What is a Safety and Soundness Bank Exam?
There are several types of Bank Exams. We will be focusing in this document on the preparation for a ‘Safety and Soundness’ Bank Exam.
The nation’s banking system is only as safe and sound as the banks within the system. These exams are typically conducted by the Federal Reserve, OCC, FDIC or respective state banking examiners. The examiners will review the bank’s books and evaluate the quality of an institutions assets and its reserves to cover loan losses. An institution’s management is held responsible for monitoring the institution’s exposure to risks. The examiners will study the institution’s risk-management procedures and internal controls. Examiners will also review compliance with an institution’s own internal policies, as well as compliance with federal and state laws and regulations. At the end of the review, the examiners issue the institution a rating that reflects the institution’s condition. The rating is an indicator of how sound it is to withstand fluctuations in the economy or if it has weaknesses that require correction.
Examiners use a CAMELS rating to describe an institutions soundness. Points are issued from 1 to 5, where 1 is the highest and 5 is the lowest.
Capital Adequacy – Does the bank have enough money, loan income and investments to cover its deposits and business costs?
Asset Quality – Is the bank making loans that are likely to be paid back? Are the bank’s investments likely to be profitable?
Management – Does the bank management make sound decisions?
Earnings – Is the bank making a reasonable profit?
Liquidity – Does the bank have enough money on hand or is its money tied up in assets?
Sensitivity – How sensitive is the bank to market risks?
Most institutions strive to achieve a 1 or 2 point rating for each of the CAMELS components for an overall composite CAMELS rating of 1 or 2. A 3 rating in any of the CAMELS components or overall composite rating could be an indicator of some correctable weaknesses while a 4 or 5 rating will typically result in a more formal written agreement or enforcement action to correct a weakness.
In my opinion, the most important CAMELS component is the Asset Quality component. For example, a 1 or 2 rating in Asset Quality is a leading component for achieving a strong component rating for Earnings. Higher earning institutions are not negatively impacting earnings by having higher loan loss reserves as result of loan losses due to having lower Asset Quality. Higher Earnings will strengthen Capital Adequacy and the component rating assessed. High Asset Quality, strong Earnings and Capital will reflect favorably on Management and lead to a higher Management rating. Not to diminish the importance of Liquidity and Sensitivity to Market Risk components, however if strong Asset Quality is present in an institution, then typically the other CAMELS component rating will be favorable as well. Based on this reasoning, the focus on preparing for your next Safety and Soundness exam should be heavily skewed toward those activities that result in the origination and ongoing quality of your loan assets. Given the concentration of commercial, commercial real estate and agricultural lending (i.e. commercial lending), the preparation for your next Safety and Soundness Exam should be heavily concentrated on the commercial loan assets of your institution.
Before the Examiners Arrive
Effective management of the loan portfolio and the credit function is the fundamental to a bank’s safety and soundness. Lending is the principal business for most commercial banks. The loan portfolio is typically the largest asset and accounts for most of the bank’s revenue. Historically bank losses and failures have resulted from lax credit standards, poor portfolio risk management, or weaknesses in the economy or some combination of all these. Before the examiners arrive, the following will serve as a guide or checklist to consider or address before the examiners arrive for your next Safety and Soundness Exam.
Assessment of the Credit Culture
A bank’s credit culture is the sum of its credit values, beliefs, and behaviors. It is what is done and how its accomplished. I have found that the managements values and behaviors that are rewarded become the standards and will take precedence over written policies and procedures. Before your next bank exam, evaluate your organizational overall ‘Credit Culture’. It starts with executive leadership and their attitudes conveyed regarding credit standards and policies. A lax credit culture could spell trouble for asset quality and ultimately loan charge offs in an economic recession. This is a tough one for executive management to conduct self-assessments. I recommend a trusted 3rd party to evaluate and report in an objective manner on the type of credit culture present in your organization.
Review the Loan Policy
The Loan Policy is the primary means by which senior management and the board guide lending activities. While it imposes standards, it is a statement of the bank’s basic credit philosophy. Before the bank examiners arrive, conduct a thorough review of your loan policy to ensure it accurately reflects the bank’s strategic direction, risk tolerance or market conditions. The loan policy should be reflective of the bank’s organization structure, complexity of lending activities, capabilities and skills of lending personnel along with the overall expected portfolio quality and earnings objectives.
The following are topics that should be covered in all cases:
- Loan Authorities
- Limits on aggregate loans and commitments
- Portfolio distribution by loan category and product
- Geographical limits
- Desirable types of loans
- Underwriting Criteria
- Financial information and analysis requirements
- Collateral and structure requirements
- Margin requirements
- Pricing guidelines
- Documentation standards
- Collections and charge offs
- Reporting requirements
- Guidelines for loan participations
- Off balance sheet exposure.
Review the Loan Approval Process
The loan approval process is the first step toward good portfolio quality. An effective loan approval process establishes minimum requirements and analysis upon which a credit decision is based. It should provide guidance on documents needed to approve new credit, renew credit, increase credit to existing borrowers and a change in terms in previously approved credits. While there is no one required process or system for approval, in all cases the commercial loan approval and supporting underwriting document should include:
- Financial information – current and historical balance sheet and income data, cash flow projections and when appropriate comparative industry data
- Financial analysis that includes repayment capacity
- Collateral identification and valuation
- Guarantor support and related financial information
- Summary of borrower and affiliated credit relationships
- Loan terms and repayment structure
- Pricing information
- Covenants and requirements for future financial data submission
- Exceptions to loan policy and underwriting guidelines with supporting mitigants
- Information to capture concentration reporting
- Risk rating or recommended risk rating.
Assess the Strength of your Loan Portfolio Management (LPM) Process
All banks need to have basic loan portfolio management (LPM) principles in place in some form. LPM will depend on size of the bank and the complexity of its portfolio and the types of credit risk assumed. An examiner will determine if a bank has an effective LPM process and this will include determining if the risk’s associated with the bank’s lending activities are accurately identified and appropriately communicated to senior management and the board of directors, including when required, if corrective action was taken. The following are key components to review when assessing the adequacy of your institutions LPM:
- Oversight – clearly defined the roles and responsibilities of management
- Risk Identification – risk rating each loan in timely credit evaluations is fundamental to LPM
- Policy Exceptions, Procedures and Underwriting guidelines – exceptions are related to either documentation or underwriting. A system is needed to identify, mitigate, monitor and report.
- Portfolio Segmentation and Risk Diversification – LPM includes identifying, managing and reporting of portfolio concentrations by type, industry and customer.
Stress Testing is a risk management concept. Sophistication of the financial model used is not as important as the process of asking the critical ‘what if” questions and incorporating the resulting answers into the risk management process. The most common form of stress testing is the ‘rate shock’ scenarios to determine their exposure to changes in interest rates. Stress testing may involve on certain types of CRE loans a stress test of occupancy rates and its impact on break even or debt service coverage. Stress testing of individual loans can be rolled up into concentrations of portfolio segments. The incorporation of stress testing at the loan level and at the portfolio level where concentrations may exist will help management guide development of contingent planning for credits or pools of credit when vulnerabilities are revealed. Before your next bank exam, review how your bank incorporates stress testing into is LPM policies and procedures.
Review Adequacy of the Allowance for Loan Lease Losses (ALLL)
All banks must have a program to establish and regularly review the adequacy of their allowance for loan and lease losses (ALLL). The ALLL exists to cover any losses in the loan and lease portfolio of the bank. Effective LPM is needed to ensure adequacy of the ALLL. There is a tremendous amount of guidance in the public domain on the establishment, calculation, reporting required for ALLL. In addition, guidance on preparing for the future current expected credit loss (CECL) methodology is readily available. This is a very important area for the bank management to have a strong ALLL policy, process, reporting and adequacy in place prior to any safety and soundness exam. I will not be able to do justice to this critical are of LPM in this document. It is an area of critical importance and I encourage strong review of the ALLL policies, procedures, and reporting to ensure you ALLL is adequately funded at all time and that the bank examiners concur with those calculations.
Review the Credit Management Information Systems
The effectiveness of the bank’s LPM process heavily depends on the quality of management information systems (MIS). Examiners will review the effectiveness of a bank’s current MIS and any limitations that prevent the management or board in fulfilling their respective oversight roles. Before an exam, evaluate your organizations MIS. An effective MIS should be able to quickly and efficiently assist your organizations lending staff and operations in its ability to underwrite and identify credit risk consistently, track and assist in collection of loan and financial documentation exceptions, and provide effective and timely past due collection and problem loan administration and reporting.
Review Collections and Workout
Loan or credit policy should articulate how a bank will manage problem credits. Successful problem loan management and work-outs depend on early identification of credit weaknesses and adverse credit trends. The bank’s credit culture and risk rating system should encourage lenders and managers to identify problem loans in a timely manner. Before a bank exam, review your policy and procedures to ensure that early identification and reporting is in place. Review your risk ratings to ensure there are sufficient risk grades to move loans that are beginning to exhibit increasing risk attributes. Once moved to certain risk grades, these grades should trigger additional oversight and monitoring. Review the credit culture to ensure that Sr. management and the board is supportive of the lenders and their early reporting of loan problems, otherwise they may be reluctant to report and lower a risk rating.
Review Lending Controls
Besides loan policy, the primary controls over a bank’s lending activities are it credit policy administration, loan review and audit functions. Independent credit administration, loan review and audit functions are necessary to ensure that the bank’s risk management process, MIS, and internal controls are reliable and effective. Before a bank exam, review how ‘Independence’ is defined within your organization and documented relative to function and reporting lines. Credit policy administration is responsible for loan policy, loan procedures, and policy related credit memos that govern the credit process. Review this area prior to a bank exam to determine how strong this unit or area governs the credit administration process. Loan review can be effective tool for internal control review of the loan portfolio and review of the credit administration policies and procedures and their effectiveness. The loan review is to be independent and should report to the board of directors or a standing committee with audit responsibilities. The LPM bank examiner will focus on the effectiveness of loan review as a key part of comprehensive bank LPM.
In conclusion, I hope the attached guide can be a helpful tool or guide to keep handy in your financial organization. Keep in mind that this is a guide and many areas will require much greater depth for each organization to research and build out on their own in their own lending policies and procedures and how they will prepare for their next safety and soundness exam. Thank you.