The Emperor Clothes: Credit Risk Underwriting

Credit risk underwriting has become an extraordinarily complicated process for business lending and investment.  Books have been written about it.  Banks spend fortunes on trying to manage it.  Everyone in finance has been taught the importance of it and yet it remains a pivotal element in the search for the Holy Grail – the reduction of investment/loan loss severity risk.  Billions are now spent on managing credit risk but nobody seems to have asked the central question of why this process is so important.  The answer appears to be we have to manage execution risk and mitigate potential loss events and credit risk underwriting is supposed to provide the answer to this issue and yet it has routinely failed, but the industry has continued to rely upon its increasingly obvious shortcomings.

This has the hallmarks of insanity: we keep doing thing the same way and keep expecting a different outcome.  Evidently our industry needs some intense therapy.

Credit risk underwriting relies heavily upon subjective decision-making criteria in a vain attempt to demonstrate the potential of the borrower/sponsor/issuer to manage execution risk (and thereby manage term, maturity and technical default risk over the term).  The CREFC Principles-Based Underwriting Framework (one of the key guidance missives routinely used as a basis for underwriting commercial real estate loans) specifically makes this point:

“One of the more difficult aspects of credit underwriting is trying to discern the character of the individuals who will be making decisions on behalf of the borrower. Evaluating character has some objective elements, but is ultimately a subjective assessment. The critical question for an underwriter is how the borrower will behave if the collateral’s performance deteriorates or payments on the loan cannot be made for some reason. In evaluating character, the underwriter considers the sponsor’s prior behavior including late payments, credit disputes or judgments and major litigation.”

Obviously, this is mining fool’s gold as what happened in the past has almost no bearing on what will happen during the term of the loan because:

  1. Rational Choice Theory states all market participants will act in their own self-interest at all times and in all circumstances.  This means that if someone is squeezed hard enough they will disregard future problems and costs in favor of what works for them now.  Think about Sears, ToysRUs and the other recent debacles in the retail sector and you get the point.
  2. The entire exercise is flawed due to the fact it fails to address the real question of what would happen to future operations (i.e.: the potential for losses) if the borrower (or any other employee, for that matter) were to be no longer part of the transaction.  This is the most important consideration and yet it ultimately gets too little attention until tragedy descends.
  3. Subjective criteria leaves the door wide open for future litigation due to allegations of discrimination or gross negligence on the part of the lender – a battle you can never really win with the additional opportunity of getting hit by traffic going both ways.  The only real advantage is to bear investors who realize a given institution’s stock is going to take a hit because they can’t sell loans.

Maybe it’s time we admitted the obvious and embraced a proactive solution to managing credit risk that would actually have the potential to mitigate execution risk on an ongoing basis.  The proactive approach would necessarily embrace a comprehensive approach to business operations planning, management reporting, accountability and measures of actual productivity and goal management.

In the alternative, we can all look at the Emperor’s clothes together while we eat more than $500 billion in losses worldwide this year.  Shareholders and regulators have already reached the boiling point on these issues so change is going to have to happen whether we like those clothes or not.

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