Credit Process & Underwriting: Sharing Ownership of Risk

by Rita Garwood January/February 2016
Credit managers — the unsung heroes of our industry — are more likely to be found at their desks than under the spotlight, but in this issue, Monitor editor Rita E. Garwood checks in with three underwriting executives to hear their thoughts on regulatory compliance, competition, how the credit risk management process has evolved and what keeps them up at night.

Before any deal can be approved, thoughtful decisions must be made. Is the borrower who he says he is? Do the company’s financials match up to its lease application? Enter the underwriting team which sifts through the supporting data and examines the associated risk before issuing a final verdict. During more than 40 years in print, Monitor has never put credit managers on center stage, but for this issue our curiosity was too strong to resist. How has the underwriting process been affected by regulation and competition, and what is the credit manager’s outlook for the future?

Keeping Up With Compliance

Rules, facts and figures are often the first things that come to mind when many people think of credit managers. As if the process wasn’t tough enough before the Great Recession, how have the ensuing regulatory compliance rules affected the underwriting process?

“The ‘After Credit Crisis’ saw improvements in tools, systems and reporting,” says Al Mancuso, vice president of Equipment Finance Credit at Fifth Third Bank. “Shared ownership of risk between credit and the line became even more of an emphasis for our equipment finance company.”

Robert Hawley, senior credit executive at Key Equipment Finance, says that while the credit risk assessment process and structuring fundamentals have not changed much as a result of regulatory or compliance issues, lessons learned from the credit crisis have had a meaningful impact on the process of risk assessment.

“We have implemented a more robust concentration framework — industry, asset, single name — that helps us manage the risks imbedded in our portfolio,” Hawley says. “We think about the lessons learned in the credit crisis and assess transactions in the context of the client’s ability to weather a similar downturn. The crisis also resulted in us exiting certain industries and refocusing our business on industries where we could grow in line with our risk appetite.”

Kevin P. Prykull, senior vice president and credit underwriting executive with PNC Equipment Finance, agrees that the fundamentals of risk assessment, process, structuring and residual setting remain unchanged. However, he says the Great Recession demonstrated that the need to adjust client expectations and effectively manage the customer experience is imperative.

“As a bank leasing and equipment finance company, we are subject to heightened standards and regulatory scrutiny like never before. So are our bank peers,” Prykull says. “Such regulatory and compliance requirements add complexities to our approach, require far more in the way of documenting what and how we do things and at times can slow down the process.”

Standing With the Competition

While clearing the hurdles of regulatory compliance, our panelists must also contend with a highly competitive environment. In her report on the ELFA’s Credit and Collections Conference, frequent Monitor writer Susan Carol indicated that credit managers have a dual approach. They are focused on structuring transactions in a way that won’t be problematic later, and they consistently look for ways to help their companies grow competitively, which brings pricing into play. How are credit managers adapting to this new reality?

“The current competitive environment is particularly fierce, and there are pressures on both pricing and structures,” Hawley says. “We have been willing to selectively accept reduced margins, but are focusing those efforts on our best clients and where an opportunity to forge a broader relationship exists. We see some stretching of terms in the market but have not been willing to compromise deal structures to win deals.”

Mancuso’s team remains focused on making decisions that are mutually beneficial for both the client and the bank. “We strive to focus on listening to fully understand the clients’ needs and objectives on every engagement and then provide each customer with innovative solutions and high quality execution,” he says.

“It is very challenging as the market moves away from our conventional norm of what makes for an acceptable transaction at an appropriate risk adjusted return,” Prykull says. “We remain disciplined in our traditional approach to risk/return and only adjust when justified. In many cases, that means walking away from transactions that don’t make sense for us.”

With loan-to-deposit ratios below 70%, there’s been talk of the use of higher hold limits to partially offset the need to grow earning assets when the size of a transaction affords this opportunity. Prykull questions this approach.

“As a mainstream bank funded by traditional deposits, we certainly have the balance sheet to entertain more growth. However, one needs to ask if this is the right time to load-up on low-spread business, particularly in light of the longer tenors on our transactions,” Prykull says. “Perhaps we may be better off to originate and then distribute some of the equipment finance paper within the market. Thus, we can meet client needs, but not weigh down the portfolio with low margined, longer-term business.”

Better Recovery Rates

Earlier this year, Monitor published the results of an analysis on bank-owned equipment finance companies that showed the recovery rate on leasing financing receivables to be significantly better than C&I loans, which suggested some truth to the advantage of having a second way out.

Prykull agrees: “Leasing has always had distinctive advantages over loans. Its tax, legal and accounting attributes tend to cause more favorable outcomes over bank loans when things go wrong. Well-secured and properly structured equipment loans also have an advantage over unsecured bank loans in terms of recovery rates.”

“By financing essential or income producing assets the probability of timely repayment is improved, even in times of stress,” Mancuso says. “In addition, recoveries and better outcomes are more likely in events of default.”

“Clearly, we have experienced better recovery rates when we have the advantage of leased assets that can be easily monetized,” Hawley says. “The key in the recovery equation is really based on the strength of the industry, the market acceptance of the asset and the condition and maintenance of the asset.”

Hawley says recovery rates for less tangible assets such as IT hardware and software have been lower as expected; however, the overall loss experience in these assets classes has been good due to effective assessment of the asset’s essentiality.

Even though overall loss rates of leases and well secured equipment loans are better than bank loss rates, and equipment loan outcomes are better than earlier expectations and predictions, Prykull warns that this is no reason to loosen standards.

“None of this should imply that we should ignore the credit aspect in our initial underwriting and decision,” Prykull says. “Collateral and asset ownership does not substitute for applying good credit judgment on the front end in the decision process. As it seems to go the credit, the industry and the collateral value all ‘head south’ in a downturn, causing us to lose more than we would like. Reducing the probability of default in the first place just makes good sense for us as a bank leasing and equipment finance company.”

Exposure Limits Under Scrutiny

Another aspect that has become critical post crisis is exposure limits. “Credit committees are more focused on exposure to both specific clients as well as to industries than they were pre-crisis,” says Mancuso, adding that the tone and tenor of credit committee meetings is positive. “The goal is still to do good business. Syndicating is the preferred method of managing exposure to large customers.”

Prykull says PNC does not use a credit committee for approval, but instead uses a very developed prescreen forum to vet the relevant issues of a deal and its impact on the portfolio. While the meeting itself has not really changed, he says some of the discussion items have. “Addressing factors like pricing and return, structure and tenor are more common and pervasive these days,” he says. “The need to evaluate and review on regulatory and compliance matters is a more frequent item in discussions than ever before. There are far more teachable moments in our discussions and messages that we send to our employees to help them fine tune the attributes of a good deal.”

Despite the added intricacy, Mancuso says post-recession regulatory requirements are not a hindrance to the deal process. “In the regulated space we have a responsibility to underwrite and maintain our portfolios n conformity with regulatory requirements,” he says. “We do feel that following industry requirements will lead to better customer relationships in both up and down markets.”

Since regulation has benefited the financial system, Prykull says this will likely cause unregulated lenders to become subject to the same level of scrutiny as banks in the future.

Assessing Long-Term Risk

Another future concern often discussed in equipment finance is the “graying of the industry.” When all of the gray-haired experts have retired, how difficult will it be for entrants in the field to assess intermediate and longer-term risk if they haven’t had the benefit of living through a cycle or two?

Mancuso disagrees with the premise that gray hair alone improves underwriting ability. “Young people can learn from past cycles even if they have not lived through them,” he says. “Data is more prevalent and easier to obtain than ever, which evens out the playing field.”

Hawley’s credit team has a few younger members who lived through the last credit crisis, which makes them better prepared to assess the risks of credit on a “through the cycle” basis. He also leverages other approaches to assess the intermediate long-term risks of a transaction, such as utilizing data and analytic observations from prior downturns. “Identifying emerging risks allows us to guide the business toward the right clients and right industries,” he says. “Leveraging the lessons learned from our Special Assets Group (SAG) is an important part of our knowledge base. We have a solid feedback loop with our SAG team.”

Prykull says talent development is a priority for PNC, which has some very skilled junior talent in the underwriting and credit organization. “We offer our high potential junior talent exposure and access to top management, and help them develop critical thinking in order to gain insight into our company, industry and economy. At the end of the day, however, there is nothing better than good old fashion experience!”

The Gifts of Technology

During the past decade, even the most seasoned professionals have had to keep up with changes in the underwriting process, thanks, in part, to technology.

“The advancement of the information age with the internet providing us access to information and data, that would have been unimaginable a decade ago,” Prykull says. “The speed and depth of such information and our ability to use it in the credit underwriting and approval process enables us to make better credit decisions.”

Hawley has seen considerable improvement in the data analytics capability of the business. “We now have better insights into industry trends, market forces and portfolio stresses much earlier,” he says. “This allows us to tailor our view on an industry or business much more responsively and adjust underwriting as needed.”

“There is greater emphasis on projections, forecasting and running sensitivities than in the past,” Mancuso says. “Anticipating downturns and adverse markets are routine in credit assessments.”

Prykull points to two other areas that have advanced significantly during the past decade. First, quantitative models for decision making have improved immensely — the sophistication, accuracy and predictiveness is better than expected. Second, there is greater emphasis on portfolio management, which provides better and timelier information and data and more predictive models, giving greater insight into portfolio evaluation. “We have come a long way on these fronts in ten years,” Prykull says.

The Horizon Ahead

Given the added emphasis on portfolio management, our panelists agree that too much exposure to certain sectors would be concerning. However, despite prevailing uncertainty in the market with respect to energy, Mancuso says cyclical and commodity based segments will always play large roles in leasing and equipment lending. To support this, Fifth Third’s team focuses on the long tenured customers with solid fundamentals who have managed through cycles in the past.

“Oil and gas exploration and production is a concern with crude trading below $45 a barrel,” Hawley says. “I also see risks in ancillary business such as oil field services and petroleum transportation as these areas have been experiencing and will continue to experience revenue pressures.”
Prykull says PNC has proactively and thoroughly assessed sectors in its portfolio for issues and will continue to do so in the future. “The obvious sectors, like oil and gas, coal, scrap metals, healthcare, public finance and international have had a high degree of scrutiny and review,” he says. “The sector with the most softness in the current market would be commodities and industries related to commodities.”

As 2016 begins, opportunities and challenges abound. As the vice president of a bank-owned equipment finance company, Mancuso says the greatest growth opportunity will be in leveraging an existing sales force and customers in order to do more with Fifth Third’s products. “The more we become a ‘front of mind’ offering the better we will do,” he says. “The competition will remain intense and unexpected challenges will occur.”

Prykull’s goals for 2016 echo a sentiment heard more frequently these days: While growth is welcomed, it is not always the primary objective. “Our growth plans are moderate,” he says. “Growth solely for the sake of growth is not encouraged; the deals must be right for PNC in the long term.”

So what keeps credit managers up at night? For Hawley, it’s the fact that the complexity of leasing transactions seems to be increasing over time. “I worry that, as an organization, this increasing complexity might bring unintended consequences or we might miss a critical risk in our assessment of a transaction,” he says. “As a result, we align our most senior credit personnel to these complex transactions to bring value to the organization.”

With the considerable focus on regulatory and compliance matters, Prykull also hopes that his team isn’t missing something. “We continue to scour the portfolio for signs of the next crack, although no new ones seem evident absent those mentioned previously,” he says. “We are always concerned about the next event risk occurrence. Those are hard to predict. As an industry, we are so focused on the day-to-day grind that there may be an opportunity to potentially miss something big out on the horizon that can impact our portfolios and business.”

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