This is why you should implement information systems to promote effective challenge

Effective challenge is the backbone of risk management for financial institutions. It provides a framework for performing critical analysis by utilizing informed individuals who can objectively identify limitations and assumptions, as well as produce appropriate changes. This is a critical way to identify the factors that could put an institution at risk. Information systems—or software solutions—provide a financial institution a number of benefits across the life of a loan and through portfolio management.

The goal of effective challenge is to ensure that key risks are not ignored. This does not mean listing every possible thing that could go wrong, but rather discerning the elements that could put the organization at risk. Focusing only on the key risks keeps the waters from being muddied by smaller items. However, it’s important not to lose sight of minor items that start to accumulate. For example, an exception to the underwriting standard of debt service coverage might be approved for a transaction because there are sufficient mitigants in that particular case. Many of these same minor exceptions can aggregate into an issue, and effective challenge means someone should start questioning what impact a number of these exceptions will have on the health of the overall portfolio.

It is a fine line. The person providing the challenge must both be open to understanding another’s perspective while also holding the line on what she thinks needs to be corrected. Sageworks’ Alison Trapp explains the top three ways information systems promote effective challenge:

Make approval more efficient to allow time for challenge.

One of the overarching benefits of software solutions in lending is the efficiencies they bring to the process. A poll from a recent Sageworks webinar revealed that nearly half of bankers believe that almost every process involving the life-of-the-loan takes twice as long as it should. By implementing software solutions to automate the spreading of borrower tax returns, for example, the institution can spend its time in credit analysis focused on the risks and thus reach a decision more quickly.

Software solutions can also ensure that critical risks for a given loan type are included in the underwriting. Business rules can be used in Sageworks Workflow, for example, to generate checklists automatically based on a number of characteristics, including collateral type. An institution can use this functionality to prompt the credit analyst to consider specific factors. For example, think about a bank or credit union considering a working capital line to a landscaping company. The credit analyst may have reservations about the seasonal nature of the borrower’s business, but a checklist with the working capital days outstanding trends, historical loan balances throughout the season and customer concentrations could be a significant help to the review process.

Use regular reporting to monitor policy and underwriting exceptions.

Financial institutions use the credit policy as a primary tool to effectuate the strategy the board of directors wants to pursue. For that reason, it is critical for the financial institution to monitor deviations from the standards it sets in its credit policy and underwriting guidelines. This detailed reporting is time-consuming and prone to human error when compiled manually; software solutions that identify exceptions at the time of underwriting can simplify this requirement significantly. Additionally, additional approval levels can be mandated by the software if a policy or underwriting exception exists.

Use portfolio data to determine samples for targeted exams.

The third line of defense focuses on reviewing the portfolio for emerging trends. Identifying potential concentrations for review is made much simpler and more effective when loan level data is made readily available along with a variety of other characteristics, such as collateral type or industry.

While growth is good, prudent growth is key. Sustainable growth relies on a combination of lines of defense to ensure that the loans a financial institution makes are grounded in the principles of safety and soundness. An organization run solely by lenders likely would have losses beyond its capital adequacy within a fairly short time period. One led solely by credit or loan review likely would never make loans at a high enough risk level to be able to make profits and stay in business. Both sides are needed and can be used to support growth. While it can be difficult to develop an environment that supports effective challenge, the benefits make that effort worthwhile.

Additional Resources:

Whitepaper: Supporting Growth with Effective Challenge

Webinar: The Process Improvement Process

About Sageworks:

Sageworks offers banks and credit unions lending, credit risk and portfolio risk solutions to efficiently grow and improve the borrower experience. By automating the life of the loan with Sageworks, bankers book commercial loans faster and reduce risk. Sageworks uniquely provides integrated solutions and industry expertise to more than 1,300 financial institutions that achieve an average 38% higher loan growth than peers.