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Maximize performance with key risk indicators

FINANCIAL INSTITUTIONS INSIGHTS  | 

In the current economic environment, it is critical that financial institutions—particularly community banks—be aware of emerging risks facing their company. An efficient and effective way to do this is to identify and develop key risk indicators. Unlike performance indicators that focus on measuring historical activity, risk indicators focus on emerging risks that threaten the company's continued performance or recovery. Establishing this framework enables a financial institution to recover, improve or maintain its performance, as well as improve its response to emerging trends and enhance its policies governing operational and regulatory areas.

The "Great Recession" and its aftermath have had an unusually harmful impact on the community banking industry. This impact is evidenced by the number of commercial bank failures resolved by the Federal Deposit Insurance Corporation (FDIC) since 2008. Among the primary causes of stress on the industry are increased exposure to commercial real estate, widening enforcement actions by examiners and less-stringent risk management activities, both prior and subsequent to the crisis. This relaxation of risk monitoring has occurred at some financial institutions despite increases in overall risk profile.

Regulatory impact of the Great Recession

In response to the industry stress and bank closure activity, regulators are using lessons learned during the recession to shape their supervisory activities going forward. One consequence of this is more rigorous examinations of many financial institutions. The tightening of exam standards can also be attributed in part to findings published in a December 2010 report by the FDIC inspector general. The report summarized the findings of Material Loss Reports issued for banks that had failed since 2008. The inspector general's report concluded that tightened regulatory and supervisory action was warranted in order to mitigate the risk of bank losses and failures, whether caused by high-risk profiles, weak risk management practices, or both.

Additionally, regulators have been issuing both informal and formal enforcement actions at a brisk pace since 2008. These enforcement actions (and corresponding downgrades in the composite CAMELS ratings of institutions) have contributed directly to the uneven recovery of community banks, and indirectly to the uneven recovery of the U.S. economy as a whole. In the case of distressed institutions, enforcement actions typically have a direct impact on lending limits, resulting in increased capital requirements and reduced access to wholesale funding sources, which themselves will reduce lending activities. The end result is a weaker institution that may be unable to generate earnings sufficient to fund the costs necessary to resolve its problem loan portfolio, eventually resulting in failure of the institution.

In the case of performing institutions, concerns about regulatory scrutiny of loan activity coupled with the need to conserve capital in an uncertain economic and regulatory climate, also have detrimental effects on their overall condition. The first result is a tightening of credit availability, which has a negative impact on the economic recovery of the communities they serve. A second consequence is less-than-optimal earnings for the institution.

Comparing risk and performance indicators

In order to effectively manage a financial institution in the current environment, its management must identify and develop forward-looking key risk indicators (KRIs) that monitor emerging fundamental business, regulatory and reputational risks. For performing institutions, KRIs will enhance the enterprise risk management (ERM) framework, as well as assist them in maintaining current performance levels, while concurrently mitigating the risks associated with regulatory enforcement actions and corresponding reputational issues. For institutions under a formal or informal enforcement action, KRIs will help monitor threats to the recovery process, as well as identify opportunities for improvement.

As mentioned above, KRIs and KPIs have different objectives and focus on different issues. While KPIs typically focus on measuring historical activity, KRIs focus on emerging risks to the institution. For example, a KPI measuring asset quality would compare non-performing loans to total loans. While this ratio is critical to assessing the current health of the loan portfolio, it offers no insight or information regarding emerging risks within the loan portfolio. Furthermore, since non-performing loans have already migrated to non-accrual status, KPIs will not help management to identify proactive measures that can be taken to mitigate losses within the portfolio. In contrast, KRIs focus on identifying and measuring emerging risks that threaten the financial performance, regulatory status and overall success of the financial institution.

Use COSO and CAMELS guidance to develop KRIs

Based on guidance provided by COSO (Committee of Sponsoring Organizations of the Treadway Commission), the key to developing and implementing an effective set of KRIs is to identify metrics that offer insight into emerging risks threatening the institution's continued performance (or recovery, as it were). Furthermore, COSO advises that recognizing critical linkage between fundamental risks and core strategies will assist the institution in isolating relevant metrics that can serve as leading indicators of emerging risks.

Based on this guidance, institutions should consider developing a set of KRIs around the CAMELS rating system used by regulators. This approach allows an institution to address both operational and regulatory risk exposure under the umbrella of managing its overall reputational risk. It is a scalable process for developing and implementing KRIs within an institution's existing ERM or risk assessment process, regardless of asset size, risk management resources or complexity of overall operations.

Additionally, emerging regulatory trends indicate continued emphasis on timely and relevant stress tests, not only for commercial real estate but for all segments of the loan portfolio. Effective KRIs can assist management in identifying and developing stress scenarios and trigger events that could have an impact on stress tests pertaining to asset quality, capital and liquidity. The resulting asset quality stress test data could then be utilized to develop and execute capital and liquidity stress tests.

By identifying an effective set of leading KRIs, management can enhance its stress testing process. During this process, management should evaluate the integrity of the data utilized in the KRIs and to complete stress tests. As with any process that relies significantly on information systems, the integrity of the data inputs will determine the reliability and validity of the resultant outputs. Since this data is essentially driving key strategic decisions within the organization, management should take steps to ensure the quality and integrity of the data. The strengths and weaknesses of reporting systems should be critically assessed to determine if upgrades or enhancements are needed.

Use KRIs to update policies

Additionally, the process of identifying and developing KRIs will assist management in updating critical policies, which address emerging regulatory trends and industry benchmarks. For example, regulators have increased their focus on peer asset quality data when analyzing the sufficiency of an institution's allowance for loan and lease losses. Given this trend, management should consider updating those policies that offer guidance on allowances for loan and lease losses. Policy updates should address how management gathers, evaluates and incorporates peer asset quality data into their allowance calculation, as well as the impact it has on their evaluation of the sufficiency of the allowance.

The challenges facing the banking industry are numerous as the moderate pace of recovery from the Great Recession continues to hamper growth in many segments of the U.S. economy. Within these challenges, however, lie opportunities for both healthy and distressed institutions. Those on solid financial ground can identify and mitigate emerging risks that threaten their future performance, while those on shakier footing can seek ways to mitigate emerging risks that may jeopardize their plans for recovery and improved performance. Overall, the development and implementation of KRIs aligned with the CAMEL regulatory model can provide a valuable tool to institutions going forward.

For more information on this topic, download the Using key risk indicators to recover, improve or maintain institutional performance whitepaper. For assistance with this topic, please contact your local financial institution specialist or John P. Behringer, Director, Assurance Services, Financial Institutions, McGladrey & Pullen LLP, at 414.298.2855.

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