Annual Reviews of Commercial Credits

By: David G. Dalessandro, Senior Consultant

What is the overall condition of your commercial loan portfolio? Do you focus on net charge-offs? Delinquencies? Financial statement exceptions to policy? Number and level of TDR’s and non-accruals? The percent of the ALLL to total loans? While all of these broad measures can be helpful, the number and nature of grade changes coming from internal annual reviews are likely to be more timely and accurate than all of the other measures combined.

Does your credit policy contain specific criteria describing relationships which must receive annual reviews? If so, have you recently evaluated whether that level remains appropriate for your portfolio today? The commercial annual review threshold should be set at a level where the required reviews will cover at least 50% of commercial exposures. Each bank should do a sort of the commercial portfolio and determine what level of exposure will yield the desired coverage ratio. Note that the annual review requirements should differ from the Watch List or Special Asset requirements as the annual reviews should be separate from those assets already identified with some level of weakness.

Now that you have set an annual review requirement, what elements of a credit analysis should be completed? Although the ultimate goal is to determine the accuracy of the risk rating, regulators will be looking for the robustness of the annual review in order to “sign off” or accept the annual review results. Note that in addition to providing executive management and the board with timely and accurate results, a solid and meaningful annual review process can help to build confidence in your systems with the regulators and potentially allow for a more efficient third-party loan review.

Minimum requirements for annual review activities should be built into the loan or credit policies so that management and the board can demonstrate to regulators that they are determined to ensure risk ratings and, therefore, that the ALLL and criticized and classified reporting is accurate.

The annual review procedures should include the following:

a) Detail of the relationship being reviewed including borrower, guarantors, SBA or other guarantees, and note numbers included.

b) Update of all borrower/co-borrower financial information used in the original approval or the latest renewal which would include spreads, debt coverage calculations, loan-to-value calculations, borrowing base analysis, etc.

c) Update of all guarantor financial information including a new complete and signed personal financial statement, most recent tax returns, and, for individuals, an updated credit report.

d) Statement of how the account has been handled since the previous annual review (or approval), including any delinquency of payment, financial information, or supporting information such as insurance, borrowing base reporting, etc.

e) In most cases, site visits by the loan officer or relationship manager or other representative of the company should have occurred since the previous annual review or approval. For CRE loans, the documentation of the visit should include perceptions by the representative of the condition of the property, occupancy trends, whether or not any deferred maintenance was noted, and if there were any changes in the neighborhood. For all credits, the representative should also use this visit to become updated on any material changes in the customer base, management, operating personnel, market conditions, condition of equipment or other fixed assets, and any other information that would help to understand the customer.

f) Update of any approval conditions and whether or not the borrower is maintaining those conditions, including any promises of deposit accounts, financial reporting, property improvements, and compliance with any financial or other covenants.

g) Confirmation that the existing risk rating is accurate or recommendations to change the risk rating up or down, and the factors that the change is based on.

The financial institution that is covering 50% of its commercial portfolio, every year, with robust and timely annual reviews should provide executive management and the board with sufficient information to understand the level and direction of credit risk and whether or not these are in accordance with the desired risk appetite.

For more information on this article or on how Young & Associates, Inc. can assist your institution in this area, please contact me at 330.422.3487 or ddalessandro@younginc.com.