Retail Lending and Risk Appetite Statement: manage risks but not measure them, add value but not impose additional costs

Risk Manager: Dreaming On Management

It appears, risk management goes to a blind alley. Risk managers are “measuring, capturing or documenting risks, making us all believe that risks and their mitigation are the ultimate goals of the exercise” as put it Alexei Sidorenko in his inspiring set of articles. The latter point, persuasion that risk mitigation is the most important goal of business management, is very useful in self-positioning and self-promotion of risk managers. The global initiatives like Basel I-II-III-and-so-on implementation are the milking cows for risk consultants (we really like them!).

But business managers sometimes are annoyed by risk managers, sometimes neglect them, sometimes even befool them. At best, they consider risk management as a necessary cost of being in business and risk managers as guys responsible for the absence of regulatory problems.

This isolation from the real world of money making makes daily activity of a risk manager boring and senseless. Many risk managers really have high proficiency in mathematics, forecasting, analysis. Wasting this expertise is a luxury that modern organisations can not afford.

How to make risk management both business oriented and remaining risk management? What real problems (not regulatory compliance) could risk management solve for business? How can risk managers help to improve the efficiency of business? How to bring business units and risk management working in harness? What managerial actions should be taken to achieve these aims? The possible answer on these questions is Risk Appetite Statement.

What Is Risk Appetite Statement?

Risk Appetite Statement is primarily a formal document which enlists risks, risk factors, their target values, trigger values for some prescribed management actions, and sets target capital adequacy and liquidity buffer levels and rate of return on economic capital. This definition is a homage to ministry of dead letters and is able to kill any healthy idea. It carries nothing useful for the real management purposes because all entities included here are imaginable or artificial. Something concrete is required to make this document worthy to be read.

We have to enrich this definition with a list of managerial actions to breathe life to it. The primary inspiration of any action is business aims. Risks also refer to the possibility that the aims are not achieved. Therefore, Risk Appetite Statement should contain specification of aims. The actions enlisted in the Statement are linked to the aims and depend on our attitude to risks, they may differ in the conditions of taking them.

Attitude to risks is a key to actionable risk management. We can not manage all risks. We shall not manage all risks. If we managed them all, there would be no source of profit for stakeholders. So, we should clearly state,

• what risks we take (and pass them to stakeholders leaving them to deal with such risks),

• what risks we manage, what risks are in scope of our business, our competence,

• what risks we and our stakeholders prefer to avoid, are not ready to carry them in any case.

Once we classified the risks, we focus on the risks we manage and (to a lesser extent) we take. All risks have their cause in change of risk factors. Risk factors may have several qualitative characteristics and quantitative measures. Some of them are related to possibility, some of them—to impact. Some of them reflect financial result (profit or loss), some of them are dealing with risk in a narrow sense.

Managerial actions posted in Risk Appetite Statement depend on the situation they should be taken in. Some of the actions are planned at the definite moment of the deal or portfolio lifecycle. Other actions should be taken if some trigger event occurred. These events may happen under usual conditions of going concern business or in emergency situation. Examples of the latter events are triggers for stop-loss sales.

Regular monitoring of a deal or portfolio we are managing should also be specified in Risk Appetite Statement.

To conclude, a living Risk Appetite Statement deals not only with risks. It deals with business as a whole. 

Operative Risk Appetite Statement is an investment policy statement aimed at the internal needs of all levels of management.

Risk Appetite Statement in Bank Management

Actionable Risk Appetite Statement permeates the process of banking management. It is a baseline for planning process. The Statement defines target characteristics of the portfolio we are planning to form in the bank.

It is also a regulation for lending process. The picture of our target borrower, the rules of lending and risk taking is a part of the Statement.

It regulates the procedures of portfolio management. In fact, management of loan portfolio is a difficult task (more difficult than management of securities portfolios). Loan conditions are usually fixed and are not subject to unilateral change. Secondary markets for loan portfolios are very illiquid. Long and thorough preparation is required for sale of retail portfolio. So, it almost excludes using this instrument as an emergency action. Sometimes, appetite for prepayment risk may dictate the rules of softening of loan conditions during the lifecycle of the deal.

Since Risk Appetite Statement formulates aims of retail portfolio, it has to be used in the assessment of the results. Profit and Loss figures attributed to business units, risk-adjusted financial results are calculated basing on the risk assumptions specified in the Statement.

Moreover, if some risks are realised, only Risk Appetite Statement can help to distinguish bad luck and risk management failure.

KRI for Retail Lending

There are several risk indicators used in retail lending: provision ratio to the portfolio volume, share of past due loans in the portfolio, 0+@3mob (share of past due loans for the first 3 months on book), 30+@6mob (share of past due loans more than 30 days for the first 6 months on book), delinquency figures. These indicators can be computed relatively easily. However, they are not leading indicators and their application to the portfolio management is difficult.

Instead of them, we recommend more complicated indicators like LTS, marginal LTS, provision forecasts, volume forecast of past due loans, past due frequencies. This computational complexity can be easily compensated by IT solutions targeted at retail portfolio management like Roll Rate Analytic System®. In return, portfolio manager gains the ability to manage.

For example, due to gradual maturing of portfolio, provisions will grow and available economic capital will consequently decrease. When loan vintage is relatively young, it produces healthy interest income exceeding the provision growth. But when provisions saturate the income, the efficiency of capital management comes under question. Thorough selection of vintage age for optimal securitisation or sale may help to double return on economic capital.

The most important characteristic of loan portfolio is LTS — loss-to-sale. It is a figure that shows cumulative losses in vintage for the lifetime of it. It grows (matures) through the life of the particular vintage and depends on initial term of loans and the credit quality of borrowers. Marginal LTS is a combined characteristic of credit quality net of initial term effects. The concept of "Marginal LTS", as introduced by V. Babikov (Financial Risk Management, Theory and practice of retail lending, 2014). In its essence, lending rules construction is a procedure that sets marginal LTS on the portfolio basing on the clients’ characteristics (debt/income ratio, region, educational level, industry, etc). Thus, when formulating Risk Appetite Statement, a manager has to set up target levels for marginal LTS. 

 

Analytical procedures (eg that are realised in Roll Rate Analytic System®) allow for measuring the impact of GDP growth or slowdown and other macroeconomic factors on LTS. Basel requirements prescribe that ratings have to be assigned to borrowers with account on possible adverse economic conditions or occurrence of unexpected events. While assigning ratings based on some rating scenario may be not well justified and lead to extensive capital charges, the objective analysis of LTS for loan portfolios is the most efficient practical way to satisfy these Basel requirements (see §§414—416 in International Convergence of Capital Measurement and Capital Standards).

Loan Underwriting

Loan underwriting procedures should be based on Risk Appetite Statement and ensure that the portfolio satisfies all the conditions specified there. Scoring cards is a technology that transforms the spectrum of borrowers’ characteristics into aggregate value that allows to build a clear-cut decision rule. It is very important to note, however, that this transformation should take into account not only the current credit quality but also its possible evolution over the time. This is not only a common sense, this is a regulatory standard. This means that scoring system should link borrowers’ characteristics with marginal LTS of the portfolio the bank is building.

Moreover, scoring cards should cover not only credit risks in terms of marginal LTS. They also should cover prepayment behaviour of a potential borrower. For example, if a net present value (NPV) of a loan is initially about 10% of its notional amount, prepayment rate at 30% per annum level deteriorates NPV to the negative –40% of notional amount. In other words, a borrower of good credit quality who makes significant prepayments brings losses to the bank. 

Experience of our clients shows that scoring card optimisation with focus on both marginal LTS and prepayment behaviour may raise incomes five-fold while new deal volume (and need for funding) decreases twofold.

 

Risk Appetite Statement: a Working Example

As is pointed above, Risk Appetite Statement is being combined of several parts regulating different aspects of portfolio management:

• target yield, interest income, other key performance indicators for the portfolio;

• target risk indicators;

• portfolio volume and other volume indicators;

• indicators that are being constantly monitored and their threshold values for taking managerial actions.

All these principles are illustrated in the figure.

Elaborating Risk Appetite Statement is a really difficult task. But it is worth to go through this way. The effect of utilisation of the hidden reserves which clear up during this process justifies all possible costs. The joint understanding of the portfolio aims and procedures across the bank makes management easier. As a result, economic capital yields are growing even in times of sharp competition and economic turmoil, even in times of tightening regulatory landscape and putting back the barriers to free capital flows up. High-quality risk management provides good nights for stakeholders and some amateurs call it simply good luck.

Let anyone with ears listen. Let anyone with risk management profit.

 

 

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