In May 2020, the FDIC, OCC, Board of Governors of the Federal Serve System and NCUA issued Interagency Guidance on Credit Risk Review to update and clarify 2006 guidance and make it consistent with CECL methodology requirements. The agencies note that an effective credit risk review function is critical to safe and sound operation because it helps financial institutions identify, evaluate, and address emerging risks associated with credit weaknesses, as well as validate and adjust risk ratings before regulator inspection.
Current credit quality generally remains high, and construction, development, and CRE risk-based capital meet regulatory requirements, at least for now. According to the FDIC, 98% of banks have CRE loans on their books, and they represent the largest type of loan for nearly half of all banks. The COVID-19 pandemic stressed the performance of CRE assets, such as offices, restaurants, and retail, curtailing borrowers’ cash flow. As history has shown, credit stress has always followed economic, political, or financial uncertainty, similar to the current post-pandemic business recovery, rising inflation, predictions of a recession and steady increases in interest rates.
These trends, coupled with emerging areas of concern, including chasing loan deals to meet growth expectations, PPP masked issues, and overall complacency, create a “perfect storm” scenario that underscores the importance of a stringent, thorough process to monitor credit quality. Some common characteristics of inadequate loan review include:
- Failure to review the entire borrower relationship
- Incomplete loan file data
- Outdated cashflow information and lack of proof of liquidity
- Inadequate consideration of contingent liabilities
- Inaccurate risk ratings, including not appropriately evaluating smaller loan relationships
- Failure to adequately analyze one-time events, such as PPP loans
Loan Review Best Practices
A strong loan review function can be accomplished with an in-house team, outsourced third-party expert, or a combination of the two. While regulators don’t prescribe one approach over another, the factors most important to them are independence from internal lending and approval functions, expertise of the loan review team, supportable loan review conclusions, and the quality of the entire process. Follow these best practices for an efficient, comprehensive, and meaningful loan review function:
Use highly experienced credit review experts. Assemble a team of qualified personnel with extensive experience in commercial and consumer lending products, credit analysis, institutional loan policies, state and federal regulations, determining reserves, and managing problem loans. Make sure these individuals are part of the loan policy review process to identify potential weaknesses or revisions that may be necessary as the credit environment changes.
Focus on complete, accurate documentation. Regulatory guidance notes that loan files with missing, stale, and improperly executed documents (document exceptions) could result in losses and result in a lesser risk grade because they can worsen problem loans and impair work-out efforts, especially when viewed in the aggregate. Individuals with appropriate experience should analyze document exception patterns to identify steps in the process (from underwriting to post close loan servicing), business lines or geographic regions where exceptions occur, and compliance needs to be strengthened.
Identify hotspots. When the broader loan portfolio is analyzed, identification of risk issues that could turn into future problems can be detected and remedied early to reduce losses. Start with an evaluation and rating of individual relationships, each credit facility, or both relationships and facilities. Your institution’s loan policy should designate who is accountable for the accuracy of risk ratings and therefore credit quality. Often, it’s the account officer because he or she knows (or should know) more about the borrower than anyone else and should be able to secure timely financial information. However, don’t forget to use the technology in place to produce data related to the portfolio, borrowers, or trends that can be actively monitored on a real-time basis, including data for loan committees and boards.
Rely on Rehmann as your credit review partner for real-time credit portfolio analysis to identify weaknesses and propose solutions to help.
Contact [email protected] or call 616.975.2855