SRC Insights: First Quarter 2004

The Importance of Effective Credit Cultures at Community Banks

by Thomas H. McManus, Senior Examiner

What is credit culture? Why is credit culture, particularly at community banks with limited resources, an important element in the credit risk management process?

Credit culture is the critical micro piece of the credit risk management process, since an appropriate credit culture determines not only a bank's profitability but also its very survival. A sample of risk profiles for more than 1,000 community banks tracked over the past eight years shows a significant increase in portfolio credit risk. The increase reflects cyclical factors, but also results from community banks taking more risk to grow their portfolios and maintain earnings. ¹ Closer to home, at least four community banks that served Third District customers in the early 1990s no longer exist. Although each bank had different causes for their ultimate demise, each shared a common characteristic: their existence was short-lived because their CEOs and boards of directors failed in their responsibility to establish a fundamental and critical element of credit risk management—an effective credit culture.

Credit Culture Defined
So what is this thing we call credit culture? How do we define it? There are numerous definitions. Some people define credit culture as simply "the way things get done around here." I define credit culture more narrowly as the sum of all the characteristics of an organization's unique behavior in its extension of credit. It not only encompasses the tangible written policies and procedures, but also intangible, such as ideas, traditions, skills, attitudes, philosophies, and standards. Credit culture is developed over time, and then communicated and passed on. It is the true spirit behind the rules.

Evolving Enterprise Risk Management Practices
The banking environment has changed dramatically from both an industry and regulatory perspective. Banking has evolved into a fiercely competitive business. Separate business line-specific risk management practices continue to evolve into consolidated enterprise risk management (ERM) frameworks, the purpose of which is to evaluate and manage the uncertainties the enterprise faces as it enhances value to shareholders. Arguably, some ERM frameworks are simply too complex for many community banks, given their traditional nature, structure, and business lines. However, creating an ERM framework does provide even the smallest institutions with a structured and disciplined approach to aligning strategy, processes, people, technology, and knowledge.

Community banks, more often without the resources of larger regional and national competitors, are expected by their boards of directors to effectively manage and compete in today's changing environment. Pressure to enhance shareholder value can lead to slippages in credit practices, such as approving marginal credits, waiving personal guaranties and other standards, and irrational pricing. That is, of course, unless an organization has a carefully defined and disciplined credit culture, supported by its board, as its first line of defense against imprudent credit and pricing decisions. In fact, credit culture concepts remain as immutable and relevant today as they were over thirty years ago.

The Essentials of Credit Culture
How can CEOs promote good credit decisions fostered by a strong credit culture? P. Henry Mueller, the former chairman of the credit policy committee and chief lending officer of Citicorp and Citibank, New York, has offered 20 self-evident essentials of good banking.² These essentials apply to the credit culture of any institution, regardless of size:

Continuing commitment to excellence.
Logical framework for day-to-day decision making.
Sound value systems that will not break down under change.
Uniform and consistent approach to risk taking.
A common credit language.
Business cycle perspective on the bank's credit experience.
Supremacy of the bank's objectives over individual profit center goals.
Candid and frank communication at all levels.
Awareness of every transaction's effect on the bank.
A portfolio with integrity and few exceptions.
Individual accountability for decisions and actions.
Balance of long-term insight with short-term view.
Respect for credit basics.
Common-sense reality checks against market practices.
Encouragement of independent judgment over the herd instinct.
Constant mindfulness of the bank's risk taking parameters.
Realistic approach to markets and budgeting.
An understanding of what the bank expects and the reasons behind its policies.
Credit systems with early warning capabilities.
Expectation that problems are identified early and that no tolerance for surprises exists.

Underpinnings of Strong Credit Cultures
Policy, process, auditing, and behavior are the underpinnings of a strong credit culture. As the starting point, credit policy provides a philosophical framework for day-to-day credit decisions. Policy will guide officers in balancing the bank's earnings objectives. Process is the line-driven operational arm of credit extension and credit strategy. Through the delegation of authority, a strong credit process will provide a policing mechanism for the integrity of the credit apparatus. Auditing is responsible for ensuring adherence to credit policy, procedures, and business plans. Behavior is related to the values held by bank employees. Each credit officer should be expected to reflect conservative risk-taking attitudes and a commitment to excellence. Exceptions to policy should be few and well documented when approved.

Each type of credit culture has its own characteristics with a driving force, which sets the priorities, stated or unstated, and produces a credit environment with different success factors.³ There are several determinants of a bank's credit culture that are beyond the scope of this article. However, the most significant determinant in developing an optimal culture is top management's unwavering commitment to credit quality. Any uncertainty or ambiguity opens the door for arguments to stretch, bend, or eliminate policies.

The CEO is Key
Banking is a business built on knowledge and behavior. The behavior of middle managers and credit officers reflects the attitudes of senior managers, particularly the attitude of the CEO in a community bank. Like the captain of a ship, the CEO is the conscience and protector of the bank's value system and sets the bank's tone and direction. A sense of what the CEO will or will not tolerate spreads like wildfire; if the CEO says or does nothing, that also sends a message.

Delicate nuances become important because acceptable credit practices depend on such intangibles as philosophies and attitudes. It is up to the CEO to send clear and suitable signals appropriate for the credit culture that he or she has chosen to establish. It is also up to the CEO to insist on prudent discipline, guidelines, and accountability.

In recent years, the notion that a smart manager can manage anything has become very popular. Thus, many financial institution CEOs lack credit training and experience. This trend is exacerbated by the abandonment of formal credit training programs by many of the larger regional banks that have traditionally supplied the community banks with their CEOs and senior staff. Credit is a discipline and, like a profession, is not quickly acquired nor can it be brushed aside lightly. Boards of directors must be mindful of the uncertainty they introduce when their CEOs lack credit backgrounds.

Conclusion
A sound effective credit culture is the foundation of credit risk management in any bank. So what is the question for examiners to ask of the CEO or chief credit officer, or for the CEO or chief credit officer to ask him or herself? The question is: what is the credit culture of this institution? If the CEO or chief credit policy officer responds with a quizzical stare or summarily dismisses the question, credit risk management could be an area warranting additional concern and examiner scrutiny. A bank without a sound credit culture is like a ship in the dark during a raging storm—when the rocks appear, it is too late to change course, and certain disaster awaits.

If you have any questions about this article, please contact Thomas McManus at (215) 574-3451.

Additional information on credit culture is presented in the following articles in The RMA Journal:

Strischek, Dev. "Credit Culture : Part I." The RMA Journal v85 n3 (November 2002): 52-55.
Strischek, Dev. "Credit Culture : Part II Types of Credit Cultures." The RMA Journal v85 n4 (December 2002): 35-39.
Strischek, Dev. "Credit Culture: Part III: Changing Direction & Implementing a New Credit Culture." The RMA Journal v85 n6 (March 2003): 38-43.

¹ John Barrickman, "Management Strategies/Asset Quality Ratings: Critical Tools for Managing Portfolio Credit Risk," RMA Journal, March 2003, p. 72.
² P. Henry Mueller, "Credit Policy: The Anchor of the Credit Culture," The Journal of Commercial Lending, July 1994, pp. 1 - 5.
³ John McKinley, How to Analyze Your Bank's Credit Culture (Philadelphia: Robert Morris Associates, 1990), pp. 29 - 33.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

SRC Insights: First Quarter 2004

The Importance of Effective Credit Cultures at Community Banks

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