Thoughtful and intentional use of credit committees: ensuring their value in the loan approval process

RMA Journal, The, April, 2004 by Brian Ranson

RMA's Editorial Advisory Board was discussing the subject of loan committees for this issue of The RMA Journal. Seeking resources, board member Dan Stein, who reviewed Brian Ranson's book Credit Risk Management in the December 2003--January 2004 issue, said he knew of no better discussion than that found in a chapter from this book. With the permission of Sheshunoff Information Services, a portion of that chapter is extracted here.

In credit risk management, the question of whether to operate using a senior lending committee approval process requires some thought. Many banks use these senior lending committees, commonly called credit committees, as the final approval point in the lending decision. Their membership generally consists of a mix of control (risk) specialists and senior lending (client) specialists with any overlap tending to favor the control process.

It is difficult to argue that the sober judgment of a panel of those with the greatest experience would not be a good idea. However, there are a number of ways in which these committees can fail to bring the expected value. This article offers some general rules and reminders designed to improve the results of your bank's use of a credit committee.

Transaction Size and Importance Are Not Necessarily the Same

Credit committees see only some part of the corporate lending transaction volume. Often, the criteria for submission to the senior lending committee are based on the size of the loan rather than the risk contributed b v the loan. But the largest risk positions (those that consume the greatest amount of economic capital) do not necessarily lie with the biggest customers. A transaction with Exxon will probably not benefit from the accumulated knowledge of the committee members. A broadly syndicated loan to an AAA-rated corporation is a pro-negotiated structure. Seldom will there be any structural complexities, such as financial covenants or collateral. The decision is simply one of a reasonable hold level at the price available. These two illustration are not credit acceptability decisions. The valuable time of the committee members is used, but their experience and knowledge is not.

There are, of course, means by which a bank can direct the decisions involving the most risk to a credit committee. If a bank has a RAROC model or a well-defined risk rating system, the output can be used to determine whether the committee should be involved. Some banks have policies requiring that loans using more than $1 million in economic capital (the dollar amount is optional) go to the committee. This may mean that a $250 million loan to Exxon does not, but a $50 million to a risk 5 will do so. The objective is to have the talents and experience of a credit committee applied where the decisions are important and substantial.

Everyone Must Learn from the Decisions Made

In corporate lending, the best results come from minimizing the bad rather than maximizing the good. Good decisions must be measured in the aggregate, because avoiding all losses is a fruitless pursuit. By the same token, it is not in the interests of diversification or portfolio profitability to reject good transactions. It is good practice through time to track the decisions of the committee for both approvals and declines. This will allow a frank appraisal of the properties of the committee. In addition, it can be valuable for members to have their voting records maintained. The objective is to assess how good decisions came to pass and why good deals were turned down. Given that these members are likely to be very senior in the organization, there should be no problem in providing these statistics to a very limited number of people: the CEO, the chief operating officer (COO), and the committee members themselves. The purpose is not to chastise (or even praise), but rather to understand organizational and individual propensities.

The other key learning process is provided to the lending officers when they meet with the committee. This is most evident when the loan agreement is bilateral, and the experience and wisdom of the committee can be put to use to suggest improvements. The lending officer can learn a great deal from this process, especially when the interaction is constructive rather than accusatory.

For some years, I was an observer in senior committee meetings. During that time it was impossible not to learn from the questions and discussions that took place. The senior officers recalled examples of Failed covenants or of problems in certain types of loans or industries where a particular structural feature would help. Such discussions add to the store of corporate knowledge.

Sound Portfolios Are Being Paid for Risk

Disagreements between relationship management and the credit department often involve the risk of the transaction. Seldom, in my experience, does the credit staff or the credit committee discuss or come to any serious disagreement on the price of the transaction. A lack of debate on pricing at this juncture is not unreasonable because the skill of the credit officer is not in price negotiation (although he or she should be aware of the market rates for various risk levels). Moreover, the role of the senior credit committee cannot be to negotiate spreads with the staff. Having said that, the adjudication of risk must take into account the payment for that risk. Without adequate payment, there should be no acceptance of risk.