Many executives at community banks fulfill many functions and wear numerous hats. However, we are advocates of separating the Chief Lending Officer (CLO) and Chief Credit Officer (CCO) functions at community banks from both an operational and strategic perspective. We still see some community banks that either do not have an official CLO role or combine the CCO and CLO roles. We feel that CCOs cannot be effective fulfilling the true strategic objective of drive loan sales and increasing relationship profitability, and likewise, CLOs cannot be effective in measuring and monitoring credit risk. In this article, we highlight some of the more important CCO value drivers and demonstrate why CCO and CLO roles are not aligned by using the risk-return paradigm and considering various real-world community bank loan scenarios.
The risk-return tradeoff model states that the potential return (yield) rises with an increase in risk. Using this principle, banks can generate higher revenue by taking on a higher amount of uncertainty or credit risk. The tradeoff does not need to be a linear function, but for our purpose, we can assume that it is without any loss in explanatory power. The risk-return relationship is demonstrated in the graph below.
The real world of banking does not follow this simple and perfectly efficient tradeoff between risk and return. Instead, loans are not efficiently priced, and some loans will price above the risk-return line and, unfortunately, more loans will price below the risk-return line. Further, banks will self-impose maximum credit risk tolerance through the adoption of loan policies. So the more realistic risk-return relationship for community bank loans is shown in the graph below.
Considering the above view of the risk-return relationship, a community bank will have an opportunity to book loans that fall above and below the efficient risk-return line. Also, bankers will pay particular attention when loans approach the bank’s maximum risk policy tolerance.
The Chief Credit Officer’s Job
CCOs have many job requirements and functions. The CCO is responsible for the review of the bank’s loan portfolio, assure that documentation complies with loan committee approvals, detect deterioration in loan quality, and review and ensure internal compliance objectives are met. CCOs also carry managerial functions and communicate with the board and other senior management. They determine and establish lending policies, and are responsible for guiding their staff. However, we believe that there are essential and rudimentary functions that CCOs must perform that cannot naturally be duplicated by other managers at a bank. These two functions are most strategic for the CCO’s role and create the highest value for community banks. These two strategic functions differentiate good CCOs from average CCOs and create tremendous value for community banks.
The first function is the implementation of credit analysis and quality assurance to assign credit risk ratings to loans. Very simply, the CCOs number one function is to assign measurable credit risk for each loan – a CCO will measure and assess the unit of credit risk for each loan on the risk-return graph. This task is not trivial and involves art and science. It is the task of predicting the future based on a vast amount of information but limited knowledge of future events. Stated another way, the CCO’s first most important strategic function is to peg each loan on the X-axis of the risk-return graph. Simple to define, but difficult to do well.
The second most important function for a CCO is to provide insight and advice on credits that can alter a borrower’s assigned risk rating. That is the ability to suggest how to alter the collateral, support, or documentation to shift the risk of a loan to the left or right in the X-axis of the risk-return graph. As each loan is presented, the CCO must be able to quantify the change in risk that can occur through the alteration in LTV, cash flow support, personal guaranty, covenants or other attributes of a credit.
Translating these functions to our graphs, the CCO must be able to place each loan on the X-axis in the graph and explain what may be changed in the credit to shift the risk left or right on that graph.
Real Community Bank Examples
As simple as these two imperative functions sound, fulfilling them properly is incredibly difficult. Good CCOs are very valuable assets to their banks. However, CCO’s primary tasks are not well connected to the objectives of a CLO, and by separating their functions, banks can achieve better results.
First, let’s consider a scenario that we often witness in loan committees. A loan is submitted that may not meet the bank’s minimum credit policy. The graph below shows a loan as “Loan A.”
The CCO must assess the credit risk of Loan A on the credit spectrum and inform management if the loan is above or below the bank’s policy guideline. In this example, the CCO identifies Loan A outside the bank’s accepted policy. The CCO will also explain how the credit could fit the bank’s policy through a change in collateral, cash support, advance rate, documentation or some other credit attribute. After this, the CCO’s job is largely accomplished. It then becomes the CLO’s job to make an argument for the credit. Banks can, and do, approve loans outside policy.
It is not necessary for the CCO to have final approval for the credit. It is more important for the CCO to define the nature of the risk and to quantify it for adjudication by loan committee. The CLO or CEO may have the credit authority to approve the credit, but the CCO’s primary function was fulfilled by identifying and quantifying the risk, and explaining how to bring the loan to within stated policy. The scenario in the graph above should be rare as most loans should be well within policy. Max credit policy exceptions should be few and far between because they represent a small percentage of the bank’s possible business opportunities, but it should not be the CCO’s job to make a case for an exception.
Let us consider another more frequent scenario. In the example below the CCO pegs the loan (Loan B) within the bank’s policy guidelines. However, based on the expected return the loan falls well below the efficient risk-return tradeoff and is an underperforming asset for the bank.
Some CCOs will argue against the bank booking the credit, but this is not the CCO’s job and is counterproductive for the bank. The CLO’s job is not to sell the relationship to loan committee, or CEO, or to whomever holds approving authority. The CLO is tasked with driving sales performance, which includes maximizing risk-adjusted return on capital. The CCO identifies the denominator (risk), and the CLO is tasked with driving the numerator (return or yield). The CLO is best equipped with information to show why the bank should accept a below-market return on risk or what additional income the bank is not considering which should be captured. The CCO’s first job was accomplished (pegging the credit risk). The second value-add from the CCO should be to advise how the loan can be structured to reduce credit risk to get Loan B closer to the efficient risk/return line. However, it is not within the CCO’s purview to maximize ROE – that task should rest with the CLO.
Let us consider a third scenario witnessed at community banks. Here the loan (Loan C) is assigned a credit risk rating by the CCO, the loan is well within the bank’s loan credit policy, and the loan is also above the efficient risk-return line. The issue that some will argue is that by splitting the CCO and CLO positions, loans like Loan C will never come to the bank. The CLO, to drive sales, will bring loans either at or below the efficient risk-return line, thereby maximize revenue at the expense of credit quality. This is where we see a different outcome – by compensating CLOs not for volume but for risk-adjusted return on capital, the CLO will drive better decision making in choosing credits. The CLO will be able to obtain more loan approvals by identifying lower risk loans since those will have a better risk-return profile and a higher probability of approval. By combining the CCO and CLO function into one position, stresses the importance of the CCO gatekeeping capital to the lowest permissible risk policy. Having just a single gatekeeper of bank credit policy drives more loans to the brink of marginal credits. This results in riskier and less profitable loan portfolios.
For those banks that argue that they do not have the ability to hire a CLO to complement a CCO, we advise those banks to take an existing senior lender and promote them to an equal corporate title given the CCO and make both individuals report to the CEO. Most banks over $1Bn in assets have concluded that the CCO and CLO positions should be separate. That decision may be the result of more loan volume and the need for more personnel to tackle the extra work. However, there are some real strategic benefits in dividing these positions. By understanding the essential value of the CCO role, and then dividing credit measurement and sales performance, community banks can unlock much more value from every CCO.
Submitted by Chris Nichols on November 13, 2018