By Thomas J. Parliment, Ph.D.
President, Parliment Consulting Services, Inc.

Several years ago, I was sitting at a board of directors meeting, while our very excellent, senior credit officer reviewed a package of commercial loans, which we were asked to approve. I was struck by the fact that every loan was rated a “3.” No matter the various situations being evaluated, every loan was a “3.” Being new to this board, I ascribed this to coincidence and waited through several months of board meetings, during which every loan we approved was a… “3.”

Finally, I was compelled to ask our very excellent senior credit officer about this situation. (As an aside, I was informed when I became a director that our senior credit officers were very sensitive and required that we apply the prefix “very excellent” when we were discussing either the officers or the loans they underwrote.) So I asked him, “Don’t we ever get a loan to review that is rated a ‘2’ or a ‘3-minus’ or a ‘3-plus’?” He patiently informed me that the board only approved loans that were rated a “3.” He further enlightened me that his underwriting process involved the evaluation of numerous, complex factors and that he weighted the strong factors more heavily and the weaker factors more lightly, ensuring that the loan came up with a “3” score!

I know. This sounds so familiar, it hurts. But the fact is that many institutions have loan underwriting processes that are either too subjective, or include objectively measurable factors that are weighted after the fact to reach a subjectively determined result. Even an institution with great loan officers and “very excellent” credit review procedures needs an objectively quantified underwriting system.

In this day and age of fierce competition for “A” credits and the pricing required to get these loans, it is important that directors ask management to implement a loan underwriting system that allows an objective evaluation of loan quality. You need an underwriting system that allows the board to measure and monitor management performance.

Figure 1 displays one example of such a credit risk scoring chart. I used this particular chart when I was teaching underwriting of commercial income property loans to federal regulators years ago. It is still relevant, and in fact, it is being used in numerous banks throughout the country. Larger banks with a large variety of commercial loan types use similar charts that vary by industry.

In any event, the chart includes a vertical axis, which lists various underwriting factors, and a horizontal axis, which scores each factor based on the inherent risk of each loan. For instance, look at the first factor, debt coverage, which is interest expense divided into the cash flowing into the project. It’s irrelevant to me whether you give a score of 1 or 10 to the excellent risk ranking. Just be sure to give some sort of ordinal score that can be totaled and provide some consistency to your scoring across your loans.

It’s also irrelevant whether you think that top category should include debt coverage of greater than 1.5x, with the next lowest category including debt coverage of 1.2x to 1.5x. Just be sure that these criteria fairly reflect the quality of your particular loan market and, most importantly, are consistently applied to each loan.

I don’t even care if you decide to assign a different weight for different factors. For instance, there are nine factors. You can weight them each 11%. Or if you choose, you may decide to give debt coverage a factor of importance of 20% to 25%. If you do this, however, keep the weight consistent across all your loans.

In this chart, every loan gets an objectively determined score. Whether you want to consider a score of between 5 and 16 points as qualifying as an “A” loan is also up to you. There is no magic demarcation between “A” and “B” and so on. I’m not even saying that you wouldn’t make a loan to a “C” credit. But you wouldn’t have any illusions that it really was a “B” loan because of an attempt to weight factors to push the loan into an acceptable category.

Furthermore, such an objectively quantitative scoring system would permit the tracking of loans as they season and perhaps migrate from score to score. This feature is critical to the systematic documentation of appropriate loan reserves.

Look, I am very aware of the need to keep directors out of the micro-management of an institution. Directors need to be focused on general policy and strategic decision-making. But it is management’s responsibility to equip directors with the tools to effectively measure and monitor management performance. I think use of the objectively quantitative risk scoring chart is just such a tool.

Thomas J. Parliment, Ph.D. has served as an investment banker, economist, consultant, and educator to the financial services industry over the past four decades. He is noted throughout the business community for his speeches and articles covering a wide range of financial and economic issues. His often humorous and always thought-provoking point of view is regularly enjoyed by readers of his numerous articles and through his frequent public appearances.

Dr. Parliment advises banks, thrifts, credit unions, and Federal Home Loan Banks nationwide. He specializes in producing one- and two-day “think tank” sessions at which management teams discuss practical retail solutions for their financial institutions.

Dr. Parliment is also Managing Director of Farin & Associates, Inc. in Madison, Wisconsin, a financial-services consulting firm that provides asset/liability management solutions, retail product pricing solutions, and Web products and services.

Dr. Parliment serves on the faculty of the Graduate School of Banking at the University of Wisconsin. He is a featured speaker at a number of programs sponsored by state and regional trade associations. Dr. Parliment serves on the board of directors of four community banks.

Formerly a professor of economics at the University of Wisconsin, Dr. Parliment earned his B.A., M.A., and Ph.D. from the State University of New York.

For more information, please contact John Biestman at the Seattle Bank.

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