Lending institutions face unique challenges in 2020.
Leading up to 2020, regulators and industry professionals voiced growing concerns related to the easing of underwriting, prolonged increasing of commercial real estate values, risk tolerance complacency, and how much longer the good times could continue — which the ongoing public health crisis answered.
Covid-19 propelled businesses and borrowers into a liquidity crisis like most have never experienced. Economists already have identified the start of a recession, but many lending institutions find themselves determining if — or when — the liquidity crisis has transitioned to a credit crisis.
The third and fourth quarters of 2020 will be most telling. Never has a bank’s loan review function been more important.
On May 8, interagency guidance was released on credit risk review systems. The guidance was well-timed given the pandemic but wasn’t impulsive, as the regulatory agencies began their review process in October 2019. The guidance focused on two key pieces of the puzzle needed for effective credit risk systems: a solid credit administration function and independent credit review.
The guidance highlighted the importance of a loan review policy and how it should incorporate the following areas:
- Qualifications of credit risk review personnel.
- Independence of credit risk review personnel.
- Frequency of reviews.
- Scope of reviews.
- Depth of reviews.
- Review of findings.
- Communication and distribution of results.
These policy areas are highlighted to help drive a successful function that provides the right level of independent challenge to the organization on issue identification, risk rating accuracy/timeliness, policy adherence, policy depth, trends, and management effectiveness. Independently reporting these observations to the board and all stakeholders provides an in-depth independent assessment to help verify the strength of internal controls and the timeliness of grading. It also provides assurance that management’s reporting and allowance levels are reasonable.
Fast forward one month to June 2020, and loan review was top of mind for these same regulatory agencies, which released “Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Financial Institutions” (FDIC PR-72-2020). This guidance looked to address the unique challenges to consider when conducting safety and soundness assessments in these unprecedented times.
The guidance memorialized how examiners will consider the unique, evolving, and potentially long-term nature of the issues confronting institutions and exercise appropriate flexibility in their supervisory response. It speaks specifically to credit risk review (loan review) by stating the following:
Credit risk review. Examiners will recognize that the rapidly changing environment and limited operational capacity might temporarily affect an institution’s ability to meet normal expectations of loan review (such as a schedule or scope of reviews). Examiners will assess the institution’s support for any delays or reductions in scope of credit risk reviews and consider management’s plan to complete appropriate reviews within a reasonable amount of time.
Classification of credits. The assessment of each loan should be based on the fundamental characteristics affecting the collectability of that particular credit, while acknowledging that supporting documentation might be limited and cash flow projections might be highly uncertain.
Loan portfolios are a lending institution’s lifeblood. Portfolios drive earnings but also can be the largest threat to an institution’s ongoing viability. In this rapidly moving environment, it is key to have a loan review function that is up to the challenge.
Operating an effective loan review function
Large- and medium-sized financial institutions often opt to maintain an in-house loan review department. While this decision makes sense for some institutions, establishing and maintaining an effective and credible internal loan review operation can present significant challenges.
Credit department responsibilities have grown increasingly complex in recent years, not only due to regulatory demands but also because of a rapidly changing credit environment and new types of credit products. With these heightened expectations, loan review functions are being pressured by regulators and external auditors to raise the bar. Is it time to step back and assess whether your loan review function has adjusted to the changing environment and the products you offer?
Answer these questions to help take a step back and determine if your institution has a robust loan review function that not only meets the demands of the regulatory guidance but is built to meet the demands of the future as well.