A Winning Recipe for Effective Loan Review

With current economic conditions, loan balances that may be declining with Paycheck Protection Program forgiveness and deferrals that are returning to their original terms, it is vital that banks understand the risk profile and changes in their loan portfolio to maintain sound practices and investor return.

An effective loan review function provides an independent assessment on the credit risk within a bank’s loan portfolio. A bank’s ability to identify and manage risk within its loan portfolio may be an area of increased scrutiny.

In June 2020, the primary supervisory agencies for banks issued the final Interagency Guidance on Credit Risk Review Systems, partially replacing the 2006 statements. The guidance focuses on ongoing credit risk review, prompt recognition of risk grade changes, independence from the lending function and timely communication to management.

An effective loan review function can:

• Make observations on how well the bank is following regulations, as well as internal policies and procedures.
• Assess the accuracy of risk grades and timeliness of appropriate grade changes.
• Provide feedback on best practices in origination and monitoring, along with noted portfolio trends.
• Prepare a bank for merger and acquisition activity.

An effective loan review function should:

• Consist of professionals with the required independence from the lending function, as well as the experience to understand and communicate best practices.
• Generate and present reports to management that are timely, clear, complete and impartial.

Determining the Scope
The bank’s internal loan review policy should detail the scope and minimum coverage for reviews, including any requirements or recommendations from the regulator. Additionally, the bank should evaluate the current policy scope, as it may need to expand for today’s credit environment.

A thorough loan review policy includes:

• Prioritizing an independent sample to capture the appropriate penetration by loan type, segment, vintage and other parameters.
• Determining optimal frequencies for various reviews to attain the portfolio coverage.
• Identifying an appropriate level of documentation review, in addition to operational and compliance reviews.

Reviewer Qualifications
The credit portion of the loan review must be performed by professionals with extensive experience in credit analysis, loan policy and regulations, portfolio monitoring and problem loan management. Personnel reviewing the portfolio must be seasoned in numerous traditional commercial and consumer lending products, and may also assist with the determination of appropriate reserves. They may also need experience in niche lending areas depending on the bank’s current portfolio and plans for future growth.

Regulatory guidance notes that insufficient loan documentation could result in losses and be cause for a lesser risk grade. A comprehensive loan review function should include an assessment of loan documentation that goes beyond the underwriting and approval of loans. The documentation portion of loan review should be completed by professionals with paralegal and banking experience, including loan closings and collateral perfection. They may need to have proficiency in documenting niche lending products, depending on the portfolio and growth plans.

Beyond Traditional Loan Review
A bank may decide to outsource or co-source the loan review function based on independence, capacity, niche lending ensuring the loan review team has experience or other factors. If its growth strategy includes mergers and acquisitions, ensuring the loan review team has experience with due diligence loan reviews, credit marks and loss given defaults, as well as distinct accounting capabilities, is vital.

An effective loan review function, with experienced professionals, allows banks to stay current on regulations, industry updates and market trends, bringing best practices to the management team and contributing to a comprehensive risk management policy.