Strategies to Address Risk Management in Commercial Lending

Commercial lending has long been viewed as one of the most complicated business processes across retail and commercial banking. In the past several years, the lending landscape has become increasingly complex due to seemingly constant regulatory changes, the increasing globalization of businesses, the interconnected nature of participants in the lending life cycle, and the often fragmented operating environment through which financial institutions are trying to deliver products and services to business customers.

Regulatory changes have put pressure on banks from both a compliance and cost standpoint, as institutions must allocate limited investment dollars to mandated compliance programs and related system updates. New capital requirements have fundamentally changed how banks write, price, and manage loans — all when financial institutions are under unprecedented pressure to reduce costs and deliver improved operating margins.

As businesses become more global, greater attention to risk management is required to ensure market, operating, and credit risks are well understood and effectively managed. As syndications, participations, and securitized loans are issued, not only does the processing complexity increase, but also the risk that must be managed across all participants.

Banks operating structures are often the result of the implementation of individual product strategies and mergers with other institutions, leading to complex and siloed technology infrastructures. These need to be designed to effectively share information across systems or nimbly respond to new requirements, thus increasing the challenges financial institutions face in adapting readily to regulatory changes and customer demands.

To effectively manage the loan life cycle and specifically address the complexities of risk management throughout the loan life cycle, financial institutions must rely on technologies that inherently improve business results through more efficient workflows, better risk management, and an enhanced customer experience.

As the economic recovery slowly progresses, commercial lenders report increased loan demand. However, the spread of loans over the cost of funds has remained low post-crisis, and loan and deposit spread margins have drastically tightened. As a result, banks are investing in technologies that will enable them to manage the lending process and mitigate associated risks more efficiently.

During the economic downturn, technology investments were severely constrained, with most funding directed toward regulatory compliance initiatives. As banks emerge from the recession, they renew technology investments to drive revenue, mitigate risk, and improve efficiencies. Forty-one percent of global commercial banking executives plan to increase investment in commercial loan origination technology in the next two years. Citing process improvement as the primary driver for investment, 35% of these firms plan to adopt or replace their commercial loan origination systems by 2026, with most implementations targeted to occur in 2025. Similarly, investment in commercial loan monitoring technology is expected to increase over the next 24 months, with 39% of executives reporting increased investments and 35% replacing or adopting new loan monitoring solutions in the next several years.

The commercial lending industry has migrated slowly but steadily from its traditional position as a credit-based set of services to a risk-based business. Credit, operational, liquidity, market, and legal risk each represent different challenges and exposures for a lending institution, and each must be considered as part of a comprehensive risk management strategy. In addition to a complete understanding of the impacts of each type of risk on any specific loan, an overall methodology must be in place for any entity issuing commercial loans to track and manage these risks at the portfolio level on an ongoing basis.

Credit risk represents the potential for a borrower or counterparty to fail to meet its obligations by agreed-upon terms. There are several steps a lender can take to mitigate credit risk, including using risk-based pricing, requiring loan covenants, and diversifying the portfolio, among others. To effectively implement these strategies, a lender must have a comprehensive view of customer and market data across the life of the loan. Operational risk is defined within Basel III regulations as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Often, technology is leveraged to reduce operational risk, allowing lenders to execute strategies that minimize operational risk within every stage of the loan life cycle. Rather than viewing these risks as prohibitive to growing their business, leading lenders are addressing credit risk management and operational risk management and implementing systems and processes that improve loan performance.

Historically, commercial loans have been considered more complex than traditional consumer loans (such as auto loans or mortgages), and recent trends have increased the complexity of commercial loans and the associated credit and operational risks associated with these loans. Each of these is worth exploring to recognize and address the new potential challenges as needed.

As we are all well aware, the volume of legislation being proposed and enacted in recent years has profoundly impacted the financial services industry. Although many of these regulations were introduced to address consumer protections, some have been extended to apply to commercial loans, subjecting commercial lenders to increased scrutiny and rigorous compliance requirements, which are more stringent than ever.

In addition to the regulations commercial lenders have been actively preparing for, such as Basel II, Basel III, Solvency II, Dodd-Frank, and others, commercial lenders must now also ensure they are adhering to requirements of the Home Mortgage Disclosure Act/Regulation C (HMDA), Truth in Lending Act/Regulation Z, and the Community Reinvestment Act (CRA), among others. For example, while HMDA is commonly viewed as relevant for consumer loans only, commercial loans secured by dwellings, including multiple-family houses, may be reportable.

Similarly, because commercial customers may request loans for personal rather than business purposes, loan officers must carefully determine the loan purpose as commercial customers applying for personal-purpose loans are protected by the Truth in Lending Act and Regulation Z. Because small business loans are now a component of CRA evaluations, commercial lenders must ensure they collect and provide data consistent with reporting requirements for CRA.

As a result, lenders must gather, process, and manage data in new ways to ensure compliance. Commercial lenders must conduct periodic reviews of compliance requirements as the ongoing changes may well affect the lending policies and activities of the organization.

As our economy becomes more global, it is natural that businesses expand operations into new geographies, establish new trading partners, and, by extension, engage in business dealings with new business entities and individuals around the globe.

As firms want to maximize these investments and seek opportunities in emerging markets, the relationships among participants across the supply chain become more closely entrenched. This expansion of networks and geographical footprint brings added complexity related explicitly to managing market, operational, and credit risks that must be addressed. Adherence to local regulations, understanding the participants in all business transactions, and attending to considerations for cultural norms and expectations regarding business behaviour can exponentially increase credit and operational risk when expanding operations and partners in regions around the globe.

For example, the challenge of adhering to sanction screening requirements increases as financial institutions are required to establish whether they can legally do business with a given entity, and local regulations and screening lists vary by country and must be adhered to.

As lenders continue to provide creative lending solutions to borrowers, the relationships among loan participants can become complex, requiring lenders to understand at new granularity the entities they are conducting business with and the interrelationships among parties.

Fortunately, technology firms recognize the complexities inherent in commercial lending and have introduced solutions that will enable financial institutions to manage both operational and credit risk better and provide for an improved client experience. The long-held ambition of straight-through processing (STP) throughout a financial institution is especially relevant in commercial lending.

Workflow automation and improved data visibility and accessibility through a single application platform are the cornerstones to enabling improved risk management, process standardization, and the efficiency gains desired by most financial institutions. Within the front office, the system can integrate with core banking systems and external databases to automatically gather borrower and guarantor financial data, thus minimizing manual entry, reducing the opportunity for errors, and achieving efficiencies.

The system can standardize and optimize spread and risk calculations in the middle office through built-in models, leading to improved credit decisions and risk-based pricing.

Finally, in the back office, the system can automatically create the necessary loan documents, manage required correspondence, and facilitate the loan booking in the bank's core bank system, eliminating redundant data entry and manual entry errors and expediting the loan booking.

The holistic application of analytics, including corporate performance management, business intelligence, and portfolio analysis, can enable a financial institution to gain a competitive advantage and achieve sound risk management. Business intelligence provides banks with a toolkit to convert unstructured data sets into actionable information.

Analytics can be leveraged in several ways to determine and enhance loan-level profitability. Portfolio analytics combines a 360° view of the client's exiclient'sposclient's exiclient'sposuresrofitability, enabling lenders to optimize lending and pricing decisions in the context of the client's risk-adjusted return on capital (RAROC) measurements. Advanced analytics in an origination system provide banks with the ability to make individual loan decisions in the context of the broader portfolio, making it possible to, for example, proactively avoid limits breaches and optimize pricing relative to capital charges.

And finally, analytics can be leveraged to provide a competitive advantage. Banks with the ability to gather and analyze data needed to drive their overall portfolio decisions before loan approval are well-positioned to increase market share.

While technology can and should play a significant role in providing transparency, enabling effective decision-making, and driving efficiencies, business processes must first be designed to address the organization's life cycle's efficient execution of standardized processes across each dimension of the lending cycle.

Through the application of business rules, modern loan origination solutions provide the ability to define the parameters around which decisions can be made and actions executed. Streamlined automated workflows further ensure the consistent execution of activities that align with established business processes. Because of the number of people, systems, and dependencies inherent in the origination process, the ability to systematically apply logic and enforce workflow is a significant benefit provided by best-in-class loan origination systems.

For example, risk policies and operating guidelines can be defined centrally by the appropriate parties and then deployed through business rules and workflow to ensure adherence to policies for all parties involved in the loan decision, whether the front-line, middle or back-office. Through wizards and interactive business logic, manual errors and omissions can be vastly reduced, and the time to originate a loan is accelerated.

Thus, despite the inherent complexities in commercial lending, technology can be leveraged to satisfy internal requirements, effectively manage risk, and meet customer demand for greater transparency and faster decisions from lenders.

Conclusions:

As the commercial lending business continues to increase in complexity, institutions that leverage solutions that enable improved risk management will be positioned for success as demand for loans increases, regulatory requirements evolve, relationships among loan participants become more complex, and firms continue to expand relationships globally.

Lenders that implement solutions that provide risk-based pricing frameworks, integrate with risk rating models and provide integrated business intelligence tools will be well-positioned to perform deal-level analysis, manage risk, and achieve improved business performance.