By: Tommy Troyer, Executive Vice President
A look back over recent issues of the 90-Day Note, or a more general scan of industry news and regulatory comments, would reveal the industry’s focus on underwriting standards and possible industry-wide changes in underwriting standards over the last several years. As we have noted previously, for any individual community bank, the important consideration is not simply how conservative or liberal underwriting standards are or whether underwriting standards are loosening or tightening. Instead, the question that is critical for the ultimate health and profitability of the bank focuses much more on whether underwriting standards, and any changes in underwriting standards, are accurately understood and monitored, consistent with an institution’s risk management capabilities, and regularly assessed to ensure that the risk/return calculus and the institution’s level of capital are appropriate for the loan portfolio’s characteristics.
The above considerations, as well as overall industry trends in risk appetite and underwriting standards, are quite naturally of interest to regulators as well. In addition to other regulatory tools (such as loan officer surveys) for measuring underwriting standards, the OCC has launched within the last year an initiative to try to standardize and collect assessments of underwriting practices during safety and soundness examinations. We have heard OCC leadership discuss this initiative at banking conventions and have heard from clients who have had OCC safety and soundness exams over the last year. While the OCC’s overall approach to assessing underwriting can be informative or, at the minimum, a great reminder of critical factors for controlling credit risk, our intention here is to highlight an aspect of controlling underwriting standards and credit risk that should not be, but sometimes is, overlooked: the role of credit policies.
The Important Role of Credit Policies
Credit policies represent perhaps the most important tool for the board of directors and bank management to define underwriting standards and credit risk appetite. While it can be appropriate for some details of underwriting criteria to be maintained outside of formal loan policy, it is not appropriate or effective to employ an overly generic credit policy that provides little specific detail about the characteristics of credits the institution desires to originate. The OCC’s assessment of an institution’s underwriting considers the range of important factors one might expect (for example, loan structure, presence of appropriate covenants, etc.). Importantly, this assessment also extends to whether loan policy provides enough detail and information to control these important characteristics of credit underwriting. Without a policy that defines the bank’s limits on factors such as amortization periods, collateral advance rates, etc., underwriting standards can loosen and credit risk can grow without the intention or even the knowledge of the board. An appropriately detailed policy sets limits on the extent of any loosening that might occur and, assuming exception tracking and reporting is effective, allows for the board to receive better information about any changes in underwriting quality.
Some institutions try to avoid having too much specificity in policy because they do not want to create too many policy exceptions or provide examiners or auditors with more opportunities to “catch” them in violation of their own policy. There certainly is such a thing as a policy that is too specific or detailed to be effective, as at a certain level of detail it is not possible for lenders and analysts to actually know or easily find all of the policy requirements. However, it is also important to recognize the risks that come with overly generic policies, primarily, the inability to effectively control the terms of credit extended and the possibility of regulatory concern about the bank’s effectiveness in defining risk appetite and controlling risk.
The amount of detail is certainly not the only factor that determines the effectiveness of a credit policy. The content of the actual details certainly matters (a well-defined minimum debt service coverage ratio of 0.75 and maximum collateral advance rate against work-in-process inventory of 150%, for two extreme examples, are specific but do not effectively control credit risk). The organization and consistency of policy also matter, as a credit policy can only be effective if it is a usable tool for lenders and credit personnel.
Many credit policies at community banks have been in place for a long time, with small or ad hoc updates put in place as needed. Young & Associates, Inc. offers a policy review service that takes advantage of our exposure to the credit policies of many community banks around the country to evaluate the adequacy of a bank’s policy and to make recommendations for enhancements. We will not tell you what your risk appetite should be, but we can and will assess the content of your policy against regulatory expectations, compare your specific risk limits to what is common across the industry so that you can have better information about where your risk appetite stands relative to peers, and evaluate the effectiveness of your policy’s layout, language, and internal consistency.
If you would like to discuss the importance of credit policies or believe your institution may benefit from a policy review, please contact Tommy Troyer at email@example.com or 1.800.525.9775.