Audit committee strategies to help mitigate credit risk 

Giulio Camerini, Steve Krase
5/9/2024
Hispanic senior data scientist analyzes credit risk reports on a large screen while the audit committee explores strategies for mitigating risk in financial services

Market volatility can introduce credit risks for financial institutions – and their audit committees. Learn how audit committees can help mitigate those risks.

With rising interest rates, tightening credit conditions, and wavering inflation, the current economic environment can be a challenge for financial services companies. Loan renewals and modifications are coming up against the higher rates, while the tightening credit is leaving borrowers – and lenders – with fewer options to refinance less desirable loans out of an institution. Portfolios are experiencing an increase in risk rating migrations as well as an uptick in foreclosures and handbacks. Meanwhile, liquidity continues to be a challenge, costs of funds continue to rise and affect earnings, and unrealized losses in investment portfolios loom large. With such a volatile market, it can be hard to determine which risks to manage and how – but audit committee members are in a position to help their institutions monitor some of these risks. The recent Crowe webinar “April 2024 Financial Services Audit Committee Overview” covers how audit committees can do so. Following are key takeaways.

Audit committee strategies to help mitigate credit risk

What should audit committees reflect on in the current market? 

Independent loan review
Whether a financial institution’s loan review function is internal or external, it's important to reflect on both the frequency and depth of loan reviews. Reviews should go beyond grading to provide value-added comments on topics like credit trends; underwriting and portfolio management, including problem loan management; appropriateness of policy exceptions; and management covenant violations. It’s also important to review the risk assessment process for scoping and seek out feedback on portfolios with identified or emerging higher risk or portfolios deemed a higher loan type (or product type) concentration. Incorporating more advanced analytics and visualizations as part of the loan review process might help enhance the process and make patterns easier to identify. If loan review is an internal function, financial institutions also might want to consider an internal audit of that process and a review of staffing to determine if both have kept pace with the size and complexity of the organization.

Board and committee involvement
The board and audit committee need to allocate the right amount of time to discuss credit metrics, trends, appetite, and other data. If that time isn’t available, audit committees could form a dedicated credit risk committee to report back to the full committee and board.

Reporting
Markets and practices are evolving constantly, which means management information systems (MIS) and reporting need to be fluid to keep up. Audit committees and boards should ask if any gaps exist in the presented data – is the right amount of economic data included, for example? What about policy exceptions, portfolio metrics, trends, and other forward-looking items? It can be helpful to bring in outside resources to analyze current data and determine what might be missing.

Management
Audit committees should reflect on their management, especially in the face of recent retirements and evolving markets. If the organization doesn’t have a seasoned team, it might be worth bringing in management with some extra experience to help work through some of the risks or train less seasoned employees.

Audit committee strategies to help mitigate credit risk

What topics should audit committees be discussing with management?

Portfolio stress testing
It’s important for organizations to stress test their portfolios, and audit committees should see the results of that testing. If committees are not receiving the data, they should ask management to provide it. If they are receiving the data, they should check to see that it goes beyond interest rates to include information about geography, product types, and other organization-specific breakdowns. The loan review team might be able to assist with analyzing large data sets. For financial institutions with heightened loan type (or product type) concentrations, it’s especially vital to continually assess and evolve stress-testing approaches.

Loan-level stress
The audit committee also should look at current loan-level stress-testing scenarios. Are they focused only on interest rates? If so, those scenarios might need to be adjusted to consider market shifts and the impact on both repayment capacity and collateral coverage.

Liquidity and deposits
The audit committee and management should discuss how current lending and credit extension are helping to increase or stabilize liquidity. Lending to transactional customers might no longer be the best use of capital, and low-yielding loan products should be reassessed.

Credit risk grading
Reviewing the credit risk grading approach is another helpful part of mitigating risk. Does the financial institution use a definition, scorecard, or model approach to grade commercial loans, and how has that process evolved? With the changing economic environment, this approach should be revisited regularly to evaluate frequency, consistency, and inputs. The volume of overrides should be scrutinized and used to identify potential weaknesses that need to be addressed.

Valuations
Determining if and how management is assessing the evolution of valuations in specific markets is vital. If the organization has an internal appraisal area, the audit committee can ask for regular updates on trends specific to core markets and collateral types and obtain market studies.

Managing market volatility can be difficult for every organization, but having these discussions can help audit committees understand both the opportunities and challenges in the current market and prepare for future market shifts.

Listen to the full session

April 2024 financial services audit committee overview

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Our team has deep industry experience in credit and loan review that can help you keep track of the latest updates, analyze critical issues, and apply insights effectively. 
Guilio Camerini
Giulio Camerini
Principal, Consulting
Steve Krase
Steve Krase
Principal, Financial Services Consulting