Know Your Customer No Longer Passé
Regulators are openly worrying as banks of all sizes ramp up their commercial and industrial (C&I) lending. C&I loans are up 10% from last year and close to reaching the pre-crisis peak of $1.6 trillion. The growth comes from long-standing players as well as new entrants, such as community banks, seeking an alternative to weak demand for other loans.
Certainly, building a C&I line of business can be an excellent strategy for portfolio diversification and yield enhancement. But with the recent recession precipitated in part by the race for real estate loans, regulators are bound to be cautious wherever competition is most heated, as is the case today with C&I loans.
Foremost among regulators’ concerns is lenders’ upfront due diligence – and with good reason. From the very beginning of the banking profession, “knowing your customer” (KYC) has been the essence of good banking. Understanding as much as possible about borrowers has been essential to higher revenues, lower losses and better returns on capital. The latest recession wasn’t the first time many banks drifted away from this fundamental principle, but the signs of drift were stark: aggressive lending volume targets, a focus on getting the deal rather than building the relationship, the use of brokers and other agency arrangements to drive volume, assets generated solely for re-sale, reduced due diligence, looser underwriting standards and light covenants.
Those banks paid the price, but so did the overall economy. At the same time, KYC was losing its “relationship” essence and becoming synonymous with regulatory compliance and anti-money laundering (AML) legislation. While an important focus, this negative, regulatory-driven perspective overlooks the positive rationale for KYC as a fundamental principle of banking. Now, as C&I portfolios expand, the time is right for banks to take back the original meaning of KYC and revive its practice in all aspects of their business.
A quick look at how regulators express their concerns about C&I’s rapid growth drives home the point: While carefully couched in the language of risk and regulations, their questions actually get at how well the customer is known. Are the bank’s risk management policies, procedures, practices and controls appropriate to their new C&I business? Do the bank’s employees have the right training, experience and skills to assess, understand and monitor the risks inherent in this business? Do the employees understand the customers’ industries? Do the employees understand and apply appropriate due diligence and controls in their C&I operations? Are employees incented in ways that don’t encourage excessive risk?
The fact is, success in the C&I lending market is not a choice between excellent relationship management or excellent credit risk management. A successful C&I bank needs both. Knowing the customer in the original sense and sound credit risk management policies, practices and controls will reinforce each other in a virtuous circle.
The core of a successful C&I strategy is your skilled frontline C&I relationship managers, credit analysts and risk management personnel. It is not enough for them to be fully conversant with all of your C&I products and services. To evaluate a customer’s financial condition they need a good working knowledge of accounting principles and the skills and tools for analyzing financial statements, global cash flow and other projections. They also require a sound understanding of business and management, which will enable them to critically analyze the customer’s business model, management strengths and weaknesses, the nuances of the industry(ies) in which their customer operates and their customer’s exposure to key purchasers and suppliers.
A good background in risk management enables relationship managers to analyze and recommend mitigation strategies for a wide range of risks that each customer faces, including economic, competitive, supplier, manufacturing, distribution, financial market, technological and regulatory. And finally, they need to demonstrate that they can negotiate and structure appropriate credit facilities and accurately explain and assess the value of C&I security, collateral, and covenant options.
As for the rest of the bank, what does it mean to have an enterprisewide approach to C&I built solidly on original KYC principles? It starts with your people – from the Board all the way down. Your human resource policies and practices – recruitment, training, compensation, performance metrics, rewards, and recognition – must be tightly aligned to knowing the customers. It means not succumbing to the temptation to reward highvolume over high quality.
It means targeting business segments about which key employees have a deep understanding. No matter how much data or analytics you purchase on a hot new geography or industry, it can’t equal the value of experienced practitioners. It means having dedicated relationship managers who can provide proper customer coverage. You measure them on customer satisfaction and loyalty, on whether their customers receive the right products and services for their needs and on how well they adhere to risk management policies.
Do your risk management policies and practices, from underwriting and fulfillment to ongoing monitoring, reflect a need for a deep, current understanding of each borrowing customer? The memory of no-doc mortgages and fast-track underwriting rightly haunts anyone who understands the value of these functions.
Your product and channel innovation strategies all flow from your collective understanding of the needs of the customer, not from hype in the marketplace or what’s happening in other markets. Likewise your marketing activities are founded on an understanding of the customer and what motivates them.
When you evaluate system purchases, upgrades or integrations, your primary focus is on how those system changes will enable employees – whether in sales, risk management, CRM or other area – to better know the customer.
The opportunity to take advantage of rising demand for C&I loans represents a good strategic fit and tremendous potential for many community and regional banks. If the original essence of KYC becomes the bedrock of each bank’s business strategy and the foundation of their focus on enhanced customer satisfaction, regulators could relax somewhat about C&I’s rapid growth. Lenders’ knowledge of the customer would drive not just the making of the loan, but also the bank’s product, delivery channels, marketing, business development and sales activities. It would be the cornerstone of good governance and risk management.
In short, across all areas of banking, KYC in its original context would be “just how we do business” and not something we do to be in compliance.
Mr. Stansfield and Mr. Thompson are partners in Atlanta based Bank Solutions Group, LLC, a global firm of consultants to the financial services sector. They can be reached at [email protected] and [email protected] respectively.