Left unchecked, credit exposures can build into large positions that are difficult to resolve, resulting in either extremely high losses or even, sometimes, failures of financial institutions. But firms can mitigate this risk by identifying and addressing a credit exposure that is going through a stressed period – before the position becomes outsized or before any loss event materializes.
Known as early problem recognition, this process addresses issues proactively, enabling solutions, maximizing recovery, and preserving client relationships. In short, it ensures the long-term viability of the institution.
To understand why this is important, just consider a few high-profile examples of companies that failed to recognize problematic credit exposures:
To recognize problems early, and to then properly address them, requires three steps: (1) a culture of inclusion that promotes and encourages psychological safety and normalizes discussions about failures; (2) the right governance; and (3) implementation of appropriate policies, procedures and training.
Let’s now take a closer look at the different components of each step:
Corporate resilience depends on an environment where employees feel safe to raise concerns, and where failures are openly acknowledged and constructively discussed. The best teams are the ones that are most willing to discuss their mistakes openly and learn from them, rather than simply reporting them. At the heart of such a culture is psychological safety.
Divya Eapen
Employees must believe that they can speak up – by voicing ideas, raising questions and expressing concerns – without fear of punishment or humiliation. This feeling of psychological safety shifts employees’ mental space from impression management to creativity.
In an environment of psychological safety, teams feel empowered to take interpersonal risks, knowing that their contributions – positive or negative – are valued. A culture of openness and accountability can transform the way organizations handle challenges, building resilience.
Rather than focusing solely on success, organizations should also normalize discussions about failures. Senior leaders play a pivotal role in setting the tone by openly discussing their own failures and the lessons learned, demonstrating that no one is above making mistakes. What's more, regular public forums – such as team meetings or company-wide town halls – can provide employees a platform to share learnings from failures.
The way an organization reacts when problems are brought to light is as important as encouraging openness. If an employee raises a concern, for example, soon after a loan is booked, he or she is unlikely to speak up again if their input is met with defensiveness or dismissal.
Conversely, when employees see that setbacks are met with curiosity and possible solutions, they are more likely to share their own experiences. This allows organizations to “fail small” and learn from mistakes.
Diagram: Psychological Safety and Accountability
Source: Amy Edmonson, Harvard Business School.
The highest-performing teams combine accountability with psychological safety. This combination fosters innovation and clears mental bandwidth for creative problem-solving by eliminating the exhausting task of managing impressions. Employees in such environments are focused on learning and contributing to the organization’s growth.
Effective governance fosters accountability and ensures the right structures are in place for problem escalation and cross-departmental conversations. The board of directors and the executive committee (ExCo) need to visibly and consistently prioritize the long-term viability of the company over short-term profits. Management, moreover, also needs to adopt smart protocols for compensation and incentives.
Let’s now drill down into each of these governance factors.
Board of Directors
Early investors often serve as board members for start-ups and scale-ups. While their involvement provides valuable expertise and capital, early investors may prioritize short-term exits over long-term stability.
Companies should transition relatively early in their journey from investor-driven boards to professional governance structures with experienced leaders, including those who have navigated financial failures. These board members provide a diverse viewpoint and set the right tone from the top.
Executive Committee
The ExCo must align on a strategy of sustained growth. While tension between origination and risk teams is natural, senior managers need to model productive debate around specific transactions, without compromising the overall strategy.
Key ExCo figures, such as the chief risk officer (CRO) and the general counsel (GC), serve as impartial and crucial escalation points when regular processes fail to resolve concerns. In addition to being named in policy documents, they must be highly visible in demonstrating leadership at townhalls, management meetings and cross-divisional meetings.
Employees need to perceive these people not only as strong, impartial and approachable but also as true equals to revenue-generating ExCo members. There should be no doubt that the CRO and GC are motivated by the long-term sustainable growth of the firm.
Compensation and Incentives
Sales incentives should prioritize sustainable growth over high-risk deals. Many financial institutions incorporate risk-adjusted measures (such as return on risk capital), but blockbuster transactions are still generally rewarded (and publicly lauded) disproportionately. This promotes high-risk behavior and makes it very difficult for junior staff to escalate concerns on these transactions.
Encouraging employees to flag small missteps before they snowball is critical. Performance evaluations (and commensurate rewards) should consider proactive problem recognition, not just revenue generation. This approach reduces risks and fosters a mindset of continuous improvement, which is essential to any growth company.
The CRO and GC should have compensation structures tied to long-term growth, ensuring they prioritize sustainable success over short-term risk-taking or seeking favor for positive year-end reviews. Annual cash bonuses for these executives should be minimal; instead, they should receive significant (yearly) increases in base salaries, so that their overall compensation is on par with that of other executives.
This novel approach enables the CRO and GR to more confidently challenge other ExCo members. It also empowers them to escalate issues to the board.
To ensure that deterioration in a credit portfolio or loan is identified and resolved quickly, a firm needs well-designed policies, procedures and training programs.
Policies and Procedures
Clear, accessible and jargon-free policies and procedures set expectations and ensure that all employees understand their responsibilities in early problem recognition. The most effective policies and procedures place accountability on employees and empower them with the ability to apply judgement (or escalate if they are unsure), rather than attempt to cover every scenario imaginable.
Policies can become unwieldy over time, as new clauses to cover new scenarios are added year after year. This complexity reduces readability and removes accountability and independent thinking and decision-making, resulting in worse outcomes to the credit portfolio.
Documentation is another area that requires careful attention. Both users and subject matter experts should regularly review documents and continuously work on streamlining them to improve clarity and effectiveness.
Training
Regular training ensures that the importance of early problem recognition remains front of mind. Senior sponsorship is key; training should be led jointly by risk teams and division heads to signal its importance.
Interactive, case-study-based training (ideally looking at problem credits within the company’s existing or historical portfolios) is far more engaging, compelling and memorable to employees. Recognizing employees who successfully identify early warning signs can further embed these principles into company culture.
An organization’s ability to recognize problems early hinges on how well its people are equipped to spot warning signs and act accordingly. When policies and procedures are well-structured, simple and supported by robust training, companies create an environment where employees feel confident in making the right decisions – reducing risk and enhancing long-term stability.
Early problem credit recognition is fundamental to the long-term success and resilience of a credit portfolio. The ability to identify and act on advance warning signs before exposures become deeply distressed can be the difference between manageable risk and catastrophic loss.
To mitigate such risks, companies should foster a culture that encourages open dialogue, establish a governance structure that prioritizes long-term stability over short-term gains, and implement clear policies and continuous training. This proactive approach to early problem recognition equips employees with the knowledge and confidence to act decisively.
Ultimately, an organization that embraces these principles will not only be more resilient but will also position itself for sustainable growth, market credibility and long-term success.
Divya Eapen is the founder of Risk Strategy Consulting. With experience as the Chief Restructuring Officer at Greensill and eight years managing stressed and distressed credits at Citi, she provides Board and ExCo training on early problem recognition with her own lived case studies.