Evaluating Credit Risk

Prior to becoming a thorn in the sides of executives and directors of small and mid-sized banks at Mid-Atlantic Partners, Jerry Shearer worked as chief financial officer of two $100 million South Carolina banks: the Bank of Charleston and Bank of Columbia. At that time, he was a liaison between management and directors, giving the board key financial and credit information about the institutions that helped the directors do their jobs.

It was after the banks were sold to the larger, $1 billion Anchor Financial in the early 1990s that Shearer says he found himself on the outside looking in. Still on the board but no longer privy to the inside financial data he was used to seeing, he had to rely on management for crucial information. It was an experience that had a profound influence on his view of bank boards and, ultimately, the investment strategy of the Columbia, South Carolina-based hedge fund where he is a principal.

“I don’t feel that, as a group, directors get the information they need to make informed decisions,” Shearer says. “My personal opinion is that directors of banks with less than $5 billion in assets just don’t have the information they need to carry out the jobs the institutions are paying them to do.”

Shearer now describes himself as “an active shareholder promoting shareholder value.” yet the concerns he had as an outside director are the same ones facing independent directors at banks nationwide today. Charged with overseeing management’s decisions, strategies, and tactics, they are largely dependent upon those same executives to keep them informed of important events affecting the institution. Without good information, it is not always possible for boards to uncover problems until it is too late.

Watching the store

For banks in particular, concerns about credit quality have escalated during the past six months in light of the fall of Enron Corp. Not only has Enron heightened worries that other companies might try be entangled in the kind of shell game the Houston-based company played, but board have a greater appreciation of how one customer’s downfall may have serious effects on their institutions. Enron’s problems created confusion at sophisticated institutions like J.P. Morgan Chase, which took several weeks to uncover its exposure to the Houston company. The bank finally pegged its risk at nearly $2.6 billion instead of its original estimate of $900 million.

In addition, economic indicators during the past two or three quarters have given risk managers at financial institutions plenty to worry about. Consumer debt is at an all-time high, mortgage debt is increasing, and bankruptcies are expected to rise by as much as 20%, by some estimates.

George Freibert, chairman of Louisville, Kentucky-based Professional Bank Services, says there is little a board can do to prevent the collapse of a seemingly solid customer. Nonetheless, there is plenty directors can do to ensure the collapse doesn’t take their bank down with it.

“I tell directors, ‘your job in overseeing the bank and its loan portfolio is not to predict when the next downturn will come, but to know that it’s going to happen, and to make sure the bank can survive it,’” he says. “It’s a matter of the board asking the right questions and not being intimidated by management.”

Among the most important questions directors can ask regarding credit quality is how much of the bank’s capital is lent to one borrower or to entities within specific industries or economic sectors. Some of the biggest bank failures in U.S. history were caused by banks concentrating too much of their loan portfolios in specific locations or industries. The crisis affecting Texas banks in the mid to late 1980s began as a consequence of excessive lending to energy-related companies in the region and ended with massive loan losses in commercial real estate in the same markets.

Concentrations of any kind of risk, whether geographic-, product- or sector-specific, can cause problems for lenders.

The litany of troubles affecting the telecommunications sector these daysu00e2u20ac”accounting irregularities, too much debt, overpaying for third-generation mobile phone networks, and overstated expectations for growthu00e2u20ac”are a recent example of how product- and industry-specific problems can impact an entire sector.

Stress tests

Sometimes diversification is difficult to obtain, particularly for smaller, geographically isolated institutions or for companies with monoline lending strategies. Still, there are steps an institution can take to manage concentrations of risk. Few have done it better than Falls Church, Virginia-based Capital One Financial Corp. The company has overcome its single-product credit card lending strategy and is branching out into automobile and small business lending through a combination of geographic dispersion of its customersu00e2u20ac”it lends to people throughout the United States and in select markets in Europe, Australia, and South Africau00e2u20ac”and with investments in technology.

The technology component helps management and the board stay abreast of credit quality by testing the loan portfolio to see how chargeoffs and delinquencies would change under different economic scenarios. The company discloses the highlights of the tests to shareholders every quarter.

Likewise, Charter One’s systems allow it to track loans generated through specific marketing campaigns, enabling management to promptly adjust the terms related to those loans to assuage credit quality deterioration. While board members are not directly involved in the such decisions, they are apprised of the results in the company’s steady credit quality trends. In January, for instance, they saw that even though chargeoffs on managed loans rose to 4.42% during the fourth quarter from 3.92% in the third quarteru00e2u20ac”still better than any other major card issueru00e2u20ac”delinquencies of 30 days or more fell to 4.95% from 5.20% the previous quarter.

“The essence of Capital One is to use information and testing to get the best understanding of credit quality and to use that superior insight to bring out the best products to consumers,” says Richard Fairbank, the company’s chairman and chief executive officer. “As we see a recession coming, for us, it’s very much business as usual, because we’ve always assumed a recession was upon us.”

That kind of information is invaluable to directors entrusted with overseeing credit quality and ensuring that shareholder value is not being eroded. Likewise, periodic reports about average loan size may indicate whether an institution is taking increasingly large exposures with single borrowers, thereby increasing severity of losses in an economic downturn.

The use of technology is imperative for larger banks. Bank One Corp., for example, opened more than 1.1 million new credit card accounts during the third quarter of 2001, alone. With that kind of volume, directors don’t have time to review every new loan coming in the door, let alone know the names and business of every borrower. They rely on technology to efficiently provide aggregated loan and delinquency information on a timely basis.

While it’s obvious that directors can’t approve individual loans with those kinds of volume levels, Freibert says directors should always review certain classes of loans, regardless of the size of the institution or the size of the debt. Admittedly, he says, larger banks’ directors are more removed from the approval process. To counter this, they “should focus their attention more on the trends in such things as classified loans and loan concentrations,” he says.

Loan committee members often cite time as their enemy in managing their workload. Freibert suggests raising the limit on the size of secure types of loans management can approve without board oversight. This way the loan committee can focus more time and attention on loans creating greater risk. In particular, he says, the board should spend its time looking at large, unsecured credits, loans to insiders, loans with exceptions, renewals, and extensions on classified items.

Know thy borrower

For many small and mid-sized banks, limited technology budgets and less experienced staff make it difficult for directors to obtain data comparable to their competitors. “Credit analysts [at larger banks] were a lot better and knew more about what to look for and analyze,” recounts Shearer. “The smaller banks didn’t have that caliber of person.”

Yet directors at smaller banks rely upon their own knowledge of the local market to supplement credit data provided by bank executives. Frank Jones, a Pittsburgh-based attorney and outside director of $2.3 billion S&T Bancorp, says the Indiana, Pennsylvania-based bank provides him and his fellow board members with a report of what is “on the front burner.” In particular, there is a list outlining which new loans the bank has approved and a periodic review of what is on the institution’s questionable loan list. Using this information in conjunction with directors’ own insights into their markets and local businesses has been successful for S&T. As of Sept. 30, the bank reported non-performing assets at a paltry 0.55% of total assets, according to SNL Securities. The credit quality numbers came even as the bank’s nine-month earnings amounted to 2.02% of those same total assets.

Directors who know the market and institution well are an invaluable asset. Thomas Rose Jr., an attorney and director of The Bank of Southside Virginia in Carson, says the new-loan lists provided by the $392 million institution give telltale hints about loan concentrations that he and the other board members can interpret. “The board would probably recognize any agriculture loans because most of those go through one branch,” Clements says. The list of new loans provided to directors contain information about who the borrower is, the credit score on the loan, key rate and terms, and a description of the collateral behind the credit. Rose says the first thing he reviews is how much each business and its owners have borrowed from the bank. In essence, he is looking to see if the bank has a significant exposure to any one borrower.

Peter Clements, chief executive of Southside Virginia, says the bank also gives directors a monthly rundown of every loan that is 60 days past due. As of Sept. 30, that wasn’t much, with nonperforming assets amounting to just 0.13%, according to SNL Securities. The candor of the report, though, keeps management alert. “We don’t have any rugs to sweep things under,” he says. “The knowledge that we are providing that information to [the board] every month makes us work that much harder.”

Ongoing, detailed communication with directors can be a factor in producing better returns, maintains Freibert. In a survey conducted in 2001, for instance, his firm found that 40.8% of top performers say their banks had hosted at least one retreat for directors per year, compared with just 34% of below-average performers. “Banks that tried to communicate with their directors and held board retreats had better performance,” he explains. “Institutions that respect their directors and have well-organized boards that know what they’re doing are generally associated with better performance.”

Investor Shearer agrees, saying institutions such as Winston-Salem, North Carolina-based BB&T Corp. and SouthTrust Corp. of Birmingham, Alabama consistently report record earnings without any surprise chargeoffs or restructurings. Ken Chalk, chief credit officer with BB&T, provides a thorough review of credit quality, profitability, and growth to the bank’s executive committee every six months. Most of the review covers credit quality issues such as past due and nonperforming loans, loans on the bank’s “watch” list, and actual chargeoffs. Troubled loans above a certain size also are reviewed individually with committee members, Chalk says.

These updates examine growth in different segments as well. Growth rates in commercial loans, small business loans, and retail loans, as well as sales finance credits, are all covered, and the general direction of the segments are carefully analyzed. “The most important thing,” Chalk says, “is the trend.”

Supplementing the semiannual reviews are monthly updates on credit quality management gives to the entire BB&T board. Although less thorough than the executive-committee reviews, directors still have a chance to probe trends in nonperforming loans, loan loss reserve coverage, and growth rates.

Finally, Chalk says, the bank takes the whole board through a comprehensive review of the portfolio once a year. This review allows directors to discuss credit quality, profitability, and growth and gives directors a peer comparison, a description of changes in policy issues, and a review of risk management strategies. “The key things to keep the board informed on are the strategic issues,” Chalk says. “What are you doing to safeguard shareholders for the long term?”

Asking the right questions

Communication is a two-way street and directors must not be reticent about asking questions of management when the answers aren’t in front of them, even though such probing may be a source of tension. Southside Virginia’s Rose says he and the other directors are not afraid to ask management questions about specific loans. And when they ask, he says, management always answers in a timely manner: “You may not get it before the board meeting is over, but by the end of the day or the next day, you’ll have it.”

Still, Freibert says the limited number of times directors question management is a source of concern. “They tend to go along with each other and rely too much on the presenting officer,” Freibert says. “But as a director you have to satisfy yourself that the loan makes sense. You can’t be afraid to vote no.”

In Shearer’s opinion, directors aren’t speaking up enough. “In the banks we have invested in and rattled their cages, we suspected that the directors were handpicked by management. I think that directors as a group generally just go to the meetings, listen to management, nod their heads, walk out the door, and draw their monthly stipend.”

Good credit quality numbers often are the result of a combination of conservative underwriting by management, open communications with the board, and greater input from directors. Rose says directors on Southside Virginia’s executive committee typically want to discuss first-time borrowers at board meetings to get up to speed on who management is financing. Likewise, the bank’s policy requires at least two members of the executive committee to sign off on larger credits. The approvals are sent straight to the directors between board meetings. “Chances are I’ve heard about these big loans in the executive committee meeting,” Rose says. “If not, I will call management to ask them about it.” Jones says S&T Bancorp has the same policy. “If we don’t have the information we want, management goes to the borrower, or whoever has it, to get it for us,” he says.

S&T looks at larger loans in a similar manner, though its reviews are run through the board’s loan committee. While the committee does not technically sign off on the loans, he says, it does wield power. After reviewing the loan documentation, directors may ask management to rework a loan that doesn’t pass muster.

But that level of oversight doesn’t always sit well with customers. Southside Virginia’s CEO says customers don’t appreciate having personal and business financial information put in front of half a dozen or so directorsu00e2u20ac”some of whom might be competitors, suppliers, or even friends. Clements says Southside Virginia doesn’t use a director’s loan committee because “it is kind of an antiquated device.” Besides, he says, loan underwriting is a management function, not a board function. As a result, he doesn’t share any financial information about specific borrowers with directors unless the loans are large enough to warrant review, and then only by the executive committee.

For most institutions, though, the loan committee is still the most common means to help the board to maintain a prudent credit culture. Moreover, there are safeguards that protect the use of inside loan information, notes Freibert.

“Many states have laws prohibiting the disclosure of any information about a bank or bank customer, but more commonly, this is a business standard which requires directors to keep the business of the customers confidential because the information is presented to them confidentially,” he says. “The violation of this code has the potential to cause financial harm to the bank as well as the individual director.”

Working as a team

In the end, the board must depend on management for timely, accurate, and meaningful information. Rose says in his case, that trust comes easily after having served on the bank’s board for nearly 27 years and helping recruit many of the executives that now serve as Southside Virginia’s management.

That trust also is the result of knowing there is adequate oversight within the bank. At Southside Virginia, an internal auditor reviews documentation for each credit and continues to look at the files regularly even after the loans are made. “That makes you feel better knowing that they are not just checking the files one time but checking them again to make sure that things are where they should be,” says Rose.

But Shearer maintains that more in-depth information is necessary for the board to make good credit decisions. When he was an outside director, he says, the president or chief credit officer of the bank would inform the board that they were underwriting a $500,000 or $1 million loan and describe the purpose the loan and the net worth of the borrower. While that information was helpful, it was not enough. “What I saw that was lacking was information that showed [the composition of] the net worth of the individual and the method of valuation,” Shearer says. “I found that valuations deteriorate rather quickly.”

Despite the criticism levied by Shearer and others about the quality of information provided to directors, Freibert says that the situation is better today than it was even 15 years ago. Largely as a result of the painful period of the 1980s, bank directors in general are more fully informed and have a better understanding of their duties.

In the end, Freibert says, it is mutually beneficial for bank executives and directors to work together. “Directors can be very helpful to a bank and its CEO. A bank needs to have a board of directors, so bank executives should make the system work for them.”