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The Risky Game of Credit Underwriting

The Risky Game of Credit Underwriting

Credit underwriting decisions are a cornerstone of any economy. Made wisely, they can assist entrepreneurship, promote economic growth, and generally ensure that capital is allocated to its highest and best use. On the other hand, poor credit underwriting decisions can negatively impact an industry or the economy as a whole.  Recent troubles in the U.S. economy are directly tied to the poor credit decisions of lenders to support prospective home owners who had little money and provided little information about their financial strength in an over-inflated housing environment. Recent failures of banks such as IndyMac are partly tied to poor credit underwriting decisions and over-leveraging.  The failure of banks to consider the full range of construction risk is leaving many banks high and dry due to the recent spate of construction business failures, with many more to come. The five consecutive years of recent losses in the surety industry was directly related to poor credit underwriting decisions. With all of these losses you have to wonder what is going wrong. The answer is twofold: an unusually high tolerance for risk and credit decisions based upon insufficient data.

Creditors

In the case of mortgages that went bad, because loans could be packaged and resold, an anything goes atmosphere developed and many risk management practices were thrown out the window. Many loans were provided based on simple applications that provided minimal financial information. The fallout of this lending environment is showcased on Mortgage Lender Implode-o-Meter. In the case of IndyMac, a large portfolio of non-performing Alt-A loans, sometimes called liar loans, and risky construction and land development lending, left the bank with very little cushion in a falling housing market. Other banks impacted by losses only relied on financial data, failing to consider all the risks of lending to high risk industries such as construction and auto dealerships.

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The ERM – Business Success Matrix, and the “Success Paradox”

The ERM – Business Success Matrix, and the “Success Paradox”

Companies usually find themselves in one of four quadrants of the ERM/Business Success matrix:

  1. A company has proper risk controls in place and is successful/profitable
  2. A company does not have proper risk controls in place and is successful/profitable
  3. A company has proper risk controls in place and is unsuccessful/unprofitable
  4. A company does not have proper risk controls in place and is unsuccessful/unprofitable

The Success Paradox

The term “Success Paradox” has been used to refer, among other things, to individuals that are economically successful not being as happy as those less economically well-off, to the increased vulnerability of developed countries to diseases such as measles, and to the concept that an enterprise, such as a poverty NGO, can put itself out of business if it is successful.

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Will the Real Risk Manager Please Stand Up!

Will the Real Risk Manager Please Stand Up!

Today I met an individual who asked what I did for a living. I was somewhat distracted and mumbled the word “risk management.” As I regained my focus this gentleman said “Oh, you’re a risk manager. I’ve had trouble with my Workers' Compensation...” and he began to talk about insurance. This was a prime example of the perception surrounding the terms “risk management” and “risk manager,” and how they’ve been equated solely to insurance coverage and insurance professionals in the past. I've witnessed this misrepresentation of the terms so many times that I felt not just inspired, but a public obligation, to write this article and help clear the confusion with the terminology that began long ago. PASSING THE SMELL TEST In the early 1960’s, two professors, Robert Mehr and Bob Hedges, developed the concept of Enterprise Risk Management. These two could easily be called the Godfathers of Risk Management. They published the first text to fully address the subject of business risk, "Risk Management in the Business Enterprise." The book introduced how risk management of an entire business could maximize efficiency, which would result in greater productivity. The basic premise was that all business risks should be managed, not simply those that could be "insured."

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Enterprise Risk Management Myths

The topic of Enterprise Risk Management can seem quite confusing, especially since there is a good deal of misinformation floating around.  In “The Top 10 Enterprise Risk-Management Myths,” Gordon Burnes of NewsFactor.com discusses some of the most common myths of Enterprise Risk Management.  The article is a good read for those interested in ERM, although we should point out that it is (like most information on ERM) still heavily IT/Financial focused.  A couple of the myths speak directly to the premise behind MyRiskControl.com:

Myth Number 7: You Can Manage Risk Only from the Center

No one is likely to argue that strong, central risk management is a bad thing. Unfortunately, many organizations make the mistake of investing only in a centralized function because it’s too difficult to federate, and they don’t know how to push risk management to lower levels of responsibility in the organization. It’s a classic issue of consistency vs. quality of information.

But, accurate information lies at the business line level. Organizations must augment their centralized risk management efforts with localized, distributed data, and the only way to reliably and cost-effectively do that is to invest in automated technology solutions.

Along this line of thinking, he continues:

ERM needs to be deployed bottom-up so that business managers are the first-line managers of risk, embedding enterprise risk management within the day-to-day business processes of the firm. They must understand the risk/reward trade-offs involved in their own decision-making. Risk management should create a bias for action, surfacing problems as they arise and empowering the entire organization to be risk managers. (more…)

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