We celebrated our 21st anniversary in August. Thank you to all of our customers that helped us reach this anniversary.
My last quarterly CEO article titled Sunny Skies and Fighting Alligators generated the most feedback of any my previous articles in recent memory. In that article, I challenged all customers to review their utilization of the Square 1 Credit Suite.
Since, like most technology and software products, they are often underutilized for various reasons. In addition, I revisited my concerns over growing complacency and relaxing of underwriting standards and loan policies. Times are relatively good at the moment, however, everything cycles and some event could trigger a future economic decline that impacts your commercial loan portfolio credit quality. It appears that interest rates are rising as the Fed unwinds its balance sheet. Geopolitical risk seems to be on the rise. The Ag sector continues to suffer and could decline further if trade deals are altered in the future. A number of unforeseen events locally, regionally, or nationally could trigger impacts on your loan portfolio asset quality.
For some of our newer customers, I have over 30 years of experience in commercial lending and bank consulting with an emphasis on asset quality and its impacts on your institution’s safety and soundness. My background runs parallel and equal to my work at Suntell. It drives the platform and ongoing enhancements to the Square 1 Credit Suite in support of underwriting and managing asset quality.
With that as a backdrop, October and November are typically the months that strategic planning occurs, I want to extend on my previous suggestion to review loan policies and underwriting standards annually by republishing the basic fundamentals and checklists for you to consider as you look at your 2018 strategic plan and how it might impact your financial institution and its commercial lending policies and activities. What follows is my counsel on those areas that should be present and reviewed annually as part of strategic planning and annual loan policy review.
Strategic Planning Considerations for Lending Activities:
Here is my brief checklist of what community institutions should be considering when evaluating or setting their strategic plans for the future:
- Understand and stick to your core lending strengths – Extending into sectors without domain expertise can result in future asset quality issues.
- Portfolio diversification – Those institutions that thrive are the ones that diversify their assets. For example, the single most significant cause of all community bank failures from 2006 – 2010 was over concentration in Commercial Real Estate. It is reported that 66% of the failures were due to CRE lending concentration.
- The right people – Do you have the right team? Every employee from your back office support to front line customer service and lenders should be chosen wisely. Review weaknesses in your team and adjust as necessary.
- Streamline technology – In order to keep up with the larger banks, community institutions must be willing to invest in technology. This means identifying those technologies that can help your staff work efficiently and support your core business lending activities.
5 Building Blocks of Loan Portfolio Management:
As you continue your strategic planning and annual policy review, I have provided the regulatory guidance on the five basic building blocks of commercial loan portfolio management for easy reference:
- Risk identification – Given the lessons learned in the 2008 recession and credit crisis, this piece is vital. Accurately determining credit risk at the borrower or loan level using a comprehensive approach that is reviewed on a regular basis is essential.
- Documentation and policy exception management – Don’t allow gaps in the loan documentation or large numbers of atypical loans to prevent the credit union from enforcing the terms of its loans. Put policies in place to rapidly address missing paperwork and minimize exceptions to the rules.
- Concentration of risk – Install procedures to identify loan concentrations with one borrower or group of borrowers, industry concentrations, and concentrations by loan types such as commercial and industry, real estate, and consumer loans. If loan policy specifies or allows for such concentrations, put additional procedures into place to identify and mitigate the risk.
- Collections and work-outs – Identify problem loans early on and work out solutions with the borrower in order to save the loan. A foreclosure benefits neither party.
- Credit management systems – A comprehensive credit management system should be able to analyze, underwrite, risk rate, handle loan approval communication, track document and policy exceptions, and manage collections. In addition, a well-designed system will provide the necessary reporting to provide management and the board the information required to understand credit and loan portfolio risk and trends.
To extend beyond the five basic building blocks of loan portfolio management, let’s drill down into the Loan Policy components and various building blocks just outlined.
The following are the key areas your financial institution’s management should review annually regarding commercial lending and maintaining controls on asset quality or safety and soundness in your institutions loan portfolio.
- Loan Policy – Is your institution’s loan policy up to date and reflective of the current regulatory guidance for loan portfolio and credit risk management practices? The loan policy is the primary means by which your institution’s board and senior management guide and monitor lending activities. The loan policy should provide a framework for your institution’s asset quality and earnings objectives, setting of limits on risk tolerance levels, and guides the institution’s lending activities consistent with the institution’s overall strategic direction. In addition, the loan policy sets standards for portfolio composition, individual credit decisions, fair lending, and compliance management. There is no ideal format for a loan policy as they can vary in length and degree of detail depending on the size and complexity of your institution’s lending activities. At a minimum, your loan policy should contain the following topics with supporting detail:
- Loan authorities
- Limits on aggregate loans and commitments
- Portfolio distribution and concentration limits by loan category and product
- Geographical limits
- Desirable types of loans
- Underwriting criteria
- Financial information and analysis requirements
- Stress testing of CRE loans and loan portfolio
- Collateral and structure requirements
- Margin requirements
- Pricing guidelines
- Documentation standards
- Collections and charge-offs
Additional topics should be considered if your institution is engaged in more complex or specialized industry types of loans.
Many financial institution enforcement actions and the supplemental communications that accompany these actions will typically indicate that the ‘root cause’ of the various areas criticized is due to a lax ‘credit culture’. A strong, up to date loan policy that is being followed will set the tone for your periodic safety and soundness examinations.
- Risk Identification – Does your financial institution have your commercial loans properly risk rated and graded consistent with your institutions risk grading policy? A primary component contributing to a financial institution enforcement action is for the examiners to downgrade risk ratings below what your institution has identified in the portfolio, particularly if there is a number of instances of downgrades they have identified. Risk ratings should be properly set each time a customer loan relationship is reviewed for a new or renewal loan request to ensure the risk grade is set properly. For term amortizing credits, an annual review process is recommended once annual financial information is received to in order to accurately review the customer against your institutions risk grade policy. An addition means of ensuring accurate risk ratings prior to an exam is to have an active internal or external loan review process that is periodically reviewing and testing the accuracy of the risk grade for a loan customer. A culture of actively upgrading or downgrading a risk grade for changing credit or environmental conditions is encouraged. Risk grades should be fluid and be based on current conditions and not future expected outcomes.
- Document and Policy Exceptions – A major weakness found in a number of financial institutions engaged in lending is the lack of proper identification of documentation or policy exceptions that exist in the loan portfolio. Your institution should have strong controls in place from a loan administration process and procedures to accurately identify and track outstanding document and policy exceptions until they are corrected. In addition, your institution’s internal or external loan review process should serve as a check against the loan administration procedures for proper identification of these exceptions. Finally, the number of outstanding documentation exceptions should be actively managed and at a minimum number of only the most recent active exceptions in the process of being corrected.
- Concentration of Risk – Your financial institution should have identified, prior to any examination, a solid understanding of where you have various concentrations in your loan portfolio. The segmentation should include concentrations to any one borrower or group of borrowers, industry concentrations, and concentrations by loan types such as commercial and industry, real estate, and consumer loans. Within these broad segments, additional segmentation should be documented where there are deemed to be concentrations by either regulatory agencies or your institutions policy limits. Additional documentation is recommended for how the bank is strategically managing the concentration and its potential impact on the bank’s overall loan portfolio risk profile. For instance, an institution with a concentration in commercial real estate loans should have strong policies and procedures in place for stress testing loans and the portfolio to determine impact on risk grades or the bank’s capital levels based on changing conditions for interest rates, cap rates, absorption and/or vacancy.
- Collections and Work-out – Prior to an exam, review your procedures and processes for handling past due and problem loans. Early identification of credit weaknesses or adverse trends is critical to the ongoing minimization of future credit losses that might be incurred if a loan is not properly managed either before it comes past due or after its risk grade has been downgraded to a criticized or classified loan.
- Credit Management Systems – While strong loan policies and procedures are critical to ensuring a good exam for safety and soundness, examiners will also be reviewing the systems your institution is utilizing to determine how well they support and supplement your overall loan portfolio management and the controls you have at the loan officer, credit analyst, and the credit and loan administrative functions. A strong credit management system(s) as provided by your core and various software applications will need to be documented in term of policy and procedures and how they support your lending function in controls and information reporting to management and the board.
I hope this easy reference is useful to each of you that are involved in the strategic planning process or maintaining loan policies and managing assets quality for your financial institution.