Development and Maintenance of an Effective Loan Policy: Part 3*
by James L. Adams, Supervising Examiner, Federal Reserve Bank of Philadelphia
This article touches on postorigination risk management activities and tools that examiners will normally find in an effective bank loan policy: a risk rating system; a monitoring framework; management information systems (MIS) and reporting; internal controls, including audit, loan review, and credit administration; and a problem loan workout function. Although maintaining an appropriate allowance for loan and lease losses (ALLL) is also a key component of postorigination risk management, much guidance and numerous articles have been written on the topic; therefore, it will not be covered in this article.1
As mentioned in the prior articles in this series, processes and procedures that govern lending activities do not necessarily need to be incorporated within one single loan policy; however, a bank should maintain a central repository that houses all relevant policies to promote consistent application by its employees.
Risk Rating System
A key element of a sound monitoring framework is a well-defined and adequately documented risk rating system. The importance of risk ratings was discussed in part two of this series, noting that the bank should have a process to assign accurate and timely risk ratings and to update ratings when appropriate. While the granularity of risk rating systems can vary significantly based on portfolio size, composition, and product complexity, management should ensure that risk ratings are accurate and reliable. Ineffective risk ratings systems will result in weak portfolio oversight, an inaccurate ALLL, and ultimately, increased credit losses.
An effective risk rating system should:
- Provide the foundation for credit risk measurement, monitoring, and reporting
- Support management and board decision-making
- Be sufficiently flexible to allow for use with various types of credit exposure
- Provide appropriate granularity of risk ratings (including regulatory classification grades) that accurately reflect the risk of default and credit losses
- Offer multiple pass grade options as appropriate for the complexity and risk of the portfolio that adequately differentiate pass risk ratings
- Precisely define ratings criteria using both objective (quantitative) and subjective (qualitative) factors
- Consider both the borrower’s expected performance and the transaction structure
- Be independently validated2
The loan policy, at a minimum, should outline these same factors.
To promote appropriate risk identification, measurement, and monitoring, the loan policy should clearly identify and establish procedures related to the ongoing management of the loan portfolio and identify the appropriate staffing level and skill sets required for such tasks.
Monitoring and reporting on the performance and collateral of loans should start immediately following the dispersal of loan proceeds. Therefore, the individual, group(s), or committee(s) responsible for ongoing monitoring, controls, and incentives should be well established to ensure appropriate oversight. While a bank may choose different management approaches for credit monitoring, many banks have the business line serve as the first line of defense for ongoing monitoring in order to leverage their lending expertise to identify potential issues and to maintain a strong, ongoing relationship with the borrower. This approach, however, is not a requirement.
The monitoring framework should also include an assessment of compliance with the bank’s underwriting criteria. This includes testing loan covenants, both positive and negative, to evaluate whether the borrower is complying with loan covenants or is in technical default, or whether the repayment of principal is expected or jeopardized.
Management Information Systems and Reporting
Sound MIS and reporting will enhance the efficiency and effectiveness of lending decisions, ongoing portfolio monitoring, and overall credit management. The loan policy should clearly identify the primary monitoring reports necessary to support credit management and to establish the frequency for producing the reports. Reports should be targeted to the user and based on the level of oversight and granularity required for management, committees, and the board. For example, management reports may be more granular, while board reports may provide a high-level yet comprehensive overview of lending activity and risks.
All reporting should be relevant and adequately convey the level of detail required by the end user. Reports should be expressed in both dollar and percentage changes along with volume and/or transaction details. This level of detail will provide a balanced report so that a single large-dollar transaction does not unnecessarily skew reports that have a significant volume of low-dollar transactions.
The following information should be readily available and routinely reviewed by management:3
- Total loans and commitments
- Pipeline reports (to identify emerging concentrations or risks)
- Loans in excess of existing credit limits
- New extensions of credit, credit renewals, and restructured credits
- Delinquent and/or nonaccrual loans
- Credits adversely graded or requiring special attention
- Credits to insiders and their related interests
- Credits not in compliance with internal lending policies, laws, or regulations
For the board of directors to be fully effective, bank management should provide the board with sufficient information that will enable directors to understand the key risks in the loan portfolio and assess the adequacy of risk management practices and internal controls. The board of directors should receive board meeting materials far enough in advance of a meeting to promote active meeting participation.4
Internal controls, such as internal audit, loan review, and credit administration, are critical functions that play an important role in maintaining effective monitoring of the lending process. The loan policy should establish a system for loan review to confirm that credit policies, underwriting procedures, and internal rating assignments are being thoroughly reviewed by experienced and independent personnel. A system for ongoing loan reviews should provide management with sufficient information to assess adherence to internal policies and the ability of approvers to accurately risk rate credit exposures.5
To be able to assess whether the lending function’s design and controls are effective and working appropriately, the board of directors or its audit committee should require regular comprehensive audits of the function. The audit plan should be risk-focused and incorporate coverage of key lending areas, including areas in which concentrations exist. Audits also should include adequate testing of compliance of the lending function with the bank’s policies and procedures. Additionally, the audit function should review compliance with loan documentation standards and federal and state banking laws and regulations, as well as the accuracy of past-due and charge-off reports. Audits should be conducted with appropriate frequency, and adequate resources should be assigned to perform the review. The scope of the audit should be suitable for the desired coverage. The audit function either can be housed internally or outsourced, based on the size and complexity of the bank’s lending activity and operations. The board of directors is ultimately responsible for determining whether the audit function is performed in house.
Loan Review Function
The responsibility for underwriting and structuring a loan according to policy and for confirming that a loan is performing to expectations rests primarily with the line of business or the party approving the credit. The line of business is also responsible for appropriately risk rating the credit and promptly identifying any emerging issues or deterioration in the credit. An independent loan review function may be used to provide additional oversight of the portfolio. Similar to the audit function, this function can be housed internally or outsourced to a qualified and independent candidate or firm; however, as with all delegated functions, ultimate responsibility for sound risk management remains with the bank.6
Loan review plays a critical function by providing an independent assessment to senior management and the board about the bank’s overall level of credit risk, effectiveness of credit risk management, and identification of potential risks that could negatively impact the portfolio. An overview of the loan review function and its responsibilities is outlined in Attachment 1 of SR letter 06-17, “Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL).”7 The attachment discusses the elements for establishing an effective loan review system.
The duties and responsibilities of the loan review function should be formally documented within the larger policy framework. The loan review policy should establish the required level of portfolio coverage and time frame(s) within which the reviews should be conducted. Loan reviews should be risk-focused, and the portfolios and individual loans that pose the greatest risk to the organization should be reviewed on a more frequent basis. The loan review scope should be clearly defined yet flexible enough to identify any new emerging risks.
Credit Administration — Loan Policy Compliance
Ongoing compliance reviews, along with a clearly articulated loan policy, impose discipline and sound loan administration. Pressures related to productivity and competition may result in lenders being inappropriately motivated to relax credit underwriting standards or to approve a loan that is not fully compliant with all aspects of the loan policy. While exceptions to a policy may be appropriate, a bank should have an MIS that properly identifies, justifies, and approves all exceptions.
A bank’s loan policy should establish clear processes for requesting, approving, and documenting policy exceptions. The policy should also require aggregate reporting of all exceptions to the board or a board committee and should include audit and/or loan review mechanisms to identify unreported exceptions.
Problem Loan Workout
The main objective in problem loan workout is to enhance or preserve the bank’s overall position with respect to cash flow and collateral; therefore, early detection of problems is the key to success. The loan policy should appropriately address the main aspects of problem loan workout, including practices and procedures surrounding nonaccrual status, troubled debt restructuring, and foreclosure. The policy should also cover the general administration and reporting processes within the loan workout function.
The workout of problem credits can be done within the line of business or, if appropriate, may need to be removed from the line of business to a separate unit that focuses solely on problem loan resolution. There are multiple benefits to retaining the workout function within the line of business, including familiarity with the borrower and the global borrowing relationship; however, moving a troubled borrower out of the business line’s oversight may allow lenders to focus on new business development and to work with performing borrowers. A dedicated workout staff can also focus on developing, implementing, and monitoring the workout strategy.
The decision to implement a standalone workout function may depend on criteria such as staffing availability and expertise, the number and dollar amount of problem credits, and the overall likelihood of reducing losses through the implementation of a separate workout function.
One of the most significant risks facing community banking organizations today is credit risk, and maintaining a current and comprehensive loan policy is one of the most effective ways to mitigate that risk.
For most community banks, the credit risk profile is directly correlated to the quality of the loan policy. The policy and procedures should be living documents that reflect current and emerging credit practices. Management and the board should continually monitor and evaluate the loan policy to determine that the bank’s lending activities are conducted in a safe and sound manner and are aligned with its strategic objectives, current market practices, and economic conditions.
While the board is ultimately responsible for the development and annual approval of sound policies, many other parties within the bank are responsible for executing the board-approved strategy. An effective policy provides the road map for all bank staff to align their efforts with the bank’s strategic direction.
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- * This is the third and final article in a three-part series. The first article, “Development and Maintenance of an Effective Loan Policy: Part 1,” appeared in the Third/Fourth Quarter 2014 issue of Community Banking Connections, available at www.cbcfrs.org/articles/2014/q3-q4/development-and-maintenance-of-an-effective-loan-policy. This article covered several topics related to what should be contained in a community bank loan policy, including defining permissible activities and establishing responsibility for conducting a bank’s lending activities in a safe and sound manner. The second article, “Development and Maintenance of an Effective Loan Policy: Part 2,” was published in the First Quarter 2015 issue of Community Banking Connections, available at www.cbcfrs.org/articles/2015/q1/development-and-maintenance-of-an-effective-loan-policy. This article explored how lending activities can be administered and controlled through appropriate and sound underwriting criteria and practices. In addition, this article addressed documentation requirements and the ongoing maintenance of credit files.
- 1 For additional ALLL resources, see “Allowance for Loan and Lease Losses,” FedLinks, January 2013, available at www.cbcfrs.org/assets/fedlinks/2013/january2013.pdf , and Stephen Wheatley, “Reversing the Trend: An Examiner’s Thoughts About Negative Provisions and the ALLL,” Community Banking Connections, First Quarter 2013, available at www.cbcfrs.org/articles/2013/Q1/Reversing-the-Trend. See also Board of Governors of the Federal Reserve System, Commercial Bank Examination Manual (CBEM), section 2070.1, “Allowance for Loan and Lease Losses,” available at www.federalreserve.gov/boarddocs/supmanual/cbem/cbem.pdf , and SR letter 06-17, “Interagency Policy Statement on the Allowance for Loan and Lease Losses — Attachment 1, Loan Review Systems,” available at www.federalreserve.gov/boarddocs/srletters/2006/SR0617a1.pdf.
- 2 Board of Governors of the Federal Reserve System, CBEM, section 2040.1, “Loan Portfolio Management, Credit-Grading Systems.”
- 3 Board of Governors of the Federal Reserve System, CBEM, section 2040.1, “Loan Portfolio Management, Management Information Systems.”
- 4 See Federal Reserve Bank of Kansas City, Division of Supervision and Risk Management, Basics for Bank Directors, “Know Where the Bank Stands,” available at www.bankdirectorsdesktop.org.
- 5 Board of Governors of the Federal Reserve System, CBEM, section 2040.1, “Loan Portfolio Management, Internal Controls.”
- 6 Board of Governors of the Federal Reserve System, CBEM, section 2040.1, “Loan Portfolio Management, Characteristics of Loan Review Program.”
- 7 See SR letter 06-17, “Interagency Policy Statement on the Allowance for Loan and Lease Losses — Attachment 1, Loan Review Systems,” available at www.federalreserve.gov/boarddocs/srletters/2006/SR0617a1.pdf.