Why Loan Review Matters More Than Ever Now

A common theme has surfaced across several recent conversations with bank regulators: their resources are stretched thinner than they have been in a long time, and more of the responsibility for catching early credit deterioration is landing on banks and their risk functions.

Performance to-date has been good. Return on assets reached a 20-year high in the second quarter and net interest margins are the best they have been since 2010. Front-end underwriting has rarely been more disciplined. Anyone reading the industry’s second-quarter results would be entitled to conclude that credit is in fine shape.

However, there are troubling signs, including non-performing loans outpacing reserve provisioning at many community banks. And most bankers acknowledge that current macro political and economic issues are beginning to produce headwinds for credit quality.

That leads us back to the reduced examiner oversight.

Where the Burden Shifted
Plenty of bankers have welcomed the lighter regulatory posture and understandably. Since Dodd-Frank, years of expanding examination scope and documentation demands were seen as excessive, particularly given the almost 15 years of benign credit.

The regulators are candid about what it costs them. They have fewer examiners and less time in the field than they did a few years ago, and their reach into individual credit files has narrowed accordingly. Bankers have described examinations that came and went without a single loan file being turned. Put those two developments together and the conclusion is uncomfortable. Loan review needs to be more robust than it has been in recent memory.

Fewer files turned at an examination does not mean fewer problems in the book. It means the check that used to arrive from outside, on a schedule somebody else set, now must come from inside. None of that depends on what the credit cycle does next.

What Merits Closer Review
So where should a bank be looking hardest right now?

1. Look hard at any portfolio where the risk grades have stopped differentiating. Most banks can find a large share of the book sitting in one or two pass grades. That looks like consistency. More often it means the scale has quit working. A grading system that cannot show deterioration gradually will not show it gradually. It will show a cluster of credits moving at once, in the same quarter, well after the fact.
2. Watch the emerging hotspots in the industries behind the collateral, not just the collateral type. Whether a loan is secured by retail, office or multifamily space matters less right now than what the tenant does for a living. Multifamily is facing headwinds from several directions at once. So is anything downstream of a consumer who has stopped spending discretionary money: restaurants, tourism and the small businesses that depend on both. One bank on the Mid-Atlantic coast tracks its tourism exposure as a category of its own.
3. Apply more risk-sensitive loan review protocols. It’s not just size of the relationship, but the risk grade, the timing of financial data and the industry that should be drivers of both annual and independent loan reviews. Weaker credits need a shorter leash than the calendar gives them. Stronger ones can usually go longer. Review capacity is finite, and banks run out of capacity to adequately review when they spread resources evenly across a portfolio.
4. Assume the call report is the last place trouble will show up. Those horses, as the saying goes, are already out of the barn. Aggregate data confirms what a portfolio has done. It says nothing about what a portfolio is doing. The useful information is which grades are migrating and in which direction, and that data is non-public, particular to the institution, and sitting in the bank’s own systems. Nobody outside the bank can see it. Nobody outside the bank is going to raise the alarm.

Whether it’s performed by a third party or in-house, loan review must be seen as a trusted partner in any bank’s risk strategy, adhering to the time-honored bank axiom: early detection reduces credit losses.

Nothing is more toxic to a board, a regulator or an investor than too many credit surprises. Thinner examination coverage does not reduce the number of surprises sitting in a loan portfolio. It changes who finds them — and when.