Loans: increase results, decrease risk

By John Baer

With the adoption of new bank regulations – including Dodd-Frank and Basel III – on the horizon, commercial banks will be bracing for higher regulatory capital requirements and the need for more transparency. Heads of risk and technology departments will need to investigate the completeness of their existing commercial origination tools and will require fact-based commercial loan systems that take into account overall portfolio and corporate risk strategies which require robust data management.

“By understanding transaction risk and the impact on your portfolio, you can make more informed pricing decisions.”
-John Baer

What changes are you seeing in technology needs at financial institutions?

John Baer. The expected increase in regulatory capital requirements will result in the commercial lending industry's need to improve underwriting processes in order to generate more profitable loans.   Over the past decade, investment in commercial loan systems has lagged investment in retail loan systems. To stay competitive, a bank's commercial underwriting processes need to be more efficient.  Banks are rethinking the way they manage counterparty risk data and how to make more informed origination decisions, based on risk appetite and the risk-adjusted performance of their overall portfolio.  From a technology standpoint, commercial banks will need to implement modern loan origination systems with robust risk analytic capabilities to address these challenges.

Firms can create operational efficiencies and reduce underwriting costs by standardizing business processes on a workflow-driven, straight-through processing platform that includes a risk data warehouse. This type of system allows enforcement of consistent risk management policies and consolidates data for reporting purposes at the same time.

With the increased banking regulation, regulators will continue to demand more granular financial and non-financial data that drive loan decisions. As such, banks are looking to streamline their systems and adopt a single risk database to bring increased transparency and efficiency to their processes. With one central source of risk data, banks can also gain a consistent view of risk across departments and reduce unnecessary, redundant systems. This consolidation of origination processes into one platform can also reduce a bank's total cost of ownership (TCO).

How are US regulatory reforms such as the Dodd-Frank Reform Act causing changes in the financial services industry?

JB. The Dodd-Frank Reform Act is quite expansive and concerns many aspects of a financial institution. One key tenet is a more unified view of data across an organization. For example, the Office of Financial Research (OFR) will be created and given broad authority to request and collect data from banks.  Financial institutions will need to have a flexible data warehouse with contract-level information.  Banks will also be required to quickly respond to regulatory requests on everything from regulatory capital to liquidity risk, necessitating centralized, aggregated and summary data.    

Firms should also recognize the business value that comes from superior analytics and improved data management capabilities within a straight-through processing loan origination system. This involves more than providing granular data, but also having complete and clean counterparty and transaction-level data to calculate regulatory and economic capital in order to identify and evaluate opportunities to improve profitability within the institution's lines of business.

To bring the most value to an IT investment, what should banks look for in a commercial loan origination system?

JB. There are many loan origination vendors, but very few offer a comprehensive, risk-based platform.  Most platforms promise better operational efficiencies, but the real power of a modern loan origination system comes from coupling workflow efficiency tools with risk analytics directly embedded into the origination workflows.  By leveraging risk scoring and risk-based pricing analytics - whether you're lending to public or private firms - more effective, informed, and profitable lending decisions are made. During the next three years, institutions will absolutely be using more and more analytics to make data-centric lending decisions.

Having an accurate assessment of your risk is very important, and having a risk rating solution is the foundation for a sound credit risk management strategy. With superior analytics as part of a standardized loan origination system, you're able to develop consistent and uniform rating criteria.

Having a standardized commercial platform with risk-based analytical workflow capabilities further helps banks to operationally integrate portfolios of acquired or merged financial institutions. Given the current competitive environment for commercial loans, banks that are growing organically or through acquisition cannot afford underwriting inefficiencies or ineffective loan decisions. 

Aside from a regulatory compliance standpoint, what is the business benefit of having better analytics?

JB. The real benefit comes from deploying capital more efficiently, increasing return on equity (ROE), Shareholder Value Added (SVA) and Economic Value Added (EVA). Many firms are concerned that higher regulatory capital requirements will lead to lower returns.  We believe, if done right, high returns can still be achieved within your risk capacity.  This is where real-time risk-based pricing capabilities that reflect your overall portfolio come into play.  By having portfolio-driven price recommendations and other analytics embedded within the origination process, your organization has a system in place for measuring and analyzing risk-adjusted return on capital (RAROC) - and will have a process in place to allocate capital more effectively. 

By understanding transaction risk and the impact on your portfolio, you can make more informed pricing decisions. It's all about how the transaction looks in the context of your portfolio and having that information at the point of origination, not a month or a quarter later.  You may very well be underweight in a particular sector and be able to price a loan more aggressively than a competitor to win the business. Risk-based pricing also helps you understand the incremental value the originating transaction brings to your portfolio.   

Do improved analytics and a straight-through loan origination systems lead to better client relationships?

JB. Absolutely. Borrowers benefit when banks know upfront what paperwork is required to underwrite a specific type of loan and relationship managers do not have to continually go back to the borrower. It is beneficial to have all client documents stored in one location, electronically within the workflow tool.

It also helps when relationship managers perform pre-deal limits checks for potential breaches. The pre-deal check also enables the proper level of approvals required to efficiently advance the underwriting process, minimizing the turnaround time of the origination process.  This will undoubtedly lead to stronger client relationships, more high-quality deals and better ROE and SVA for the bank. 

Finally, banks can use analytics and workflow automation to streamline the loan origination process so high quality borrowers can be fast-tracked, saving firms unnecessary opportunity costs.  

Biography

John Baer is a Senior Director of Product Management at Moody's Analytics where he is responsible for the Credit Assessment and Loan Origination product line.  Prior to Moody's Analytics, John was with Ernst & Young, advising private equity and corporate clients on investment acquisitions. John specialized in financial due diligence, working alongside commercial lenders valuing targeted transactions.