Six steps to ERM at regional banks: A seven-part series explores risk management at regional banks to help senior managers make better decisions about methodologies and process

RMA Journal, The, June, 2003 by Peter Nakada

Regional banks are in the middle of a profound transition away from a traditional credit officer culture, in which the bank's principal risk decision was whether loans were "good" or "bad," toward a world in which each loan is assessed in terms of its contribution to the bank's sustainable risk-adjusted profitability.

While credit risk will remain the key factor in this assessment, regional banks are also increasingly expected to take formal account of the whole family of risks attendant on a business decision--notably operating risks of various kinds--and to move toward enterprise-wide risk management.

In this new world, creditors will be rated on a scale that's linked to objective probabilities of default, while facilities will be assessed for robust "loss given default" and "exposure at default" numbers. The impact of each loan on the concentration risks of the bank's portfolio as a whole will become transparent to group and business line managers alike, and the cost of the capital required to support each individual loan--including market and operating risks--will be factored into its price.

Few regional and smaller U.S. banks have yet moved far toward this vision, but business imperatives suggest that they will do so. In Figure 1, we've mapped out six key steps toward this "ideal bank" and it seems clear to us that few regional institutions have reached Step 5, while many smaller institutions remain stuck at Step 2 or even Step 1.

More worrying than slow progress, however, is making a false step. It's easy for institutions to lose their way if they don't keep in mind the real long-term goal--sustainable risk-adjusted profitability that will attract investors and drive up the share price. Some of the newfangled ideas banks are being told about might even set back an institution if this end goal is not kept firmly in mind.

Let's walk through the six crucial steps to enterprise risk and capital management at regional banks, noting how to avoid the banana skins.

Step 1: "We make only good loans."

In this world, credit decisions are taken by the business line, subject to some limited central oversight. The process is based on a credit judgment where the answer tends to be either "yes" or "no," give or take some deal structuring.

Business line performance is evaluated in terms of any growth in net income or in the volume of business, while the risks associated with the business line are managed in a largely intuitive manner. It is quite common for the lines of business to remain poorly defined and for the bank to be unsure whether a particular activity is, in fact, making any profit.

Write-offs are attributed to poor judgment, or to changes in the circumstances of the business or the economy. Provisioning, reserving, and capital management are determined and managed at the center by a separate process.

While banks at Step 1 are concerned about originating good quality loans, they have limited regard for the relative quality/pricing of loans or for the way in which each loan affects the performance of the bank's whole portfolio of loans (e.g., risk concentrations).

Step 2: "Loans should be graded."

Banks often move to Step 2 under peer group pressure or following comments from regulators. They may also be driven by a desire to better differentiate risk and make their lending decisions more internally consistent.

The decision process is still "yes/no." Loans are awarded facility grades by line officers, typically using 5-6 "good" grades and 3-4 "bad" grades. However, despite the apparent granularity of this grading system, most of the "good" loans fall into one grade. As a result, the grading systems of these banks would have to be improved to meet industry best practice (or pass the quality tests included in the latest Basel Committee proposals for banks that want to adopt the Internal Ratings Based approach to regulatory capital).

Meanwhile, the bank focuses on the relative risk of loans rather than making any objective calculation of their probability of default. The grading process is administrative: There is no impact on the pricing of approved loans. Provisioning is not linked to the grading system and capital is not allocated to each line of business.

However, the bank begins to assess business line performance, perhaps supplementing the net income and growth of business numbers with a ''return on assets'' calculation.

Step 2 is a modest improvement over Step 1, but offers a foundation for more ambitious steps.

Step 3: "ROE is the name of the game."

The next step is rather more ambitious and represents an attempt to maximize return on equity capital (ROE). Often, a firm-wide equity hurdle rate (i.e., minimum ROE) is published. New performance measures for businesses include calculations that compare the ROE to the hurdle rate, as well as transaction-based incentive compensation.

As part of an attempt to understand their costs, banks at this stage commonly invest heavily in relatively sophisticated funds transfer pricing tools and upgrade their cost allocation systems-two of the key components in any ROE calculation. But it is all too common for banks to overlook the most important ROE component of all: the cost of risk capital required to support each of the bank's activities.