Jeff Judy

Jeff's Thoughts - February 4, 2009

Responding To Risk

Recently I used this space to write about risk as a combination of probability and consequences (or impact). I suggested that awareness of both contributors to risk, when looking at credit opportunities and performing borrower analysis, is crucial to maintaining credit quality and avoiding ugly surprises.

Now I want to encourage you to think about your response to risk. Note that I am not simply limiting myself to "mitigating risk," the more commonly used phrase. A complete response to borrower risk that protects the bank works on a broader level, and starts with risk assessment.

Let's summarize those two components of risk in a simple table:

Low Probability Low Impact	High Probability Low Impact
Low Probability High Impact	High Probability High Impact

To put it very simply, most bankers expend almost all their effort on the right hand column.

Now, it makes perfect sense to respond to high probability, high impact challenges to repayment. Certainly you have to examine those closely and take steps to protect your interests.

But the next level of response is usually reserved for the other high probability threats. Why? Because they are easy to see.

So easy to see that banks frequently experience very painful consequences from overlooking that "southwest quadrant": the items that aren't very likely, but that have a devastating impact on the borrower's business if they occur.

The first response to risk, then, is to identify it properly. If you are overlooking some rare, but potentially catastrophic, turns of events, you are not protecting your bank.

After that, it is common to focus on lessening the impact, and there are several strategies available, such as:

Developing secondary sources of repayment, such as more collateral or guarantees
Using hedging or derivatives to mitigate the financial impact of trouble in the borrower's business;
Transferring some of that risk, perhaps through participations -- both selling off risk to other institutions, or taking part in transactions that will reduce your portfolio concentrations;
Taking advantage of government programs that provide backing or insurance against a complete disaster in your borrower's health;
Managing lending limits and explicitly monitoring concentrations to ensure that you do not set the stage for a really hard fall when a couple of borrowers go south on you.

That said, don't overlook opportunities to reduce the probability of negative events. If you do a good job of risk assessment, clearly identifying the high-impact items even if they are unlikely, you may pick up threats to the business that the owners and management have missed, or at least underestimated.

In that case, work with your customers to help them find ways to reduce risk. They may be able to take steps to reduce the probability of a specific threat becoming a reality. Or they may be able to make changes that will lesson the "domino effect," that will make it less likely that a serious problem in one area of their business will bring the whole company to the brink of disaster.

Too many bankers seem to have the philosophy, "take the risk and structure your way out of it." If you take a two-pronged approach to responding to risk, tackling both the probability and consequences of the challenge to repayment, you will assess risk more accurately, have more options for containing or reducing overall risk, and perhaps push some of the risk management responsibility back onto your borrower.

The result? A healthier borrower in a healthier portfolio!