Ten pitfalls with credit risk reporting

This paper introduces a strong and controversial point of view, which we believe may help foster debate about a number of fundamental high-level issues currently affecting the financial industry. The Capco Institute is open to controversial ideas. The Journal of Financial Transformation will occasionally publish thought-provoking papers with a view at stimulating debate. Credit risk is as fundamental to banking as wheels are to a bicycle. Banks have been in the business of lending and managing the resulting credit risk since their inception. However, despite its centrality to core banking, it has presented some of the greatest challenges to banks. The credit crisis of 2008 reinforced the fact that it is the most critical risk facing many banks, and inadequate credit risk management has led to the closure of hundreds of financial institutions. But in many ways it is often the least understood risk. Identity used to be visual and bankers knew the people they lent to and could assess their credit-worthiness intimately. As identity migrated from visual to digital, bankers had to rely on numeric profiles and statistics to determine credit-worthiness – hardly the realm of customer intimacy. While such data might support portfolio analytics, they do not provide adequate insight into individual borrowers and the risk of lending to them. Consequently, executives at financial institutions have, at times, only a basic picture of the credit risk facing their organizations and the potential problems germinating in their portfolios. Credit risk reporting is the basic mechanism through which a bank gets a view of its overall exposures, and is able to identify hotspots and flashpoints, be they instrument-specific, borrower-category-specific, or geographyspecific. Credit risk reporting is also a critical tool for a bank to have proactive credit risk management and informed risk taking. Consequently, poor credit risk reporting can result in huge bottom-line impacts. In our experience most large financial institutions have credit risk reporting and analysis capabilities that are not commensurate with their importance to the organization. However, most banks don’t even realize their reporting is poor. This is because the credit risk reporting they receive changes little, while their institutions have expanded and the complexity of their portfolios and instruments has grown exponentially. Here are the top 10 shortcomings in credit risk reporting. If a bank is experiencing any of these problems with credit risk reporting and analysis, there is likely to be a strong business case to be made for updating the institution’s capabilities to address them before they manifest themselves in the form of more severe issues and losses.