Once a loan is booked, it needs to be reviewed over time for changes in credit. The problem is that many banks have only one type of commercial loan review. This standard review usually requires approximately eight hours of work from credit, loan administration, and management. When this effort is combined with data expense, the report is produced at a cost of just over $1,000 per credit. If you are one of these banks that only have one type of review, then the good news is that you can save a material cost anytime you want AND have better risk management. Since credit follows a normal distribution, creating one-size fits all credit review is incredibly inefficient. In this article, we explore the problem and the solution plus show any bank that is worried about efficiency how to squeeze out better performance while improving the customer experience.
The solution is simply to optimize the review process. While this can look many different ways, the simplest way to start is to create three different types of reviews and then assign each to a specific credit spectrum. If a credit is low risk, has improved or has not changed, then there is little need to a full review and the credit process should be one of updating numbers and validation. For some banks, in good times, this is 90% of all credits. For the average bank, and for the sake of this analysis, we will assume that credits that fall into the above category compose approximately 70% of the portfolio.
Higher risk credits and credits that have deteriorated, then receive the standard review as before. Very complex, risky or credits that have materially deteriorated get a full review which takes more time and is more encompassing. By assigning each review to your credit spectrum, you get the distribution as graphically depicted above.
The Cost Savings
A “Light Review” with the help of third party data (PayNet, Experian, etc.), takes about three hours of effort and can be done once per year. If you conservatively assume that 70% of an average bank’s portfolio would qualify, that is a cost of approximately $250k per 1,000 credits. Comparatively, a medium or standard review takes about eight hours and is done twice per year. While this currently composes 100% of the average community bank’s credit review process, we can now shift this review to the credits that best warrant that level of analysis. We conservatively estimate that approximately 25% of a bank’s credits fall into this category. Finally, a full review with enhanced re-underwriting takes place and is likely done on a quarterly basis in order to hyper-monitor the credit quality. Here, given the current state of credit quality, we estimate that 5% of the credit relationships would fall into this category.
As can be seen below, this optimized allocation of resources would net a bank more than $1mm in cost savings per 1,000 credits. That is a 48% savings – money that can be better utilized for compensation, fintech investment or shareholder dividends.
Banks need to reduce their efficiency ratio below 40%, in our opinion, to be competitive in the long run. As such, here at CenterState, we are taking dramatic steps to improve our process and allocation of effort. Depending on the types of credit, risk profile and distribution, banks could further optimize and have five or more different levels of reviews. Getting more granular in the review process not only saves costs but also better matches effort with risk. Consider that if you over-allocate resources to quality credits, you get no benefit. The level of risk remains the same. However, this is not true if you under-allocate. Not putting enough effort into risky credits could potentially leave the bank under-reserved and slow to react to changes. We saw this occur during the last downturn and it will no doubt occur again.
In addition to better cost and risk alignment, there is also the side benefit of being less intrusive to your client and more flexible to their needs since the average light review process requires less effort and information on the customer’s part.
This is just one of the many changes we are doing at CenterState Bank. If you are interested in finding out more, we will have the team that is responsible for this effort on a free webinar coming up June 27th. If you are interested in learning from our experience in order to save time and improve upon our process, please feel free to register HERE.
Submitted by Chris Nichols on May 18, 2017