Credit Culture

Looking at Credit Culture this month, The FDIC recently released their quarterly banking profile (QBP) for the third quarter of 2017. The Wall Street Journal analyzed this information and stated, “The rate of 12-month loan growth at U.S. banks in the third quarter hit its lowest level since the end of 2013, according to data released last week by the Federal Deposit Insurance Corp. That marked the sixth consecutive quarter of decline for this measure of loan growth.”[1]The QBP also reported total annualized loan growth rates for community banks to be 7.3% at the end of the third quarter, down from 7.8% at the end of the second quarter.

The current bank cycle is in a historically long expansionary phase. This has led to strong credit quality and intense competition in the market to grow earnings. The reporting for the current quarter reflects some softness in loan demand, potentially further escalating the means with which bankers choose to compete for the few deals.

In the OCC Advisory Letter 97-3, Credit Underwriting Standards and Portfolio Credit Risk Management, the OCC was concerned with credit quality and portfolio monitoring with respect to the length of the healthy economy, competition, and easing of commercial underwriting standards. Sound familiar? This was included in an advisory letter published in January 1997 and demonstrates that what was old is new again as these concerns echo the current banking environment.

The purpose of the advisory letter was to remind bankers how the OCC views sound portfolio credit risk management processes. The first of six bulleted topics was listed as an “Assessment of the credit culture,” which the OCC defined as, “A bank’s credit culture is the sum of its values, beliefs, and behaviors, should reflect the standards and values of the board of directors and senior management.” More simply put, it is the way things get done. Every bank has a credit culture, whether intentional or situational, whether implied or explicit. The nature and effectiveness of the credit culture will strongly influence the relative long-term success of the bank.

John McKinley and John Barrickman published, “Strategic Credit Risk Management.”  (Robert Morris Associates: Philadelphia, 1994.) In this work, they identified four primary types of credit cultures:

• Values Driven
• Immediate Performance Driven
• Production Driven
• Unfocused

In “Credit Culture, Part II: Types of Credit Cultures,” by Dev Strischek (RMA, 2002) these four types of credit culture are further defined to include key characteristics of each credit culture:

Values Driven

• Focus on long-term consistent performance is top priority
• Driven by company values
• Demonstrates a strong credit organization
• Success is based on balanced, prudent profitability

Immediate Performance

• Share value is top priority
• Driven by the annual profit plan
• Credit takes on risk during periods of weak loan demand
• Success based upon strong risk management in a down cycle

Production Driven

• Market share and loan volume is top priority
• Driven to be the biggest
• Credit finds a way to do the deal
• Success based loan approval process and the ability to manage loan pressure

Unfocused

• The top priority changes frequently
• The driving force changes with priorities
• Credit tends to be reactive
• Success based on consistent credit risk management process

Despite their presentation as separate, distinct cultures, most banks possess elements and aspects of all of them. The value of the preceding descriptions and discussions of the four credit culture models lie in helping banks figure out what culture they have now, and what they need to develop in order to move toward a more values-driven culture.[2]

The culture, risk profile, and credit practices of a bank should be linked. If the credit practices and risk-taking activities of a bank are inconsistent with the desired culture and policies, management should find out why and initiate change to bring them back in balance. When practices do not correspond to policies, lenders may not clearly understand the culture, credit controls may not be effective, policies and systems may be inappropriate for the credit environment, or employees may be rewarded for behaviors that are different from those advanced by policy. If the risk profile deviates from cultural norms, management should reassess the limits, policies, and practices.

The Federal Reserve Bank identified four underpinnings of strong credit culture:

• Policy
• Process
• Auditing
• Behavior

As the starting point, credit policy provides a philosophical framework for day-to-day credit decisions. Policy will guide officers in balancing the bank’s earnings objectives. Process is the line-driven operational arm of credit extension and credit strategy. Through the delegation of authority, a strong credit process will provide a policing mechanism for the integrity of the credit apparatus. Auditing is responsible for ensuring adherence to credit policy, procedures, and business plans. Behavior is related to the values held by bank employees. Each credit officer should be expected to reflect conservative risk-taking attitudes and a commitment to excellence. Exceptions to policy should be few and well documented when approved.[3]

“The CEO’s commitment to credit quality legitimizes credit discipline. Top management’s endorsement for credit quality and expectation of high credit quality standards will prompt all levels of the organization to participate in and support the standards.”[4]“While policies, rating systems, and controls are integral to discipline, top management must lead in order to instill discipline. The credit process may be fine-tuned to catch risky deals, but the CEO must be prepared to tell both lenders and credit approvers that unacceptable risks are not to be approved.”[5]

It is understandable that a bank may feel pressured to ease underwriting standards in today’s competitive environment. Nonetheless, bank management should keep in mind that, regardless of the current environment, the loans and leases the bank underwrites must be consistent with its long-term strategic portfolio objectives and the level of risk the bank is willing to tolerate over the long run.[6]

Enlighten Financial is a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to us directly, please call: (920) 445-8881.