For the majority of the cycle, bankers and regulators see eye-to-eye on grading. Maybe that’s because in a benign economic environment every borrower looks good. There’s little in the way of arguments about whether a particular obligor is a grade 7 or 8.  No haranguing about the accrual status either. Then one day it happens; the regulator disagrees with the bank rating and insists it be downgraded. The banker chalks it up to a bad day, or maybe lack of sleep, for this particular examiner. But then it happens again. And again. Soon, the banker is left wondering what’s going on. Thoughts of being in perfect harmony with the regulators on grading calibration vanish, and now all of a sudden it seems banker and regulator are speaking two different languages.

Due to the perceived misses, regulators gradually begin to impugn the bank’s grading system, which in turn leads to criticism of the loan loss reserve: "How can you know your reserve is adequate if you can’t even grade your credits properly?"

The bankers feel betrayed. They’ve worked hard to align themselves with the regulatory thought process on grading, and now they’re suddenly getting their hands slapped for being out of sync.

The bank’s reaction is gradual. First there is the denial stage ("The regulators are wrong!"). Then there’s the anger stage ("Why didn’t the regulators just tell us they were changing their standards?"). Then comes the acceptance phase, followed by the adjustment stage.

It’s usually the people in the Credit Review department who first notice the regulatory sea change, and they’re the ones who initiate the transition for the bank. This is a very painful process. Regulators hint that the internal grading process is beginning to fail and indict the Credit Review department for the problem. Credit Review responds by trying to interpret the new regulatory expectations. At first this is a clumsy effort because neither they nor the regulators themselves are certain as to what the new standards are. Eventually alignment occurs and Credit Review begins to implement it throughout the company.

There is a predictable uproar. Accused of selling out to the regulators, Credit Review is often derided as being nothing more than an extension of the (choose one) OCC, Fed, FDIC, OTS, or state. Credit Review is now caught between two competing forces: line management and regulators. Neither group is inclined to be sympathetic. Since the regulators carry the bigger stick (read: "We’ll tell the board you’re not doing your job"), the review function puts its head down and plows forward. It takes a severe beating in the process.

Eventually, the line side of the organization begins to come around. This occurs for several reasons, but neither Credit Review nor the regulators will go away. Further, some of the credits that are being "unjustly" criticized begin to take on, in the immortal words of Hulk Hogan, an "odiferous" smell. Such credits imply that maybe, just maybe, the regulators and the Credit Review function might be right. Eventually, everyone gets in alignment and begins to grade credits the way they need to be called. This alignment occurs somewhere around the time problem credits are beginning to rain down in every segment of the portfolio.

It’s all a normal part of the business cycle. Everyone has a role in this opera: regulators, reviewers, and lenders. They all play their roles predictably and they play them well.

Let’s face it: The process has begun once again. Recognize it, adjust, and move on. As an industry, the faster we accept the inevitable and the sooner all parties stop throwing stones at each other, the quicker the alignment will occur. Then everyone can get focused on the real issue: dealing with the problem credits.

Kevin Blakely, President and CEO
kblakely@rmahq.org