By: David Reno, Director of Loan Review & Lending Services
Loans, especially non-consumer loans, typically represent the greatest level of risk on your balance sheet. Therefore, effective commercial loan portfolio management is crucial to control credit risk. It can serve as an early indicator of emerging credit risk related to lending to individual borrowers, aggregate credit exposure to related borrowers, and the overall credit risk associated with a loan portfolio. It serves as an integral part of an institution’s credit risk management system that is a continuum comprised of the following stages:
- Well-formulated lending policies, procedures, and practices that are consistently applied, well-known to all credit and lending staff, and compliant with regulatory guidance
- The collection and accurate credit analysis of financial and other underwriting information
- Assignment of an accurate risk grade
- Proper and qualified approval authorities and risk-based process
- Correct and thorough documentation
- Pre-closing preparation and loan closing
- Post-closing credit administration
- Internal annual loan review
- External/independent loan review
- Timely problem loan identification and management
- Proper calculation of the ALLL
- Collection and loss mitigation
Effective and efficient loan reviews can help an institution better understand its loan portfolio and identify potential risk exposures to contribute to the formulation of a risk-based lending and loan administration strategy.
Regulatory Background
The OCC, FRB, FDIC, and NCUA issued the Interagency Guidance on Credit Risk Review Systems in FIL-55-2020 dated May 8, 2020, which aligns with Interagency Guidelines Establishing Standards for Safety and Soundness. This guidance is relevant to all institutions supervised by the agencies and replaces Attachment 1 of the 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. The final guidance details the objectives of an effective credit risk review system and discusses such topics as sound management of credit risk, a system of independent, ongoing credit review, and appropriate communication regarding the performance of the institution’s loan portfolio to its management and board of directors.
Credit Risk Rating (or Grading) Framework
The foundation for any effective credit risk review system is accurate and timely risk ratings. These risk ratings are used to assess credit quality and identify or confirm problem loans. The system generally places primary reliance on the lending staff to assign accurate, timely risk ratings and identify emerging loan problems. However, the lending personnel’s assignment of risk ratings is typically subject to review by qualified and independent peers, managers, loan committee(s), internal credit review departments, or external credit review consultants that provide a more objective assessment of credit quality.
Elements of an Effective Credit Risk Review System
The starting point is a written credit risk review policy that is updated and approved at least annually by the institution’s board of directors or board committee to evidence its support of and commitment to maintaining an effective system. Effective policies include a description of the overall risk rating framework and responsibilities for loan review.
An effective credit risk review policy addresses the following elements:
Qualifications of Credit Risk Review Personnel. The level of experience and expertise for credit risk review personnel is expected to be commensurate with the nature of the risk and complexity of the loan portfolio, and they should possess a proper level of education, experience, and credit training, together with knowledge of generally sound lending practices, the institution’s lending guidelines, and relevant laws, regulations, and supervisory guidance.
Independence of Credit Risk Review Personnel. Because of their frequent contact with borrowers, loan officers, risk officers, and line staff are primarily responsible for continuous portfolio analysis and prompt identification and reporting of problem loans to proactively identify potential problems. While larger institutions may establish a separate credit review department, smaller institutions may use an independent committee of outside directors or other qualified institution staff. These individuals should not be involved in originating or approving the specific credits being assessed, and their compensation should not be influenced by the assigned risk ratings. Regardless of the approach taken, it is prudent for the credit risk review function to report directly to the institution’s board of directors or a committee thereof. Senior management should be responsible for administrative functions.
The institution’s board of directors may outsource the role to a third-party vendor; however, the board is ultimately responsible for maintaining a sound credit risk review system.
Scope of Reviews
Comprehensive and effective reviews cover all segments of the loan portfolio that pose significant credit risk or concentrations. The review process should consider industry standards for credit risk review coverage, which should be consistent with the institution’s size, complexity, loan types, risk profile, and risk management practices. This consideration helps to verify whether the review scope is appropriate.
An effective scope of review is risk-based and typically includes:
- Loans over a predetermined size along with a sample of smaller loans
- Loans with higher risk indicators, such as low credit scores or approved as exceptions to policy
- Segments of loan portfolios, including retail, with similar risk characteristics, such as those related to borrower risk (e.g., credit history), transaction risk (e.g., product and/or collateral type), etc.
- Segments of the loan portfolio experiencing rapid growth
- Past due, nonaccrual, renewed, and restructured loans
- Loans previously criticized or adversely classified
- Loans to insiders, affiliates, or related parties
- Loans constituting concentrations of credit risk and other loans affected by common repayment factors
Review of Findings and Follow-Up
A discussion of credit risk review findings should be held with management, credit, and lending staff and should include noted deficiencies, identified weaknesses, and any existing or planned corrective actions and associated timelines.
Communication and Distribution of Results
The results of a credit risk review are presented in a summary analysis with detailed supporting information that substantiates the concluded risk ratings assigned to the loans reviewed. The summary analysis is then periodically presented to the board of directors or board committee to maintain accountability and drive results. Comprehensive reporting includes trend analysis regarding the overall quality of the loan portfolio, the adequacy of and adherence to internal policies and procedures, the quality of underwriting and risk identification, compliance with laws and regulations, and management’s response to substantive criticisms or recommendations.
Summary Insights
The back-testing that is performed by the loan review process is necessary to ensure that an institution has in place a comprehensive and effective credit risk management system and that an institution acknowledges and practically applies the established framework of its unique but compliant credit culture.
An effective external loan review process is not so much a traditional audit exercise as it is an advisory process that produces meaningful dialogue between the review firm and the institution that seeks to identify and interpret various aspects of credit risk to minimize risk of loss by implementing industry best practices, maintaining regulatory compliance, and supporting the institution’s long-term viability in continuing to serve the needs of its customers and community.
For more information on the role of loan review in the credit risk management system, contact David Reno, Director of Loan Review & Lending Services, at [email protected] or 330.422.3455.
