced since then. As participants in these pivotal improvements, they chronicle a variety of new methodologies and the external forces and industry changes that shaped them.

Following more than a decade of quiet, nonperforming loans and charge-offs have churned up during the last three years. However, only among the very largest bank holding companies are net charge-offs/loans averaging over 1.00%, the levels reached by most bank holding companies with over $1 billion in assets in the late 1980s and early 1990s. Today, most large BHCs have managed to keep their loan losses at 0.50% or less.

Arguably, different economic factors are in place, including rock-bottom interest rates and a more stable real estate market. Perhaps a bigger difference, however, is the banks themselves. The earlier difficult period taught banks some new lessons, and they have become, on balance, better credit risk managers.

Size

In 1992, there were 42 bank holding companies with assets greater than $10 billion. Today, there are 63. Ten years ago, Citicorp was $214 billion; now it's over $1 trillion. The predecessors of Wachovia were a fraction of the company's current $300-plus billion.

When asked about the impact of size on credit risk management, these bankers almost universally voiced these benefits:

* Reduced concentrations, which many large banks have accomplished by not Jetting their hold limits increase proportionately with loan growth.

* Bigger budgets, rendering more sophisticated portfolio management tools affordable.

At the same time, most of this expansion was accomplished with acquisitions, which are typically disruptive and distracting. Norman MeClave, a credit risk executive who has worked at several large financial institutions, describes a merger as a "one-to two-year process, diverting enormous management time and taking eyes away from the business." Michael Loughlin, executive vice president, Commercial Credit Policy, at Wells Fargo, cites the challenge of integrating officers used to different cultures and procedures. His bank has invested a great deal in "training, systems, and policy and procedure realignments" to get everyone on the same track.

Another concern is syndicated credits. Many observed that the deal quality of the largest corporate originators has declined. Buyers relied on good underwriting by the issuing banks, not realizing that some of these syndicators were holding less and emphasizing fees and deal turnaround time. However, Richard Wright, Hibernia's chief credit officer, points fingers in two directions, contending that "both originators and participants have become more tolerant of higher debt levels and goodwill and more comfortable with enterprise value as a secondary source of repayment than they should have."

Investment Banking

Investment banking and related activities now contribute 10-15% to the revenue of BHCs over $25 billion. Several credit risk managers observed that such fee-driven income helps diversify a bank's revenue sources and can be less risky. On the other hand, investment banking is a cyclical business that often moves in tandem with lending: When the equity markets are down, loan demand is typically down as well. McClave believes that banks have the ability to conduct this business. The problem is that "when it's successful, it boosts earnings; when it's not, there's staggering overhead to carry."

Several credit risk managers also contend that this transaction-based business doesn't mesh well with a relationship-banking strategy, which emphasizes the risk-mitigating benefits of getting to know your customers. Additionally, a different level of risk expertise is required for these businesses, including an understanding of market risk and unique operational risks.

Capital Levels

Large BHCs are better capitalized than they were in the late 1980s. Most of the senior credit risk managers interviewed felt that more capital affords more flexibility in dealing with problem loans. Thomas Parker, senior vice president, Risk Management, at Wachovia Bank, also appreciates how higher capital "benefits a bank's competitive position to the extent that it contributes to a better rating for letters of credit and other credit support instruments."

However, most credit risk managers also agreed with AmSouth's Kimble Vardaman, senior vice president, Credit Administration. She pointed out that credit risk managers are "focused on identifying and covering expected losses," while the role of capital is to cushion unexpected losses. Simply having higher capital, in and of itself, has not altered her bank's credit risk practices.

Loan Sales Market

New pathways to loan sales have greatly improved the secondary market. Unlike in the late 1980s, there is now an active market for nonperforming loans. Indeed, many of the credit risk managers interviewed indicated that investors regularly contact them, seeking workout assets. At the same time, the syndications market is much bigger than it was 10 years ago, and a new trade group, the Loan Sales Trading Association, has sprung up.