1

THE 8 STEPS OF
CREDIT RISK MANAGEMENT
Safeguard your lending program by learning
about the 8 steps of managing credit risk.

02/08/2021
 2

MANAGING CREDIT RISK

Know your
customer Analyze
Monitor the nonfinancial
risks
relationship
Close the Elements of Understand
Credit Risk
deal Management the numbers

Present the Structure the

deal deal
Price the deal

02/08/2021
 3

1 KNOW YOUR CUSTOMER

• Knowing your customer is the

foundation of the credit process.
• You must operate on pertinent,
accurate, and timely
information.

02/08/2021
 4

KNOW YOUR CUSTOMER (CONT.)

• The information you gather and the relationships

you establish are critical to positioning yourself as
a valued financial consultant and provider of
financial products and services.
• Establishing a good relationship can bring a long
stream of equity to your institution.

02/08/2021
 5

KNOW YOUR CUSTOMER:

PRE-CALL PLANNING
• Find out as much as you can about
the company and its industry prior to
meeting with the customer.
• This up-front exploration allows you to:
– Make the most of the time that
you have with the customer.
– Set up an effective calling plan to
guide you through the interview
process.

02/08/2021
 6

KNOW YOUR CUSTOMER:

THE INITIAL INTERVIEW
Elicit key information. Listen for verbal cues and Establish your credibility as
watch for non-verbal a knowledgeable
cues to help establish a professional and friendly
customer’s needs. businessperson.

Ask questions about the Develop your initial Start to evaluate

company’s products observations about management’s
and services, management’s behavior. qualifications and abilities
customers, suppliers, to carry out the company’s
facilities, management, business strategy.
ownership, and history.

Investigate competition,
Identify the company’s
market share, and the
business strategy and what
probable impact of
the company must do to
economic conditions on
succeed.
the business.

02/08/2021
 7

2 ANALYZE NONFINANCIAL RISKS

• Understand your customer’s

business by analyzing
nonfinancial risks.
– Information gathered in this step
is critical to positioning yourself
as a financial consultant to your
customer and a valued member of
your financial institution’s lending
team.

02/08/2021
 8

ANALYZE NONFINANCIAL RISKS (CONT.)

An understanding of the economic and

industry factors that influence a
company’s financial stability and
financing requirements is necessary
before evaluating the numbers.

02/08/2021
 9

ANALYZE NONFINANCIAL RISKS (CONT.)

There is risk to every line item on the balance

sheet and income statement.

Learn how to evaluate those risks, which fall into

the broad categories of:
• Industry
• Business
• Management

02/08/2021
 10

ANALYZE NONFINANCIAL RISKS:

MICRO AND MACRO LEVELS
• The concept of risk
management can apply to
a single loan or customer
relationship (micro) or to
an entire loan portfolio
(macro).
– At the micro level, a loan is a
risk.
– At the macro level, a
portfolio of loans is a risk.

02/08/2021
 11

ANALYZE NONFINANCIAL RISKS:

MICRO AND MACRO LEVELS (CONT.)

• Your credit policy department

will identify risk factors and
Identifying query the entire loan portfolio
(macro) to judge whether
Risks the particular risk is relevant
to other customers of your
institution.

• How does this identified risk

The Key affect a company’s ability
to repay debt?
Question

02/08/2021
 12

ANALYZE NONFINANCIAL RISKS (CONT.)

Evaluation Critical Thinking Risk

Analysis
• Evaluating • Evaluation • Properly
industry, develops your analyzing these
business, and critical thinking risks gives you
management skills, integrating information to
risks enables you economic, help structure the
to ask questions political, and loan in a fashion
of customers and market issues that will ensure
prospects in into the overall the highest
order to fully underwriting probability of
identify, quantify, process. repayment.
and possibly
mitigate key risks.

02/08/2021
 13

ANALYZE NONFINANCIAL RISKS (CONT.)

The focus of risk analysis is not to

eliminate risk, but to understand its
effect on your client’s ability to repay.
Certain fundamentals of risk
management have emerged as classic,
time-proven strategies.

02/08/2021
 14

ANALYZE NONFINANCIAL RISKS (CONT.)

Financial institutions that have (or want to gain) a
significant exposure to a particular industry usually have
industry experts on both the lending and credit analyst
teams.

Industry experts provide an intimate knowledge of an

industry and will:
• Identify, understand, evaluate, and mitigate risk.
• Provide expertise in the event of a loan workout situation with a
customer.
• Provide efficient marketing strategies in acquiring creditworthy
and profitable clients within a particular industry.

02/08/2021
 15

ANALYZE NONFINANCIAL RISKS (CONT.)

Identify the
risk.

Anticipate
unidentified Analyze the
risks. risk.
The Process of

Understanding
Risk
Monitor the Quantify the
risk. risk.
Mitigate the
risk.

02/08/2021
 16

3 UNDERSTAND THE NUMBERS

There are many benefits and risks associated with

establishing a banking relationship. As a lender, you
should know:
• How the requested funds are going to be used
and how they are anticipated to be repaid.
• How to identify, categorize, and prioritize all of
the risks inherent with the customer that are
known at the time of the analysis as well as
those that are anticipated to be in existence over
the period of the relationship.

02/08/2021
 17

UNDERSTAND THE NUMBERS (CONT.)

Before beginning any financial

analysis, it is important to
understand why companies and
individuals borrow money.

02/08/2021
 18

UNDERSTAND THE NUMBERS:

THE REASON FOR BORROWING

Established
New Clients
Relationships

• It is doubly important to • Your assessment of the

probe into how and why loan will be guided by
the loan request your knowledge of the
originated. changes in your
customer’s asset
structure as it goes
through its business
cycle.

02/08/2021
 19

UNDERSTAND THE NUMBERS:

REASONS FOR BORROWING
Support increased Finance inefficiencies Purchase of long-term
level of sales, in working capital operating assets or
necessitating asset management, investment assets,
increased funding i.e., slow down in including purchases
for inventory and accounts receivable or related to merger and
accts. rec. inventory turnover. acquisition strategies.

Repay trade creditors,

other bank debt,
Make personal Show more cash
“friendly” debt, taxes,
investments. balances.
or any other liability
that has come due.

Make payments for

Pay expenses, but
dividends and stock
hopefully not
Repay long-term debt. repurchase programs
unplanned operating
within the equity
losses.
account.

02/08/2021
 20

UNDERSTAND THE NUMBERS:

REASONS FOR BORROWING

The reason for borrowing provides you with insights into

the company’s ability to repay.
• A complete understanding of the historical and
projected financial performance of your customer is key
to your analysis.
Once you are comfortable with the nature of the loan
request, the process of understanding the numbers can
begin.

02/08/2021
 21

UNDERSTAND THE NUMBERS: THE PROCESS

To understand the numbers:

• Focus on the financial capacity of
the company as evidenced by
the information provided.
• Examine the accuracy of the
information.
• Examine the quality and
sustainability of
financial performance.
02/08/2021
 22

UNDERSTAND THE NUMBERS:

THE PROCESS (CONT.)
Knowing the Auditor
Analyze the competency and reputation of the firm or individual
preparing your customer’s financial reports.

Accounting Fundamentals
Review the auditor’s Engagement Letter, Financial Statements, and
Management Letter, as well as accounting fundamentals and generally
accepted auditing principles (GAAP).

Balance Sheet Quality Analysis

Analyze the balance sheet along with relevant liquidity and
leverage ratios.
02/08/2021
 23

UNDERSTAND THE NUMBERS:

THE PROCESS (CONT.)
Income Statement Quality
Analysis
Analyze revenues and costs along with income statement ratio
analysis.

Cash Flow Statement

Analysis
Analyze operating cash flow, investing cash flow, financing cash flow,
and cash flow ratios.

Analyzing Financial Efficiency Cash Flow Drivers

Use profitability ratios and turnover ratios to analyze a company’s cash
flow drivers.

02/08/2021
 24

UNDERSTAND THE NUMBERS:

THE PROCESS (CONT.)
Developing Projections
Determine the reasonableness of assumptions behind business fundamentals
and swing factors.

Personal Financial Statement

Analysis
Analyze the personal financial statement and tax return in the event that you
are lending directly to or seeking additional credit support from an individual.

Company Financial Statements

Analyze the company’s financial statements and provide an overview.
Obviously, a small company will have a simpler chart of accounts, while a
large domestic or international corporation will be more complex.

02/08/2021
 25

STRUCTURE THE DEAL:

4 UNDERSTAND THE BUSINESS
Before completing a financial analysis, identify the
characteristics
that influence a company’s success.

The nature of the

business.
The competencies
or deficiencies of The nature of the
management. industry.
Areas to
Study

The impact of
The business economic
strategy. conditions.

02/08/2021
 26

STRUCTURE THE DEAL (CONT.)

• Having completed the analysis

of the business, you can then
move to analyzing the financial
reports: historical and
forecasted.
• Understanding profitability and
cash flow, liquidity, and
leverage are key to structuring
the facility.

02/08/2021
 27

STRUCTURE THE DEAL (CONT.)

Once you have identified the

underlying borrowing cause(s) and
understand both primary and
secondary repayment sources
available, the next step is to
structure the loan.

02/08/2021
 28

STRUCTURE THE DEAL (CONT.)

Loan structure depends on the nature of

your customer’s business and how your
institution intends to provide financial
services to the company.

02/08/2021
 29

STRUCTURE THE DEAL (CONT.)

• Loan structure is • The structure of • Your customer

important because the deal needs this
your customer appropriately assurance in order
needs to clearly establishes your to run the
understand the customer’s business
boundaries within expectations for efficiently, i.e., if
which it can how your institution they operate in
operate and will perform during accordance with
continue to depend the term of the the terms and
upon your relationship. conditions of the
institution for its loan agreement,
financial services your customer can
needs. expect funding
from your
institution.

02/08/2021
 30

STRUCTURE THE DEAL (CONT.)

Project how the company
will perform in the future,
including likely primary
and secondary repayment
sources.
Consider requiring Anticipate challenges
additional loan support, and problems that may
such as guarantees. arise.
Structuring a
Customer
Relationship
Match an appropriate
type of loan to both the
Secure the credit loan purpose and the
facility with collateral. likely repayment
Develop a set of sources.
covenants that protects
your institution for the
duration of the
relationship.

02/08/2021
 31

5 PRICE THE DEAL

Determining the
appropriate pricing is
critical.
It ensures that your
financial institution will
be adequately
compensated for the
risk of the deal.

02/08/2021
 32

PRICE THE DEAL: COMPLEX FACTORS

DETERMINE THE FINAL RATE
Interest rate risk may In addition to company-
Commonly, loan pricing
be managed specific variables,
systems are based on
through the use of factors that affect
floating rates.
financial futures and pricing include:
options.
Interest rate risk Marketplace in
mgmt. and loan which the
pricing are highly bank
interrelated through This pricing tactic
operates.
the pricing models. ties the loan rate
to a base rate
General economic
As the major source that responds to conditions.
of profitability for movements of
many banks, loan money market
interest income rates. Matching the pricing
plays an important and maturity of the
role in shareholder bank’s assets and
return. liabilities.

02/08/2021
 33

PRICE THE DEAL (CONT.)

Your financial institution’s

finance and lending divisions,
in conjunction with the
ALCO, will set loan pricing
and service fee strategies.

02/08/2021
 34

6 PRESENT THE DEAL

Communicating your
findings in a cogent and
professional manner is a
critical step in getting your
proposal approved.
Credit decisions should
not be made on financial
statement analysis alone.

A credit review would not be complete

without an equally significant emphasis
on the qualitative issues such as the
ability of management, the competitive
business environment, and the
economic issues relating to the
business.

02/08/2021
 35

PRESENT RE THE DEAL (CONT.)

Summaries &
Recommendations
Economic &
Sources of Competitive
Repayment Key Credit Environments
Elements

Financial Analysis Management

and Projections Assessment

02/08/2021
 36

7 CLOSE THE DEAL

Closing the deal takes place

after the analysis,
structuring, and pricing
have been completed.

02/08/2021
 37

CLOSE THE DEAL: BEST PRACTICES

• Prepare a closing memorandum or detailed loan
1. documentation checklist.

• Provide sufficient time for the borrower and other

2. involved parties to gather documents.
• Provide instructions on how to complete your
standard documents to the borrower and other
3. parties; ensure that the forms are returned to you for
review prior to the closing.
• Prepare drafts of loan documents and deliver them
to the borrower or other involved parties prior to the
4. closing with sufficient time for the recipients to have
the documents reviewed by their own legal
counsel.
02/08/2021
 38

8 MONITOR THE RELATIONSHIP

By having an appropriate
structure to the relationship,
agreeable to both parties, you
have established a mechanism
for monitoring individual
transactions within a relationship.

02/08/2021
 39

MONITOR THE RELATIONSHIP (CONT.)

Monitoring can be accomplished in two ways:

2. Require that an officer

1. Have a loan covenant of the company
checklist that routinely regularly
tracks your customer’s (e.g., quarterly) certify
adherence to covenants. as to the company’s
compliance with all of its
outstanding agreements.
Note: Failure to notify your customer of a covenant default may
make your institution’s future enforcement of the covenant difficult.

02/08/2021
 40

MONITOR THE RELATIONSHIP (CONT.)

Periodic reviews, ratings, and audits can ensure

that the client is one that will create long-term
profitability for your bank.

02/08/2021
 41

LEARN MORE
For additional information about the credit
process,
visit www.rmahq.org where you can:
• Find many related articles in the Credit
and Lending Studies Packs.
• Enroll in The Lending Decision Process for an
in-depth look at the lending process and learn
how to accomplish the best practices
discussed in this white paper.
• Subscribe to eMentor to make smarter, faster
credit decisions.
• Apply for the Credit Risk Certification exam.

02/08/2021
 42

SHARE THIS PRESENTATION

Visit http://www.rmahq.org for information on risk management.

RMA is a member-driven professional association whose sole

purpose is to advance sound risk principles in the financial services
industry.
RMA helps its members use sound risk principles to improve
institutional performance and financial stability, and enhance the risk
competency of individuals through information, education, peer
sharing, and networking.
Become a member today.

02/08/2021