Credit Risk Management and Credit Culture

Credit Portfolio Management

The philosophy underlying modern portfolio management is anchored in diversification. Lending institutions and investors in general become exposed to greater financial risk when their risk assets become concentrated in specific industries, economic sectors or subsectors and geopolitical locations. Failure of such economic sectors, underperformance of industries and geopolitical instabilities will trigger broader systemic crisis as archived in the history books. Such occurrences have significant impact with the potential to wipe out investors equity.

It is therefore imperative that lending institutions and investors alike diversify their portfolios across multiple asset classes, industries, economic sectors and geopolitically to keep risk at a minimum whilst seeking appreciable returns. Asset correlations in the portfolio must be modelled properly with the appropriate metrics and the portfolio restructured in the light of developments in the market space. In lending institutions such as banks and non-banks, building, managing and optimizing credit portfolios are enhanced through 

• strong credit cultures and credit policies
• standardized risk measures and models
• portfolio segmentation
•  stress testing
• independent control functions 

Credit Culture 

Credit culture as defined by Caouette et al. is the collection of principles, actions, deterrents and rewards within the lending organizations. It is also the totality of the credit values, beliefs and behaviours of these institutions (financial). These concepts should be rigorously and thoroughly developed over time and well communicated to employees. Credit culture is idiosyncratic. It differs from one institution to the other. Irrespective of institution size and market capitalization, a strong credit culture is central to building a healthy loan portfolio and successfully managing it.

The credit culture in any financial institution relates to how credit goals are accomplished through a lending strategy. It is very important that the employees understand the institution’s credit culture and risk profile as stipulated in their credit policy guideline. Culture has a profound influence on the lives of a group of people that credit culture also exerts a similar influence on an institution’s lending and risk management system.  It is plausible for undocumented values and behaviours to take precedence over written policies. The later does occur in cultures where certain values are rewarded. An example can be made of growth oriented financial institutions that aggressively grow their assets (on balance sheet) and remunerate employees based on the size of the portfolios they originate and manage. This situation creates a classical agency problem: a culture for employees to take on more risks.  The converse applies to institutions that approach credit very conservatively. Such institutions may lend to reputable and well-established firms. A balance has to be struck in managing the lending institution’s credit portfolio with respect to its risk profile as communicated by the board of directors and implemented by senior management.

Banking is Risky

Banking is a risky business. Besides shareholder’s capital, banks depend on customer’s deposits to fund their intermediation business in which they grant credit to finance businesses. The financial intermediary role of banks has evolved into an extremely competitive one due to significant regulatory changes (closing the loopholes) and industry best practices. Complex financial products (derivatives) have been and are being developed to enhance survival and profitability of these banks. As said by billionaire investor, Warren Buffet, these “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” Sadly, as the risks of financial instruments increased with their evolution, good credit culture was being downplayed until the global financial crisis and the consequences are there for all to see. 

Historical evidence proves the importance and role of credit culture. Without sound credit culture, credit risk is poorly managed since the credit appraisal process becomes deficient in proper rigorous analysis. The purpose and role of credit culture in guiding lending institutions’ operations fails in its entirety when credit culture is taken for granted. Successful financial institutions develop strong credit culture where credit facilities are thoroughly appraised. 

Creating and Keeping the Culture?

The board of directors’ approved and management implemented policies, operational processes and behaviours when clearly defined and communicated to the employees of an institution enable credit culture of an institution to play an integral role in credit risk management. These implemented policies represent the legal framework for the daily operation of the institution. Credit underwriters are guided by these policies in safeguarding the best interest of the institution and theirs as well. New employees irrespective of their entry levels must be introduced to the institution’s credit culture through their induction and or training programme. Tangible materials that spell out the dos and don’ts must be given them as reference materials whenever in doubt. It’s the status quo of some institutions that new employees sit an “exam” that reflects their knowledge of the institution’s credit culture and lending policies. This also enhances the credit culture and brings all hands on deck for a common purpose with unified thought pattern and actions. Intangible aspects of an institution’s credit culture such as unique philosophies should be passed on through day to day interactions and communication with experienced employees at post. An enforcer of a strong credit culture is auditing-process by which credit policies are adhered to and processes and behaviours ensured (McManus, 2004). This control function whips employees in line in the discharge of their duties following approved procedures.

Credit Culture and Risk Management

A culture in which employees demonstrate good awareness of inherent business risks and the risk appetite of the institution is an effective tool in risk management. Management by communicating firm wide risk tolerance and appetite clearly and succinctly is in a position to create a workforce with a credit culture consistent with the risk management aspirations of the board of directors. Such a culture emanates from the senior management and cascades through the institution. Each employee of the institution should have a clear idea of what is acceptable in pursuing the objectives of the institution without having to take on unnecessary risk. 

Conclusion

Considering the risky business of financial intermediaries, it is important not to underplay the role of credit culture in managing financial risk. A quality credit portfolio is a function of strong credit culture since such a culture encapsulates all factors related to credit quality, extension and management. Principally, credit culture underpins the foundation of credit risk management because it guides credit lending decisions and profits institutions that nurture and make it part and parcel of the institutional fibre.