KNOWLEDGE The Most Valuable Intangible

Anju P. Bhargava

While employed by a large bank, the author oversaw a study of loan losses with the intent to prevent such problems in the future. The results are as useful to banks today as they were to the institution conducting the analysis in the early 1990s.

One of the many challenges facing bankers is also one of the most important: internalizing lessons learned from past losses. Although each economic cycle has its unique characteristics, given vary ing underlying forces at work, banking veterans can attest that the fundamental lessons remain unchanged. They also can attest that sharing this message with younger professionals can be a frustrating exercise.

Lending, Opus 101. Whatever the circumstances surrounding it, the basic credit transaction remains the same. Fundamentally, a loan results from the interaction between the relationship manager and the customer. The instruments through which the relationship manager orchestrates the transaction are knowledge, the micro culture within the business unit, the quality of the portfolio, bank policies, and the corporate strategic vision. Just as the success of a concert depends on weather, audience, acoustics, and other factors, the RM's symphony can go out of tune from myriad external factors affecting the industry as well as repercussions from regional and global economic shifts. Loan losses result from a disconnect of one or more of these internal or external factors.

One Bank's Story

In the 1990s, a $30 billion regional bank (the U.S. subsidiary of a major global bank) recognized the need to capture and integrate its collective learning into the organization's awareness system. The bank management acknowledged a simple truth: you have to know where you have been to know where you are going. It set to work changing the credit culture environment and putting a management decision audit tool in place.

In 1994, the bank's office of the chairman authorized an in-depth study--an autopsy, actually--of more than $1 billion in charge-offs from 1989 through 1993. The purpose was to ensure that history would not repeat itself. Quantifying the crisis provided a way for the staff to understand the past and accept the transformation of the bank's credit culture through key corrective initiatives. (According to the Office of the Comptroller of Currency, this was the only financial institution to undertake such an extensive and critical introspective analysis, though many others had a similar loss experience).

The study began by forming a small (1.5 person) task force in the risk management unit. This independent area had not been involved in decision-making during the crisis period. Separation from the line, including the workout areas, allowed for objectivity in research.

A multi-pronged approach to leverage learning integrated credit analysis, audit, and reengineering techniques with technology. As the bank's MIS was geared more towards data capture than analysis, a data base was developed to capture the qualitative information and take different snapshots of the quantified loan loss portfolio. Through an in-depth review of the credit files supplemented by interviews, each credit was dissected to record the facts and the understanding behind the numbers. The objective was to turn the data in the files along with the experience and the wisdom of the people into a usable tool.

Staff cooperation was at a high level as they were eager to learn from past errors. From the beginning, the staff was assured this was not a witch-hunt but a learning exercise. In fact, no names were recorded in the analysis. This made the people comfortable and willing to provide the necessary details.

The sample. The sampled credits represented a cross-section of industries where loan losses were experienced from 1989 through 1993. Greater emphasis was placed on understanding issues related to the large dollar charge-offs. The study discussed below is a composite of 11 primary industries affected. It should be noted that not all industries and divisions in the bank experienced loan losses. And the findings are no doubt representative of the experience at other regional U.S. banks.

Industry sources [1] indicate that more than 30% of the large banks (with assets over $2 billion) went through a crisis in the 1980s. The crisis was caused by changes that started in the 1960s--deregulation leading to disintermediation, banks' commitment to growth in terms of earnings per share and leveraged, industry-wide trendy pursuits (LDC loans, commercial real estate funding, and leveraged buyouts), and increased competition from nonbanks.

In examining the loan losses, a trend in thought patterns and business cycles was discovered. A study of loan losses is akin to dissecting the heart of a bank. Loan losses do not occur in isolation; rather, they reflect the health of all functional disciplines. The key findings include:

1. Credit analysis. In the sample, major factors in charge offs related to inadequate credit evaluation. The analysis categorized the causal factors as internal to the organization and external relating to the borrower and over all economic environment (see Appendix 1).

The review of the sampled loans with losses revealed that due diligence (defined as information gathering) was generally recorded in the credit files. There was sufficient information to make the decision. Weaknesses were largely in analysis; that is, interpretation of data and the conclusions reached from the avail able information in 73% of the sampled credits. For instance, industry analysis was done but not subjected to critical thinking. There was a tendency to emphasize strength and downplay the realistic weaknesses.

Inadequate understanding of the fundamental business of the customer was seen in 48% of the credits reviewed. Deficiencies were noted (63% of the sampled credits) from inception of the relationship. This led to weakness in loan structure (53% of the sampled credits) and, later, to the bank's inability to collect on the guarantee. In these instances, the guarantee, at best, became a negotiating tool. Minimal value obtained in 31% of sampled credits also highlighted collection difficulties in foreclosure.

The sample showed failure to syndicate (28%) as instructed by the approvers. The risks from inception were compounded when later there was failure to react appropriately to early warning signals (56% of the sampled credits).

From an external perspective, poor management of borrowers (89% of sampled credits) highlighted their inability to provide realistic projections (61%) and the bank's inability to analyze them appropriately. Lack of control (46%) and experience in managing the business (44%) includes succession issues. In the middle market, the potential impact of a new management structure with the second generation--a prevalent factor--was not clearly understood.

All these factors were magnified by the economy, evidenced through a downturn in product demand (52% of sampled credits). Character weakness and integrity of management and/or owner (38% of sampled credits) contributed to the decline. Also noted were commingling of company and personal funds and subsequent diversion of funds.

2. Secured transactions. Historically, regional banks provided mostly secured, closely monitored loans to privately held middle-market companies. Later, certain niches were expanded into the money center banking arena. The primary culture of secured lending prevailed into the 1980s. As a result, the majority of charge-offs (94% of the sample) were secured transactions, despite the implied monitoring they would have required.

The credits in the loan loss sample indicated that the comfort derived from the secured transactions enabled the bank to transact with some high-risk borrowers (30% of sampled credits). Industry sources [2] indicate that the banking industry, in general, has found that the character of many borrowers has declined. somewhat in the last decade. The findings in this study corroborate that viewpoint.

3. Borrowers' growth. Entrepreneurs and small businesses contributed greatly to the 1980s expansion. This growth was financed by bank debt and by tapping the equity markets, including new IPO issues. In this environment, the sampled credits showed failure to understand the realistic aftermath of continuous growth of the companies, including appropriate capital structure.

The impact of the excessive growth is illustrated by the public companies studied in-the loan loss sample (see Appendix II). Similarities were also seen in some of the companies, privately held by large or institutional investors. As would be expected after an IPO, management usually worked on keeping the stock price high. Once management grew flush with cash, they expanded (100% of the public companies in the sample), sometimes into nonrelated activities. In the credits reviewed, the borrowers' management was unable to assimilate the growth (30%). They did not have proper controls and sometimes lacked the required experience. Expansion masked losses. Management fraud (30%) was often seen as an attempt to overcome the negative trends.

Debt financing for companies on the growth spree was not appropriate. For many of the companies in the sample, the debt financed served as quasi equity, that is, in lieu of real equity. Occasionally, a direct equity position was taken and/or acquisition loans were financed by bank debt such that investor equity was minimal. In some real estate transactions, there was a propensity to lend against equity-to-be achieved rather than cash flow. The pricing did not reflect the increased risks. In some cases, the collateral was equity and could not be adequately monitored. For example, it was difficult to mark restricted stock to market.

4. Portfolio. The bank's portfolio of credits in the loan loss sample exhibited high aggregate exposure levels, industry concentration, and expansion out of the geographic markets. These losses were primarily in the project finance portfolio, an anomaly to the bank's core business.

It should be noted that the risk and growth of a portfolio are correlated. It is difficult to grow beyond the GNP without taking additional risks. Moreover, it is difficult to isolate oneself from structural secular changes occurring in the industry and the primary regional economies being serviced.

5. Strategy. The U.S. economy changed in the 1980s and grew significantly. General market expectations of continued growth highlighted the industry, as did minimal foresight of eventual correction. During this time, the bank's portfolio grew substantially both by acquiring more new accounts and by increasing outstandings to the existing customers.

The credit analysis in the loan loss sample exhibited a lack of understanding of the underlying economic fundamentals, including cyclicality of different industries. Reaction to market changes was slow. The subsequent impact of the 1987 crash was not clearly understood for some time. In the sampled credits, on average, 56% of the original gross amount was charged-off.

6. Approval. The credit culture was not consistent through-out the organization. Occasionally, there was no follow-through on conditions placed by the approvers. In some instances, customer-relationship orientation overrode credit quality and the underlying transaction economics.

Prior generations of bankers had been influenced by the 1920s crash and the Great Depression. The 1980s, however, was a period of high growth; a largely stable economy experienced only small corrective blips and no major catastrophes. Banks were thus lulled into believing the industry was invincible.

Study Conclusions

Bankers acknowledge they have to be right 99.5% of the time; the margin of error is very small. In this context, extracting knowledge and developing expected loss predictors is essential. Appropriate training, with cohesive interaction among all the disciplines in a bank, paves the way to earnings improvement.

Several key guidance factors to avoid major losses in a middle market loan portfolio emerged from the study. These are summarized below and explained in more detail in Appendix III.

Training. "Learning without thought is labor lost; thought without learning is dangerous" (Confucius, 551-479 BC). Loan loss avoidance requires training programs that develop strong technical and analytical skills. Relationship managers need learning tools to increase critical thinking and peripheral vision. Increased knowledge leads to improved confidence levels and strengthens a banker's ability to decline weak deals from inception. Effectiveness of the continuing education programs should be periodically tested.

With the commercial banking industry aligning itself closer to the investment banking community, application of corporate finance techniques is needed for the middle-market arena. Realistic assessment of credit analysis should not only take into account the regional economy but now, increasingly, the global economy. During marketing efforts, RMs should be aware of limitations to collections imposed by structures and guarantors, especially in a bankruptcy situation.

Evaluation of all aspects of collateral assessment and management is required to ensure underlying viability of the overall transaction, regardless of the collateral value. Ongoing seminars on legal issues will keep relationship managers current on relevant topics. The analytical approach should place greater focus on understanding borrowers' growth. It is important for a relationship manager to continually sharpen skills in discerning capital structures appropriate for a middle-market borrower.

Strategy. From a strategic perspective, a bank needs to focus on its vision of prudent, long-term objectives, yielding appropriate returns rather than a short-term focus.

Portfolio management. Continual monitoring of portfolio concentration and clarification of the market position of the different niches served will allow a bank to quickly refocus if lumpiness occurs.

Bankers need to emphasize prudent portfolio management through balanced growth and asset quality while keeping in mind the changing economic and competitive realities. High-growth companies taken public through recent IPOs need to be watched carefully. Sometimes management may not have the skills required to transform an entrepreneur enterprise into a professionally managed company.

Credit files have a wealth of knowledge. By dissecting the data and examining the causal factors, a savvy institute can metamorphose a negative event into a learning platform. The industry has access to limited portfolio trend analysis data for private companies. As the U.S. economy grows through small business and middle-market companies, a need to track such data is called for.

Assessment of the portfolio through risk-rating strategies should be expanded to allow for monitoring through quantified qualitative factors as well. Recycling of knowledge from workout areas to the front-line will sharpen a relationship managers' ability to react timely to negative trends and to identify early warning signals.

For banks, accurate measurement of risk and analysis is necessary not only for portfolio management but also for developing flexibility in improving balance-sheet ratios in the dynamic marketplace. One such mechanism for balance sheet management and diversification of risks and concentration could be through securitization of C&I Loans. Capturing analytical information, supplemented by eventual standardization of loan documentation, could overcome cultural hurdles and accelerate the industry's movement towards securitization.

Approval process. Decision making should be based on an analysis by experienced lenders who understand the bank's philosophy, expectations, and policy rationale. Placing credit responsibility closer to the business units nurtures a strong credit culture. Monitoring of independence in approvals reinforces the integrity of the approval process.

Automation. Process refinement with automated line functions is a means to improve productivity and improve efficiency ratios. The credit process should be developed with a goal of providing automated analytical tools at all levels. Though automationis an integral part of today's analytical environment, the analysis needs to be filtered through the lenses of sound judgment and experience. Computer-literate analysis without judgment can blind-side the analyst and management.

The post-automation age now calls bankers to go beyond recording static data. There is a need to record analytical aspects and develop a "knowledge highway." Lost knowledge translates into wasted dollars. Automation through data management of qualitative information can make judgment--the gut reaction--even more powerful.

High levels of automation in selected products, such as credit card portfolios, have allowed the industry to perform creative financial engineering. Extending these techniques to middle-market and large corporate loans will bring market efficiencies, particularly in the secondary loan-trading market.

What did the knowledge capture achieve? The bank's experiment in capturing the most valued intangible--knowledge--allowed the institution to understand and accept the lessons from its loan-loss period. In essence, it quantified the experience and turned the wisdom of its staff into a usable learning tool. By disseminating the findings throughout the organization, the bank empowered its employees with management decision-making knowledge, thereby crystallizing the importance of ongoing corrective actions and improvements at all levels.

The structural shifts in the global and regional economies affecting the business environment are irreversible changes. The challenge for the banking industry and the successful banks will be to maximize synergies and uphold prudent credit standards in an increasingly interdependent, technology-driven, global market. Today's competitive environment requires banks to be low cost providers where every loan and every officer must create value for the bank. Continual recycling of knowledge through the information highway can become a cost-efficient training exercise while inculcating the desired credit culture environment throughout the organization.

Bhargava may be contacted by e-mail: APBhargava@aol.com

References

(1.) "Value-Building Lessons Of The 1980s," David Cates, RMA Journal of Commercial ending, September 1993.

(2.) "Why Bad Loans Happen To Good Banks" by John McGovern, RMA Journal of Commercial Lending, February 1993.

Major Risk Characteristics

Major risk characteristics were standardized to identify leading trends in the sample of credits that recorded charge-offs from 1989 through 1993. Quantification is based on the frequency of occurrence.

Internal

Deficiency in credit analysis related to:

a) at inception (73%)

b) of industry (63%)

c) failure to understand fundamental business of customer (48%)

d) financial structure analysis (44%)

e) expansion into unfamiliar markets (38%)

f) ongoing analysis (25%)

* The deficiencies in credit analysis led to weakness in loan structure (53%)

* Failure to react to early warning signals (56%)

* Inadequate secondary protection deficiencies, focused primarily on insufficient guarantor coverage analysis (31%) (Documentation inadequacies were not quantified for this analysis).

* Failure to carry-out specific instruction--primary approval conditions not met were: failure to syndicate/sell down to the approved level (28%)

* No deliberate misrepresentation or omission of material facts was found.

External

As related to the borrower/environment:

* Poor management "category" was the primary external factor: (89%)

a) unrealistic projections with inadequate probing (61%)

b) lack of control (46%)

c) lack of experience and next-generation succession issues (44%)

d) management changes (14%)

e) weakness of financial capability (11%)

No labor strife/strike was seen.

* Weakness in structure high lighted inability to rely on the strength of the guarantee as minimal value was obtained across all industry lines (40%)

* Character integrity issues (weakness of borrower) (38%)

* Excessive debt load of borrower (30%)

* Expansion by borrower into unfamiliar markets and/or acquisition of non-related business (30%)

* Downturn in product demand/price (economic cycle, industry, etc.) (52%)

Appendix II

Public Companies

The impact of excessive growth is exemplified by the public companies reviewed.

* Most had become public within 10 years, through an IPO issuance

* All had significant available cash.

* All expanded, many through acquisitions.

* 30% masked losses through expansion.

* 30% exhibited aspects of management fraud.

* Most had partial management ownership.

(Appendix III appears on following page.)

Appendix III

Key Guidance Factors

How to avoid major losses in a middle-market loan portfolio.

Training

Feedback

* Review the "lessons learned" with Line officers, and others involved in the credit process, in a "hands on" manner, through current case studies.

* Hold ongoing "basic skills" workshops to reinforce history of current trends.

* Perform periodic "tests" to check on staff's knowledge of key issues.

Credit

* Analytical and probing abilities to expand peripheral vision and to understand: Real purpose of loan.

- Customer needs versus wants.

- Sources of cash flow and repayment.

- Appropriate capital structure.

- Corporate financing and investment banking concepts for middle market.

- Contingent liabilities.

- Impact of contraction and growth, specifically in a new public company.

- Downside analysis to include costs of unwinding (fixed rate, past dues, interest lost).

- Product and business cycles.

- "Contrarian" movements outside the "normal" range.

* Ability to detect and react to early warning signals.

* Review analytical approach to financing equity or quasi-equity.

Secured Lending

* Understand all aspects of collateral assessment and ongoing management.

* Knowledge of regulations affecting individual industries.

Guarantor

* Ensure RMs have in-depth understanding of guaranty/guarantor issues.

* Understand limitations with guarantees, particularly collection in bankruptcy.

* Understand differences between limited versus general guarantees.

* Ensure Personal Financial analysis includes risk assessment.

* Seek collateralized guarantees.

Industry

* Industry analysis to bridge the gap between theory and practice and to understand:

- Economic trends as they relate to projections.

- Business and product cycles.

- Supply/demand.

* Expand focus from regional to global economy.

Checking

* Sharpen probing techniques for Bank checkings.

* Expand ability to discern another bank's strategy of exposure reduction.

* Reinforce ways to assess management including life style issues.

Specialized Lending

* Working knowledge of:

- Acquisition financing.

- Project oriented transactions.

- Leveraged buy-outs.

- Developers expansion process.

Legal

* Understand legal issues pertaining to:

- Agency role.

- Documentation.

- Lending liability.

- Holding company structure.

* Hold ongoing "basic skills" workshops to re-enforce issues.

Other Disciplines

Long-term Strategy

* Focus on prudent long term objectives yielding appropriate returns, rather than strategies and policies where high, short term returns are emphasized.

* Clarify market position in the different niches.

Organization Strategy

* A sense of corporate pride, confidence and appropriate knowledge levels.

* Empower and enforce ultimate credit decision responsibility at the line level, since the line is the primary gatekeeper.

* Reinforce separation of duties between Credit Approvers and the line.

* Emphasize earlier "consultative" entry of specialists (for transactions with real estate and acquisition undertones and when negative trends begin).

Approval

* Strengthen independent decision-making instead of industry herd instinct decisions.

* Discourage undue reliance on external or internal referral sources.

* Approve based on economics versus pre approvals, pre-dispositions or downward pressures.

* Deter relationship orientation from over-riding credit quality and underlying transaction economics.

* Understand dangers of "rushing" the transaction during approval.

* Evaluate the need for frequent "extension" requests--an indication of problems.

Portfolio Management

* Focus on obtaining and keeping high quality assets, from inception.

* Enter new niches slowly, after thorough up-front study. Balance portfolio development with in-house capacity (knowledge, resource level).

* Continually evaluate portfolio concentrations and relationship aggregations (including industry, geography, risk profile, transaction size, pricing).

* Expand analysis to reflect impact of changes in other parts of the portfolio (inter/intra/industry/relationship).

* Develop appropriate exit strategies for bottom performers, including liaison between line and loan management/credit approvers.

* Set limits on exceptions, from portfolio perspective, to ensure integrity of policies or to modify the policies to suit the business needs.

* Ensure standardized application of credit ratings.

* Develop an early warning system: manual or automated.

* Include:

- "default costs" in pricing high risk loans (such as quasi-equity).

- risk capital basis in pricing to fully reflect the risks.

* Analyze public companies portfolio to ascertain growth risks magnified through IPOs.

Credit Process

* With a focus on knowledge retention and interactive data analysis, evaluate the entire credit process to automate:

-All phases of Relationship from inception, approval through ongoing maintenance:

- prospects - documentation

- credit write-ups - Loan processing/account history

- exceptions

- Transaction structures in a template format to allow for further customization, as needed.

- Comparative industry information with key ratios.

- Portfolio trends.

- Key economic trends.

* Provide manual (library) and/or automated source for gathering industry related information and market intelligence.

* Encourage information sharing across organization.

Staff

* Hire staff with appropriate experience, suitable for the business.

* Balance compensation, motivation and turnover.

* Increase opportunities and understanding through periodic rotations (line and staff).

* Ensure officers fully understand the bank's philosophies, expectations, and policy rationale.

* Develop realistic productivity measurement criteria.

Ongoing Actions

* Continually analyze decision trends through a representative sample of Loan Losses.

* Integrate credit analysis, audit and re-engineering techniques with technology.

* Provide management feedback for ongoing fine-tuning of credit process.

* Emphasize importance of research

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