Account for the steps through which risk is taken on, namely credit origination, credit risk assessment and credit approval.
The idea
Credit risk is taken on through three linked steps. Origination is sourcing and structuring new business. It means finding borrowers inside the target market, taking the initial request and shaping a proposal. This is usually done by relationship managers who are rewarded for volume. Credit risk assessment is the analysis of the borrower and the deal. It covers financial and cash flow analysis, an internal rating and an estimate of default probability, and the effect of collateral and structure on loss given default. Credit approval is the formal decision to accept the exposure on stated terms and within limits. It is taken by an individual or committee with the right delegated authority. The sequence matters, since approval needs a finished assessment. The key control is separating those who originate from those who approve, to avoid conflict of interest.
A practice question
Which activity is part of credit origination?
- Estimating the probability of default of an applicant using financial statements.Why not: This is credit risk assessment, not origination.
- Sourcing prospective borrowers and structuring an initial credit proposal. - correct
- Giving final consent to the exposure under delegated authority.Why not: This is credit approval, the formal decision stage.
- Tracking the borrower's covenant compliance after the loan has been drawn.Why not: This is post-approval monitoring, which follows the three steps of taking on risk.
Origination is finding and shaping business. Assessment analyses the risk and approval is the decision.
A harder one
An analyst reviews three years of a manufacturer's statements, projects cash flows, assigns an internal rating of 5 and proposes financial covenants. Which step in taking on credit risk is the analyst performing?
- Credit risk assessment. - correct
- Credit origination.Why not: Origination is sourcing and structuring the business, not analysing the borrower's creditworthiness.
- Credit approval.Why not: Approval is the decision by someone with authority; an analyst's recommendation is not the decision.
- Ongoing credit monitoring.Why not: Monitoring is done after the loan is drawn; here the loan is still being considered.
Financial analysis, rating and a recommended structure are the content of credit risk assessment.
The hardest tier
At a bank, relationship managers can approve loans up to USD 20 million and are paid on loan growth. Losses in that size band rise. Which change best addresses the cause?
- Raise pricing on loans in the band to compensate for the extra losses.Why not: Treats the symptom: higher margins do not fix the incentive to approve weak credits.
- Let relationship managers also perform the credit assessment so they carry full ownership of each loan decision.Why not: Concentrates more of the process in the conflicted group and removes independent analysis.
- Require monthly origination reports to the board, with approval authority and incentives left as they are.Why not: More reporting does not change who decides or the incentives behind the decision.
- Move approval for the band to an independent credit function, keeping manager input at origination. - correct
The root cause is the combination of origination incentives and approval authority. Independent approval restores the separation between the two.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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