Jeff Judy

Jeff's Thoughts - May 25 , 2011

"Watch" Is Not a Risk Rating

Every bank has some version of the "watch list," regardless of what they call it. This is the bucket where they put the credits they are worried about, where the possibility, even the probability, of default has risen to the point where extra attention is warranted.

Of course, all of these banks also have risk rating systems, a series of bins into which credits are sorted according to their quality. And in that risk rating system, which may have half a dozen or ten bins or some other number, they draw a line somewhere, the line between the "passing" credits and the ones that are in trouble.

The problem is that in many banks, these two systems for categorizing credits in the portfolio not only overlap, they are completely redundant. The symptom of this is when all of the "passing" credits posted on the watch list have the same risk rating.

That's a sign that "watch" is just a designation for a loan that is close to the pass/fail line. In some banks, getting on the watch list has little to do with actions the bank will take, and more to do with accounting, reserves, and procedures.

And that has unfortunate consequences for the bank in two areas: efficiency, and risk management.

In terms of efficiency, the bank's resources for monitoring borrower activity, for picking up leading indicators of failing customer health (or even of improving customer health!), are effectively being allocated based on risk rating. Some credits get more monitoring than is necessary, while other credits that really do merit close attention are more or less ignored.

And that leads to the risk management problem. A "watch" designation should indicate that the bank will be watching the borrower more closely, requiring more frequent and better updates, shortening the review cycle to determine when additional action is required. And that "watch" label should be attached to any credit subjected to materially changed conditions, regardless of its risk rating.

For a textbook case, look at Frank and Jamie McCourt, the couple who owned, among other things, the Los Angeles Dodgers baseball team. Who wouldn't want to be their banker? Rich and prominent, they were sure to be assigned a lovely risk rating at just about any bank ...

Until the divorce, that is. Their bitter fight has tied up assets, to the point that there may not be enough cash make the May payroll, and major league baseball is stepping in to manage the situation. Divorce proceedings between owners of a business suggest watch status, regardless of risk rating. But how many creditors sat back and watched their opportunities for repayment disappear? Where do you think all the McCourts' cash went? To their banks? Not likely.

Similarly, when the housing market crashed, it had a much more immediate impact on some types of businesses than on others. Consider not only companies that depended on real estate for profits, but those reliant on building supplies and other contractor related goods and services. They needed to be watch listed as soon as the bank could see the coming change in economic conditions, while they still had good risk ratings.

Do not let your "watch" category be a reaction to your risk rating system. Too many banks attach the watch designation as a consequence of a change in risk rating.

If you want to avoid some really painful and ugly surprises, use "watch" status to anticipate possible risk rating changes, not simply reflect them.