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Manage Transition: For Banks 0-5 Years

Credit Risk


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:

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:

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:

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:

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: