Managing Credit Risk in the Modern Age

What are some traditional credit risk metrics and why are they not enough?
Past due amounts, debt service coverage (DSC), collateral valuations (LTV) and net charge offs (NCOs) are traditional credit metrics banks and boards follow in keeping track of credit quality. They’re meaningful as they depict credit quality at the loan or transactional level—where it all begins. However, the traditional metrics chronicle past performance, not the future. Following the financial crisis and all that the industry learned from it, banks must be more forward looking, probative and quantitatively sophisticated in credit risk management. It is imperative that banks use macro metrics, which require different disciplines and methodologies, because they give a picture of the bank’s aggregated profile of risk—the sum of the parts—for management, boards and investors. Both approaches are needed. However, the use of macro metrics doesn’t mean traditional metrics should be thrown out.

What are some new terms directors should know in looking at the risk of the overall portfolio?
Many of these new terms emerged from the global financial agreements known as Basel II and III and were largely for big, global banks until after the financial crisis. Groups of loans can be analyzed for potential EL (estimates of loss), which are the product of PD (probabilities of default) multiplied by LGD (loss given default). Due to their predictive attributes, they should now be central to the macro-risk assessments and a part of the nomenclature for all sized financial institutions. Many directors have become familiar with these terms as most capital raises or M&A due diligence processes use them to establish portfolio credit marks.

A concept called risk grade migration shows you the direction the different risks in your portfolio are moving and EL/yield analyses show you how much you are getting paid for the risk you are taking on. These metrics can inform the board about the integrity of credit oversight and future loan pricing protocols.

Another concept to understand is the baseline loss estimate within stress tests. It’s the core loss estimate the portfolio would have suffered before stress conditions were applied. While stressed losses are not likely losses, they are possible losses and the key benefit to calculating them is to understand the bank’s ability to withstand theoretical losses. One aspect of the Dodd-Frank Act that is rarely discussed is the potential for regulators to add a supervisory assessment of additional capital should it be deemed necessary. Embracing these more macro concepts will be a significant investment against such a punitive assessment. It also contributes to more informed and effective bank management.

What questions should directors ask themselves and management about the credit culture?
Given the different disciplines and approaches for transactional and macro credit risk, have we synced the two culturally? Does our credit culture encourage individual accountability? Does our organization challenge assumptions within the entire credit process? Are we too reliant on committee decision making at low levels of the approval chain? Within legal and regulatory constraints, are we getting paid for the risks we’re taking?

How does loan review fit into this process?
Independent loan review is more important than ever, for two reasons. First, as hunter-skinner lending cultures emerged within the past decade, a bank’s credit function has become the de facto underwriter of credits. It needs its own, independent validation. Plus, as the credit crisis wanes, and the pressure grows for loan growth, there needs to be a reliable check on what is put on the bank’s books that might hurt the bank down the road.


David Ruffin


David Ruffin is a principal at IntelliCredit, A Division of QwickRate.  His extensive experience in the financial industry includes an emphasis on credit risk in a variety of roles that range from bank lender and senior credit officer to co-founder of the successful Credit Risk Management, LLC consultancy and professor at several banking schools.  A prolific publisher of credit-focused articles, he is a frequent speaker at trade association forums, where he shares insights gained helping lending institutions evaluate credit risk—in both its transactional form as well as the risk associated with portfolios based on a more emergent macro strategy.  Over the course of decades, Mr. Ruffin has led teams providing thousands of loan reviews and performed hundreds of due diligence engagements focused on M&A and capital raising.