Credit Risk

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Asset Quality

Sections in this Topic

Overview
Loan Policy Elements
Credit Underwriting
Commercial and Commercial Real Estate Loans
Consumer Loans
Loan Review
Risk Ratings
Top Five Common Lending Mistakes
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Overview

Credit risk is a key element in a bank's performance. Good credit risk decisions will help a bank operate profitably. An effective credit risk management process requires a thorough loan policy, clear underwriting guidelines, a loan review process, and the ability to measure risk.

Loan Policy Elements

The loan policy is the foundation for maintaining sound asset quality because it describes the organization's risk tolerance and provides the parameters for managing those risks. At a minimum, every loan policy should address a list of important elements, such as:

Desirable and undesirable loans.
Underwriting standards and monitoring requirements for all loans offered and extended by the bank. Adequate monitoring and controls are particularly important to manage the risks associated with construction loans and loans secured by accounts receivable. Specific underwriting criteria for unsecured commercial and consumer loans are also essential.
The credit approval process, including lending authority and responsibility of the board in reviewing, ratifying, and approving loans.
Transactions requiring credit memoranda.
Transactions requiring audited, reviewed, or compiled financial statements.
Transactions requiring environmental audits.
Credit and collateral file maintenance.
Documentation requirements for all loans.
Insider transactions, including overdrafts to ensure compliance with Regulation O.
Appraisal guidelines to ensure compliance with Regulation Y and the Uniform Standards of Professional Appraisal Practices (USPAP).
Risk-rating definitions and guidelines on pricing for risk.
Portfolio mix and risk diversification guidelines.
Collection and problem loan resolution procedures.
Charge-off and nonaccrual policies.
Method for determining the adequacy of the allowance for loan and lease losses (ALLL).
Requirements for annual credit reviews by relationship managers on all term loans over a pre-determined size to determine the financial health of borrowers.
Procedures for approving loans that are exceptions to policy.

Generally, the loan policy should be reviewed and revised by the board at least annually and communicated to all appropriate personnel. Deviations from the loan policy should not be recurring or excessive and should be reported to the board of directors.

Credit Underwriting

Commercial and Commercial Real Estate Loans

Many credit decisions in community banks seem to be based on management's previous experience with borrowers and proposed collateral values rather than on information in financial statements. A credit memorandum that contains the following should accompany all commercial loans over a pre-determined size:

The purpose of the loan. If the lender does not understand the customer's borrowing need, an inappropriate structure could result and negatively affect cash flow and repayment capacity.
The sources of repayment (primary and secondary).
A description and valuation of any collateral and the source of the valuation.
A summary of the borrower's direct and indirect debt with the bank and a brief reference to payment performance.
An analysis of current financial information that includes an assessment of trends in revenue, operating expenses, and net profit, and a summary of changes in key balance-sheet components, such as receivables, inventory, cash accounts, short- and long-term debt, and trade accounts. Changes in balance-sheet components often prompt a company's need to borrow but can also affect its ability to meet debt service requirements.
An analysis of the borrower's repayment ability for term loans that includes a calculation of the debt service coverage ratio (net income + depreciation + interest expense – dividends/current portion of long-term debt). Generally, this ratio should exceed 1.15:1. If debts to other creditors are not considered, the applicant's repayment capacity is overstated.
An analysis of the guarantor's financial condition that includes a debt-to income analysis and a brief summary of information in credit bureau reports and in personal financial statements with emphasis on liquidity, net worth, contingent liabilities, and income.
The risk rating.
Rationale for deviating from loan policy guidelines, if applicable.

Similar underwriting standards should also apply to loans secured by income-producing properties. However, rent rolls should be obtained during the underwriting phase and throughout the life of the loan to determine whether net operating income provides adequate debt service coverage. Lenders are also encouraged to perform stress tests (sensitivity analyses) to determine whether properties will generate cash flow during periods of rising interest rates or declining occupancy rates.

Consumer Loans

High consumer debt levels could translate into serious financial hardship for individuals and families that are overextended and added potential for losses for financial institutions with exposure to retail loans. To reduce these risks, underwriting guidelines should require the following:

A complete and signed loan application that references the purpose of the request.
Debt-to-income calculations for all new and renewed loans to determine an applicant's ability to service the proposed debt, plus any existing debt.
A current credit bureau report.
Income and employment verifications on all new customers.
Tax returns for self-employed borrowers.
Written explanations for extending credit to borrowers with debt ratios outside policy guidelines, with less than ideal credit scores, or with poor payment performance with the bank.

There are several consumer compliance issues to consider. For a brief review of consumer issues, go to Consumer Compliance.

Loan Review

All banks, including community banks, are expected to have loan review functions. To conserve costs, many small community banks have chosen to outsource the loan review function, rather than follow the route chosen by large multi-regional organizations and some larger community banks, which have established internal loan review departments. Clearly, there are many benefits to having an in-house loan review staff, but regardless of the structure, loan review should focus on the following:

The accuracy of credit grades assigned by lenders.
The quality of credit underwriting.
Deviations from loan policy guidelines.
Loans not accompanied by adequate credit or collateral documentation.
Violations of banking laws and statutes.
Borrowers' compliance with loan covenants.
The method used for determining the adequacy of the allowance for loan and lease losses (ALLL).

Loan review reports should be distributed to all senior officers involved in the lending function, internal audit, the audit committee, and the board of directors. If any material weaknesses or deficiencies are found in the reports, a written response outlining a plan of corrective action should be addressed to the chief executive officer and the board of directors or a committee of the board of directors.

Risk Ratings

Community banks are expected to have formal credit-grading systems that ultimately translate into the pass, special mention, substandard, doubtful, and loss categories used by supervisory agencies. Risk ratings should be developed for various credit types based on their unique features and risk characteristics (e.g., credit scores, debt-to-income ratios, collateral type, and loan-to-value ratios for consumer loans and debt service coverage, and financial strength of management/major tenant and loan-to-value ratios for commercial real estate credits).

Ideally, grading systems should have several pass categories based on the borrower's earnings/operating cash flow, leverage, and net worth. Collateral (quality and control), the company's management, and the strength provided by any guarantors should also be considered. Because grades reflect varying degrees of risk, they are expected to be major components for determining the adequacy of the ALLL and loan pricing. An inaccurately graded loan may lead to incorrect and uncompetitive pricing and over- or under-reserving.

Clear ownership for rating a borrower should be established and, in most cases, should reside with the loan officer. An independent source, in most cases, loan review, should periodically validate the accuracy of the rating.

Top Five Common Lending Mistakes

The following list outlines the top five mistakes lenders make:

Absent or inadequate cash flow analyses (debt service coverage and debt-to-income calculations) that do not consistently validate a borrower's ability to repay debt.
Speculative real estate loans that are often extended to builders without adequate cash flow and liquidity analyses to validate their capacity to carry unsold inventory for extended periods.
Poorly specified risk ratings that do not accurately reflect the financial condition of, or the risks posed by, borrowers.
Consumer loans that are made to customers with high debt-to-income ratios and unfavorable credit histories, or credit decisions that are often based on proposed collateral values rather than on debt service capacity.
Loan pricing that is not commensurate with risk.