Handling Portfolio Credit Risk: Has Your Bank Defined Its Risk Appetite?

In their analysis of the root causes of the financial crisis, banking regulators determined that one of the main problems was the fact that many banks had not appropriately defined their risk appetite. As a result, regulators are engaging an increased emphasis today on portfolio credit risk management. They expect community banks to create a risk appetite framework that sets a forward-looking view of the bank’s desired risk profile in different scenarios while establishing processes for achieving this profile. The framework will clearly define roles and responsibilities in the areas of monitoring and appraisal while setting up the practices that link the board’s objectives with management actions to ensure that the risk profile remains within the defined limits. Community banks should draft a risk appetite statement that explains the aggregate level and types of risk the bank is willing to assume within its risk capacity. This statement should include both qualitative and quantitative measures expressed relative to earnings, regulatory capital, risk measures and liquidity needs, among other factors.

A Vigorous Risk Management Program

The risk appetite framework and statement form the foundation of a robust risk management program that should be closely integrated with your bank’s overall strategy. This will become the basis for establishing a risk culture that should permeate the entire bank — sensitizing all employees to their role in managing credit risk while holding them accountable for the results. According to Enhancements to the Basel II Framework:

“It is the responsibility of the board of directors and senior management to define the institution’s risk appetite and to ensure that the bank’s risk management framework includes detailed policies that set specific firm-wide prudential limits on the bank’s activities which are consistent with its risk taking appetite and capacity.”

Your risk appetite statement should energize strategic and day-to-day business decisions and be consulted whenever you’re considering to introduce a new product or service, expand existing product or service lines, or enter new markets.

To be effective, the statement should:

• Report material risks under normal and stressed conditions.
• Evidently state the amount and types of risk your bank is comfortable with.
• Permit management to take action so the statement has a real effect on the bank’s business strategy and risk profile.
• Implement the risk culture established by the bank while setting clear boundaries and expectations.

Questions to Request

In determining your bank’s appetite for risk and level of risk tolerance, you should ask yourself several important questions: 1. How will we know when we should slow down growth to avoid overextension? 2. How important is growth and expansion in the current market environment? 3. What is our pain threshold, or the dollar amount of a material transaction? 4. In what areas (e.g., industries, markets, types of borrowers) does growth and expansion make the most sense for us? Once you’ve answered these questions, you can regulate your strategies to echo current market conditions. For example, in an expanding economy, you could employ a more aggressive risk strategy by implementing lower debt service requirements, higher loan-to-value ratios, longer terms and slower amortizations. In a slowing economy, meanwhile, you might lessen your risk appetite by raising debt service requirements, lowering loan-to-value ratios, shortening terms and speeding up amortizations. In the 2013 release of Guidance on Supervisory Interaction with Financial Institutions on Risk Culture, the Financial Accounting Standards Board (FASB) specified the following indicators of a sound risk culture:

• It starts at the top. The bank’s risk culture and core values must be set by management and the board of directors.
• All employees are held accountable. Employees at all levels of the bank understand the risk culture, as well as the fact that they are personally accountable for how their actions impact the culture.
• Trials and feedback are welcome. A range of views and feedback from all levels of the bank are encouraged as part of the decision-making process.
• There are incentives for the desired risk behaviors. Employee behaviors that reinforce the bank’s risk and credit culture are compensated financially.
• Line of business growth is managed prudently. In addition, policy and portfolio limits are followed while the risk, credit culture, and message are reinforced continually and consistently.

Share Your Statement Organization Wide

It’s serious that your risk appetite framework and statement be shared throughout the organization, but especially with your line lenders. Otherwise, lenders may simply default to behaviors that result in the highest compensation for themselves — regardless of whether or not these behaviors agree with your risk and credit culture. To talk further about managing portfolio credit risk, please give The Whitlock Company a call at 417-881-0145.