A GlobeRisk Perspective on Commercial Banking
Commercial Banking has done extremely well in recent years but, in 2007 is walking on water.
Low inflation and low interest rates has led to significant asset inflation, financed by the banks on apparently attractive returns with credit default falling to all time lows within the western economies. Working capital lending has also been supported by moderate and stable economic growth.
On the acquisition funding side, sponsors have done very well as strong stock markets have delivered all the positive benefits of highly geared structures. However, with the exception of the UK and some European countries, stock market valuations are no longer attractive and a sharp decline will expose the negative aspects of geared borrowing.
This has already emerged for hedge funds (and some investment banks) in relation to sub prime mortgage backed investments, particularly where heavy gearing has been used.
In the last five years Banks have invested heavily in improved credit rating tools as part of the introduction of Basel2. In our view, whilst it is beyond doubt that a huge improvement has occurred in the "rank ordering" power of default rating tools, several major issues remain:
- As is usual in this stage of the lending cycle Banks are investing less in workout/recovery infrastructure and are lending with increasingly weaker conditions, warranties and other covenants
- Loss on default models are poorly understood, particularly in relation to modern lending covenants
- The migration of credit rating to "good" over the last five years has led to some complacency in relation to the ability of credit ratings to migrate to "bad" during a recession
- Consideration of economic cycle effects is poor, especially in relation to the "hype" areas of portfolio management and credit derivatives
Portfolio management has seen a lot of attention in recent years. Unfortunately, rather like RAROC in the mid 1990's much portfolio management effort misses the point and organisations are not receiving good value. The key issues are
- Establishing clear objectives for the optimisation
- Exposure measurement methods that are consistently based on the risk consumption of respective products
- Establishing a consistent risk limit methodology for obligors taking into account obligor size, risk and payment affordability and, taking account of contract maturity
- Incorporation of guarantors, collateral and other support in a risk consistent way across all obligors
- Establishing effective transfer pricing and cost allocation mechanisms so that revenue can be compared on a consistent basis
Finally, "everyone" knows that a lending business needs a credit department. Custom and Practice for credit departments and credit officers has developed over several years and operating model flexibility is well understood.
Very few commercial banks have made any progress with two key questions?
- What value does the firm get from its credit processes?
- Can we do it better?
(Issues in respect of credit derivative modelling are covered in our perspective on Investment Banks)
GlobeRisk has developed several consultancy services to assist banks as they address these issue areas
GlobeRisk has developed a suite of credit rating models. In each case the models integrate default likelihood, exposure measurement, collateral and other security and residual default:
- Project Finance Rating Models
- Property and other Asset Finance Rating Models
- Rating Predictor Models
- Country Risk Rating
- General Commercial credit rating models
- Underwriting review
To help banks with the optimisation of credit processes GlobeRisk has three services
- A review of underwriting processes
- A world class credit process design (Credit 2011)
- Achieve effective portfolio management
From a Firmwide risk management perspective, GlobeRisk services include:
- Maximise your Share Price
- Risk Adjusted Performance Management and Value Based Management (VBM)
- Economic Capital and Risk Based Shareholder Value
- Design of firmwide operating models
- Capital Efficiency program
- Governance, Controls, Audit and Risk Management framework optimisation
- Total Enterprise Risk Management (TERM)
- Strategy Development assistance