Whose Job Is Credit Risk?
WHITE PAPER//////////ENSURING INSTITUTIONAL FINANCIAL SAFETY

WWW.MOODYSANALYTICS.COM

//////////INTRODUCTION

A teller’s actions may have provided early warning tobank management about a business customer’s credit
risk. It started when the business owner, an individual
well-known to the teller, began withdrawing large amounts
and transferring funds to accounts at other institutions.
Understanding that the business needed cash to repay its
loans and recognizing that these were unusual transactions
for this customer, the teller brought it to the attentionof branch management, which in turn notiﬁed theappropriate loan ofﬁcer and credit administrators. While
this customer was neither in default nor engaging in illicit
activities, the warning prompted timely conversation
with the borrower and allowed the bank to revise
its credit terms, constraining the diversion of funds toother ventures.
While this story highlights the actions of an exceptional employee, it also raises some instructive questions:

What institutional norms empowered
this employee to take this initiative?
How did the employee gain thenecessary skills and knowledge tomake the appropriate judgment?

MOODY’S ANALYTICS

To what extent does this employee’s
behavior reﬂect the values of
the institution?
How likely are other employees tobehave in the same fashion?

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//////////INVESTING IN SAFETY

Building a foundation of credit skill and knowledge among all employees creates a strong risk management
culture that protects the ﬁnancial safety of the institution. Yet most people would say that credit risk is theloan ofﬁcer’s job. So why should a ﬁnancial institution invest in developing credit skill and knowledge insomeone when it’s “not their job”? Because there are consequences for not doing so.
The Occupational Safety and Health Administration (OSHA) establishes guidelines that are designed tokeep employees safe in the workplace. Unsafe working conditions and practices have consequences, so formost businesses, compliance with OSHA requirements is a given. But what about the ﬁnancial safety ofyour institution?
First, let’s examine the consequences of “unsafe credit conditions.” Loans are a ﬁnancial institution’s biggest
asset—and biggest risk (even though they may not be the biggest new income generator in today’senvironment). Loans are only proﬁtable when principal is repaid with interest. So what are the costs ofcharging off a single loan of $100,000? It’s more than the current-period loss of principal and interest.

If the bank’s return on assets is 1 percent, inorder to earn back the loss, the bank would
need to make $10,000,000 in new loans thatall performed for one year. That’s interest on
100 new loans of $100,000 each to replace theprincipal and interest lost on a single $100,000
bad loan.

$

100K

1 BAD LOAN$

10MM
100 NEW LOANS

Here's another perspective: If the net interest margin on the bank’s loans is 3 percent, then charging off asingle loan of $500,000 would more than wipe out the total proﬁt contribution from the remaining loans ina $10,000,000 portfolio.
Clearly, even relatively small proportions of credit losses can adversely impact the ﬁnancial health of alending institution. Here is a simple syllogism: Everyone’s job is dependent on the health of the institution.
Credit risk affects the ﬁnancial health of the institution. Therefore, everyone should care about credit risk.

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//////////KNOWING YOUR CUSTOMEROne of the basic tenets of building and managing relationships is knowing the customer. This is especiallytrue for credit-based customer relationships; knowing your customer not only helps strengthen therelationship but also detect and avert credit risks. The problem is that banking relationships, particularly
credit relationships, are rarely one-dimensional. It takes teamwork to serve and maintain the overall
relationship. Each team member, from loan ofﬁcers to operations specialists to letter of credit processors,
has a point of contact with information about the customer, whether through direct or indirect interaction.

	What are your team members learning about
customers’ credit risk from their normal, day-to-day
interactions with customers?
Are they asking questions to learn more?
Are they asking the right questions?

KNOW— YOUR —C USTOMER	Do they know how to interpret the customer’s
answers?
Are they noting what they learn?
	Are they empowered to act on or disseminate thisinformation?

Knowing your customer involves knowing who at your institution has a connection to any part of thecustomer relationship. Whether they realize it or not, these individuals can inﬂuence credit safety by simply
understanding the nature of risk in the customer information they see and hear. The most highly effective
credit-driven organizations do not leave such opportunities to chance.

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Ensuring that each group has the applicable credit skills and knowledge can contribute to ensuring ﬁnancial
safety for the institution. These groups include:
SENIOR MANAGEMENT/BOARD OF DIRECTORSCREDIT-FOCUSED STAFF

MIDDLE MANAGEMENT//////////OTHER NON-CREDIT UNITSSALES-FOCUSED STAFF

ADMINISTRATIVE AND
SUPPORT UNITSSENIOR MANAGEMENT / BOARD OF DIRECTORS

Through meetings and memoranda, the senior management of one regional bank conveys theimportance of being a “credit-driven organization” where everyone proactively contributes tomanaging credit risk. However, lacking speciﬁcity and deliberate top-down drivers to sustain thismission, behavior down the organization becomes inconsistent, increasing risk and diminishing theimpact of senior management’s message.

Senior management has a responsibility to ensure the ﬁnancial safety of the institution. There is little roomfor error at the top, because this is where accountability for institutional credit risk must begin and end.
Senior management is responsible for:Establishing and communicating goals, objectives, and strategies related to credit risk
Balancing credit risk and short-term growth/proﬁts
Creating and enforcing credit policies and practices
Clarifying the organizational structure to support efﬁcient risk management

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In high-performing credit cultures, senior management conveys its commitment to the ﬁnancial safety ofthe organization by initiating and fostering an institution-wide respect for managing credit risk. Leaders
should visibly support the cultivation and use of credit skills at all levels of the organization to draw
attention to the issue and develop trust among those who are expected to execute credit policies andstrategies. Senior management must also watch for and address the inevitable imbalances between thecompeting priorities of managing credit risk and short-term revenue or asset growth. These imbalances willinvariably result in poor ﬁnancial performance, or worse.

After receiving an infusion of equity capital from its new owner, the senior management of aregional bank was determined to generate quick results by aggressively lending in the commercial
real estate market throughout the state. While the bank was able to book new loans of an amount
multiple times its new capital, it was also able to generate substantial fee income, primarily
because many of the borrowers were of higher credit risk. Management assumed that theunderlying value of real estate collateral would mitigate this risk…until it didn’t.

Misguided executive leadership is demonstrated in more than just such blatant examples. Most anecdotes
of effective and ineffective credit risk practices at all levels can be traced back to senior management.
This is not to suggest that senior management must micromanage or oversee all activities that may
contribute to credit risk. The point is that when it comes to credit risk, senior management must lead theway, early and often. They must communicate regularly about this priority and ensure that all systems andincentives are aligned to support it, instead of simply setting a goal, monitoring, and hoping everyone else
follows through.

//////////

MIDDLE MANAGEMENT

A ﬁnancial institution followed a practice of absorbing loan charge-offs centrally while basing
bonuses on proﬁt at the group level. After some deliberation, this practice was changed sothat each group was required to absorb its own loan losses on its respective P&L . Driving
accountability down the chain sharpened focus on credit risk, resulted in a higher-quality
portfolio, and improved proﬁtability.

While the vignette above might appear to be an example of senior management leadership, it also
illustrates the impact of driving responsibility and accountability for credit safety to the appropriate levels.
In many instances, credit risk practices are most tangibly felt at divisional or departmental levels and below.
Middle management plays a crucial role in ensuring the credit safety of the institution. Middle managers
are the bridge between senior managers and employees, and like senior managers, they must exhibit andreinforce credit risk management practices.

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Middle managers are responsible for:
Implementing and executing credit strategies
Overseeing their units’ credit-related activities
Providing credit coaching and mentoring
Middle managers must interpret and enforce risk management practices within their units, as wellas adjudicate conﬂicts with other units. For example, conﬂicts can occur when one department has
primary responsibility for underwriting credit risk while another department originates the deals. Middle
management must balance the tension between these two areas. Layers also exist in functions not directly
involved in credit underwriting or origination. Here, successful middle managers embrace the institution’srisk philosophy and translate its applicability to the actions of these units. One of the most important tasksof middle managers in all functions is coaching and mentoring their staff. This is particularly critical toachieve results from the institution’s investment in training.

A large bank invests heavily in credit training for lending staff, relying on the trainers alone toensure that new skills and techniques are used properly and sustained after training. Management
cites other priorities and cost as reasons that middle managers are not involved either before,
during, or after training. Within months of completing the training initiative, it becomes apparent
that the quality of analyses by recent trainees is inconsistent; they seem tentative when making
and presenting decisions. In the short-term, this situation requires more supervision by middle
managers and a greater investment in time than would have been needed if coaching had been
conducted during or immediately after training. Over the long-term, the problems discredit senior
management’s talk about the importance of credit culture and training.

Moody's Analytics' decades of work with clients to improve risk management skills has empirically shownthat coaching is the key to transferring skills from the training environment to the job, and for ensuring thatskills are sustained. How well prepared are your middle managers to provide this vital function?

//////////CREDIT-FOCUSED STAFF

Consider the example of a large bank lacking an institutionally uniform understanding of cash
ﬂow, while actively engaged in lending to different markets. Some units relied heavily on
EBITDA measures; others favored a UCA cash ﬂow approach; and still others used net proﬁt plus
depreciation. Management was unaware of the inconsistencies in calculating, representing, andinterpreting cash ﬂow—until bank examiners became critical of credit risks being assumed becauseof the various metrics used to calculate debt service coverage.

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Credit-focused staff includes all employees with direct and daily activities involving credit risk: loan ofﬁcers,
credit administrators, credit analysts, underwriters, loan documentation specialists, relationship managers,
credit review, collections, and special assets. This category also applies to all types of credits and markets(corporate, commercial, consumer, real estate, domestic, and international).
Credit-focused staff is responsible for:
Evaluating lending opportunities
Recommending, structuring, and documenting loans
Monitoring loans and managing credit relationships
Ensuring institutional compliance with regulatory requirements
Overseeing aggregate credit risk at a portfolio level
Credit-focused employees are the institution’s main line of defense. Their collective actions have by far
the greatest inﬂuence on institutional credit risk, and thus typically receive the most attention and largest
allocation of credit-related resources. Yet, as the example illustrates, ensuring that consistent and effective
practices are being followed is an ongoing challenge.
The skills required by this group include questioning and data gathering; credit analysis techniques and loan
structuring; evaluating sources of repayment; and forms of support, pricing, documentation, presentation,
monitoring, and negotiating. Most employees don’t start out with these skills, and those who do have priorexperience often ﬁnd that their approach is not exactly aligned with the institution’s way of doing business.
A critical success factor for credit-focused employees is matching their training with the speciﬁc skills thatmust be applied consistently throughout the organization.

A high-performing regional bank has earned a well-deserved reputation for the quality of its credit
training program. Over decades, this program has generated scores of highly qualiﬁed loan ofﬁcers
who have become the core strength of the institution. Alumni of the program are actively recruitedby rival banks, but most have chosen to remain, citing pride in being afﬁliated with an institution
known as the best at managing credit risk.

Pride and passion for the job are qualities that can elevate a risk management culture to the nextlevel. When credit-focused staff are appropriately recognized and rewarded for their approach to risk
management, the result is often excellent institution performance.

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//////////SALES-FOCUSED STAFF

A bank that is focused on small and mid-market businesses has a dedicated business development
staff whose role is to build new relationships. Typically, the business development ofﬁcers havebeen effective salespeople with little or no credit experience. Customer relationships involving
credit often led to tension between the sales team and the credit analysts and underwriters. The
bank addressed this by requiring all business development ofﬁcers to participate in a modiﬁed
version of the credit training given to the lenders.

Sales-focused staff includes all employees with direct and daily activities involving the development of
new customer relationships and the expansion of existing relationships: business development ofﬁcers,
relationship managers, account managers, sales support, and customer service staff. Employees in theseroles may have little or no credit expertise, yet they have a direct inﬂuence on credit risk.
Effective sales and business development activities can actually improve credit risk by driving morequaliﬁed opportunities into the pipeline and generating a larger pool of credit prospects from which theinstitution can then select the best deals. Successful institutions build superior sales-driven organizations
by viewing both selling and credit risk as everyone’s job.
Related to managing credit risk, sales-focused staff is responsible for:Pursuing qualiﬁed prospective borrowers
Identifying and presenting new lending opportunities
Establishing and building credit customer relationships
Building relationships with qualiﬁed borrowers involves asking questions and interpreting information todetermine, at least preliminarily, whether the credit risk is likely to be acceptable to the institution. Manyorganizations have attempted to address this through training in prospecting, selling, and relationshipmanagement skills.
Banks that achieve the best results have also required training in basic business acumen, fundamentals ofcredit analysis, and risk management. These organizations have found that even basic knowledge of credit
among sales teams yields higher quality prospects, which in turn results in a higher quality loan portfoliowith sustainable proﬁtability. These banks also claim that sales teams are more efﬁcient and productive
when they have a better understanding of credit risk.

A bank's internal employee survey revealed that the loan underwriters felt intimidated by thepressure put on them by the business development staff. They were afraid to say “no” to many ofthe loans, even when the level of risk made them uncomfortable.

MOODY’S ANALYTICSENSURING INSTITUTIONAL FINANCIAL SAFETY///// 9Growth is a challenging driver in competitive markets, and there have been instances of executive priorities
falling out of balance. Sales-focused staff can have a profound effect on credit risk, especially when theirinﬂuence appears to be endorsed by senior management.
One of the most effective ways to balance sales efforts with a strong risk management culture is to train
sales staff in credit skills.

//////////OTHER NON-CREDIT UNITS

The management of an inﬂuential ﬁnancial institution has applied some outside-the-box
thinking to its treasury management group by providing training in business acumen and credit
fundamentals. Treasury management teams apply these skills in collaboration with credit-focused
staff to craft relationship solutions that use cash management services to improve businessborrowers’ cash ﬂow and optimize credit utilization. Management believes that this approach
strengthens customer relationships, while enhancing fee income and limiting credit risk.

Other non-credit units include money market and investment services, retail services, treasury
management, and trust services. Employees in non-credit functions provide important support for credit
relationships and are often a critical source of customer knowledge that may affect credit risk.
Non-credit units are responsible for:
Providing non-credit services to customers with credit relationships
Identifying credit-related risks and opportunities

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By developing their business acumen, business lending, and credit skills, employees in non-credit units
build their understanding of business operating cycles and business and consumer cash ﬂow drivers. This
helps the units provide better non-credit solutions, and it improves their ability to detect credit risks andopportunities.

A retail services unit of a bank recently noticed several large deposits made by an individual.
Knowing that the customer and his spouse had loans with the institution, the service employee
refrained from attempting to cross-sell deposit or investment opportunities. Instead, the employee
brought the information to the attention of the loan ofﬁcer, believing that it might be relevantto the customers’ cash ﬂow and credit risk. The loan ofﬁcer investigated and discovered thatthe customer had received an inheritance, and as a result was able to proactively reduce andrestructure the loans in a way that was more favorable to the customer and the institution.

The ability to recognize customer behavior that may increase or decrease credit risk is an extremely
valuable skill for employees who are not normally involved with lending activities. While training teaches
them what to look for and why, the institution’s credit culture will determine how (or whether) they act on
the information.

//////////ADMINISTRATIVE AND SUPPORT UNITS

When it needed to upgrade its loan platform, one progressive bank took an unusual approach.
After deciding to use in-house IT resources, the bank invested in basic credit training for its
technology specialists. It did not take long to realize returns on the investment, beginning with the
efﬁcient and collaborative design of speciﬁcations, and culminating in development of a systemthat exactly matches the needs of all credit-focused staff that is precisely tailored to the risk
management practices of the organization.

Administrative and support staff play important roles in supporting the activities of credit-focused units.
While they may not typically have customer contact, their contributions can make managing credit
risk either easier or more challenging. These functions include auditing, accounting, central operations,compliance, human resources, IT, legal, and marketing.
In terms of credit risk, administrative and support staff are responsible for:
Supporting credit-focused staff
Identifying credit-related risks and opportunities

MOODY’S ANALYTICSENSURING INSTITUTIONAL FINANCIAL SAFETY///// 11When support staff understand the basic elements of credit and risk management, they are better prepared
to deliver solutions that meet the needs of credit-focused staff. High-performing institutions understandthat the beneﬁts of accurate and efﬁcient support justify the investment in training support staff.

The human resources group at a large ﬁnancial institution was in charge of hiring and training
credit professionals. While they received considerable guidance from credit administrators, HR
managers felt they needed more, and took the initiative to participate fully in credit training. This
training provided valuable insights about the nature of credit risk management, which led to more
effective collaboration with credit administration, better hiring selections, and even an improved
training curriculum.

Not all support units are able to take the initiative that these HR managers did. Often, senior management
must launch the effort to support risk management. Nonetheless, determining how everyone’s job affects
credit risk is a good ﬁrst step to ensuring the ﬁnancial safety of your institution.

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//////////SUMMARY

1

2

The strongest credit cultures are built on
the contributions of all employees.

The actions (rather than pronouncements)of senior management are vital to creatinga risk-aware environment and balancing
this perspective with growth initiatives.

3

4

Skills, knowledge, and initiative drive thecontributions from non-credit staff to help
manage risk. Training and coaching provide
and sustain skills and knowledge, while
culture promotes initiative.

Efﬁciency and productivity improve withcredit and risk training, as non-credit
units are able to recognize events that
impact credit risk and communicate more
effectively with credit-focused staff.

Ensuring the ﬁnancial safety of your institution is everyone’s job. Many of the top-performing ﬁnancial
institutions in the world have discovered that the beneﬁts of developing credit skills and knowledge acrossthe organization outweighs the cost of training.

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The Moody's Analytics Difference
We understand that your business operates in a highly competitive marketplace
where the skill level of your associates correlates directly with enterprise success.
We leverage the expertise of our own credit, banking, and training experts
to ensure that our training solutions provide your organization with targeted
content that enables growth in the volume and quality of your loan portfolios.
Get in touch for more information about our learning solutions.