As Interest Rates Rise, Loan Review Gets a Second Look

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In 1978, David Ruffin got his first mortgage. The rate was 12% and he thought it was a bargain.

Not many people who remember those days are working in the banking industry, and that’s a concern. Ruffin, who is 74 years old, still is combing through loan files as an independent loan reviewer and principal of IntelliCredit. And he has a stark warning for bankers who haven’t seen a rising interest rate environment, such as this one, in more than 40 years.

“Credit has more hair on it than you would want to acknowledge,” Ruffin said recently at Bank Director’s Bank Audit & Risk Conference. “This is the biggest challenge you’re going to have in the next two to three years.”

Borrowers may not be accustomed to higher rates, and many loans are set to reprice. An estimated $270.4 billion in commercial mortgages held at banks will mature in 2023, according to a recent report from the data and analytics firm Trepp.

Nowadays, credit risk is low on the list of concerns. The Office of the Comptroller of the Currency described credit risk as moderate in its latest semiannual risk perspective, but noted that signs of stress are increasing, for example, in some segments of commercial real estate. Asset quality on bank portfolios have been mostly pristine. In a poll of the audience at the conference, only 9% said credit was a concern, while 51% said liquidity was.

But several speakers at the conference tried to impress on attendees that risk is buried in loan portfolios. Loan review can help find that risk. Management and the board need to explore how risk can bubble up so they’re ready to manage it proactively and minimize losses, he said. “The most toxic thing you could fall victim to is too many credit surprises,” he said.

Some banks, especially smaller ones, outsource loan review to third parties or hire third parties to independently conduct loan reviews alongside in-house teams. Peter Cherpack, a partner and executive vice president of credit technology at Ardmore Banking Advisors, is one of those third-party reviewers. He says internal loan review departments could be even more useful than they currently are.

“Sometimes [they’re] not even respected by the bank,” he says. “It’s [like] death-and-taxes. If [loan reviewers are] not part of the process, and they’re not part of the strategy, then they’re not going to be very effective.”

Be Independent
He thinks loan review officers shouldn’t report to credit or lending chiefs; instead, they should report directly to the audit or risk committee. The board should be able to make sense of their conclusions, with highlights and summaries of major risks and meaningful conclusions. Their reports to the board shouldn’t be too long — fewer than 10 pages, for example — and they shouldn’t just summarize how much work got done.

Collaborate
Loan review should communicate and collaborate with departments such as lending to find out about risk inside individual industries or types of loans, Cherpack says. “They should be asking [the loan department]: ‘What do you see out there?’ That’s the partnership that’s part of the three lines of defense.”

He adds, “if all they’re doing is flipping files, and commenting on underwriting quality, that’s valuable, but it’s in no way as valuable as being a true line of defense, where you’re observing what’s going on in the marketplace, and tailoring your reviews for those kinds of emerging risks.”

Targeted Reviews
Many banks are stress testing their loan portfolios with rising rates. Cherpack suggests loan review use those results to adjust their reviews accordingly. For instance, is the bank seeing higher risk for stress in the multifamily loan portfolio? What about all commercial real estate loans that are set to reprice in the next six to 18 months?

“If [loan review is] not effective, you’re wasting money,” Cherpack says. “You’re wasting opportunity to protect the bank. And I think as, as a director, you have a responsibility to make sure the bank’s doing everything it should be doing to protect its shareholders and depositors.”

Carlyn Belczyk is the audit chair for the $1.6 billion Washington Financial Bank in Washington, Pennsylvania. She said the mutual bank brings in a third-party for loan review twice a year. But Cherpack’s presentation at the conference brought up interesting questions for her, including trends in loans with repricing interest rates or that were made with exceptions to the bank’s loan policy. “I’m fairly comfortable with our credit, our loan losses are minimal, and we probably err on the side of being too conservative,” she said.

Ruffin doesn’t think coming credit problems will be as pronounced as they were during the 2007-08 financial crisis, but he has some words of advice for bank boards: “Weak processes are a telltale sign of weaknesses in credit.” he said.

Historically, periods of high loan growth lead to the worst loan originations from a credit standpoint, Ruffin said.

“We do an unimpressive job of really understanding what’s sitting in our portfolio,” he said.

This article has been updated to correct Ruffin’s initial mortgage rate.

Loan Review Best Practices: Key to Combating Credit Risk

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Despite current benign credit metrics, there’s a growing industry-wide sentiment that credit stress looms ahead.

There’s a proven correlation between early detection of emerging credit risk and reduced losses. Effective and efficient loan reviews can help your institution better understand the portfolio and identify potential risk exposures. Now is the time for banks to ensure their loan review, either in-house or external, can proactively identify potential credit weaknesses, gain deep knowledge about the subsegments of the portfolio, learn where the vulnerabilities exist and act to mitigate risk at the earliest opportunity. It’s time to emulate a whole new set of loan review best practices:

1. Trust your reviews to professionals with deep credit experience — not just junior CPAs.
Your reviewers should be seasoned experts that are skilled in the qualitative and quantitative axioms of credit, with hands-on experience in lending and risk management. Because their experience will drive better reviews and deliverables, it’s a good idea to ask for biographies of people assigned to your institution.

2. Confirm your review includes paralegal professionals to conduct separate documentation reviews.
It is essential that your loan reviews include specialists with technical expertise in regulatory and legal compliance, lending policy adherence, policies, collateral conveyances, servicing rules, among others — working in tandem with seasoned credit professionals.

3. Insist on smart, informed sampling.
To uncover vulnerabilities in specific segments of the portfolio, rely on a selection process that helps you choose very informed samples indicating possible emerging risk.

4. Quantify both pre- and cleared documentation, credit and policy exceptions.
In the best of times, many loan reviews show almost no bottom-line degradation in loan quality for the portfolio as a whole. On close examination, you may find significant numbers of technical and credit exceptions indicating that the quality of your lending process itself may need to be tweaked.

5. Understand your own bank’s DNA.
In this complex economic environment, it is imperative for institutions to analyze their own idiosyncratic loan data. Arm your loan review team with the ability to automatically drill down into the portfolio and easily examine trends and borrower types to inform risk gradings, assess industry and concentration risk, along with other variables. Seasoned reviewers will be incredibly valuable in this area.

6. Observe pricing based on risk grades, collateral valuations and loan vintages.
Loans originating around the same time and credits that tend to migrate as a group tend to share common risk characteristics. Isolating and analyzing those credits can answer the important question, “Are you being paid for the risk you’re taking?”

7. Pair loan reviews with companion stress testing.
Regulators are encouraging stress tests as a way for banks to learn where their risk may be embedded. Companioning the tests with loan reviews is a productive way to gain this knowledge. Start at the portfolio level and do loan-level tests where indicated.

8. Transparently report and clear exceptions in real time.
Banks can benefit from using fintech’s efficiency to remove huge amounts of time, team meetings and staff intrusions from the traditional process of reviewing loans. An online loan review solution gives teams a way to see exception activities and clearances as they happen.

9. Comply with workout plan requirements prescribed by interagency regulators.
Banks typically design workout plans to rehabilitate a troubled credit or to maximize the collected repayment. Regulators now require institutions to examine these plans independently as a standard loan review procedure that reflects a healthy degree of objectivity.

10. Deliver comprehensive management reports and appropriate high-level board reports with public/peer data.
Management should receive prompt and thorough loan review reports; board members should receive high-level reports with appropriate, but less detailed, information. Public data or analyses of your institution’s performance as compared to peers should accompany this reporting.

11. Conduct loan reviews as a highly collaborative and consultative exercise — counter to “just another audit.”
An effective loan review is not an internal audit experience. It’s an advisory process, and this approach is extremely important to its ultimate success. Substantive dialogue among participants with differences of opinion is key to favorable outcomes for the institution.

12. Take advantage of a technology platform to automate every possible aspect of the loan review process.
Best practices call for the efficiency that comes with automating the loan review process to the maximum extent possible, without sacrificing substance or quality. Technology enables faster and more complete early detection of vulnerabilities.

Loan reviews are critical to an institution’s risk-management strategy. It’s a one-two punch: Deeply qualified reviewers combined with automated technology that delivers a more efficient, less intrusive loan review process that will help combat the looming credit stress ahead.

Assessing the Value of Your Loan Review Department

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Bank directors know that while there are many risks that all banks face — including some serious emerging issues — the major, ever-present risk that causes the most bank failures is credit risk.

The question then becomes: how well do they know the key components of an effective credit risk management system that can protect the bank’s safety and soundness and minimize the liability of the directors? The loan review department is a key aspect of an effective risk management system — yet it may not be functioning effectively. While bank directors are justifiably concerned about future economic conditions and the potential impact on their loan portfolios, are their institutions’ loan review departments really effective “early warning systems” for credit risk?

Part of the loan review challenge today is the difficulty in finding and retaining credit risk professionals. Loan review analysts are not on a typical bank “career path;” finding people with the right skills who are interested in a loan review position is a growing challenge. Is a hybrid staffing model blended with outsourced loan review services a necessity to address staffing issues today?

Other relevant challenges for banks include a growing acceptance and desire for a remote work arrangement, which can minimize collaboration, peer exchange and interpersonal communications. Only now are affordable technology tools emerging to support the loan review function to assist remote workers. Are banks investing in automation of this area? How can directors determine if loan review is bringing in the value it should to you and your bank?

Bank-Specific Considerations
When assessing the value of a loan review department, including efficiency and effectiveness of their functions, a lot depends on the characteristics of the bank itself. Smaller banks may have no choice than to use an outsourced model or hybrid blend of resources due to a lack of available internal skilled resources. Much larger banks typically staff their department with internal resources, which can present different management and career path issues. A bank with a rapidly growing book of loans may face difficult decisions on their model.

The specific responsibilities of a loan review department differ depending on the institution’s history and credit culture. Some banks virtually re-underwrite their sampled loans during exams — including financial re-spreading and deep dive document compliance. Other banks focus on a current validation of the risk rating and potential risk of credit deterioration. In many banks, loan operations does quality control checking for loans booked and internal audit performs documentation reviews, while other banks consider such duties to be part of loan review. Obviously, each bank needs to assess and clarify its department’s structure and responsibilities scope, along with its staffing model.

Other areas that differentiate different loan review departments include sample penetration thresholds and goals. Some departments have goals to review 60% or more of all borrowers over a certain threshold of loan size, while other’s objectives have less volume and more “risk targeted” exams. A more forward-looking model in vogue today is using “continuous monitoring” to watch emerging risk patterns and trends.

When assessing the value of a loan review department, management and the board should thoroughly understand the current state and how these bank-specific characteristics factor into the model of their team. It’s appropriate to challenge the current model and question its business value. As part of their responsibilities to the bank, directors must perform their duty of care and “trust but verify” the effectiveness of their loan review department.

Banks today are looking at any and every opportunity to build efficiency and cut costs, even in important areas of risk control like loan review. Many institutions have not been considered the loan review department’s cost-effectiveness in years. While banking has seen rapid change in many operational areas, thanks to automation and process changes put in place during the pandemic, loan review has languished. Many departments today are doing running the same way they have been in the past. Rapid and meaningful assessment of the effectiveness and efficiency of the loan review department can bear significant fruit in two of the most important areas of banks today: risk management and operational efficiency. Now is a good time for the board to exercise its duty of care and assess the loan review department’s ability to deliver these benefits.

Crafting and Implementing an Effective Loan Review Function

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Performing the loan or credit review function is a regulatory requirement for banks of all sizes and a key credit risk management practice.

Loan review not only helps banks assess emerging risk in their portfolios, but can also protect the institution by identifying loans with potential risk rating downgrades before regulators do. Sometimes called the last or “third line of defense,” an effective loan review function includes a partnership between the loan review staff and the lenders and credit teams that make up the first and second lines of defense to ensure the ongoing constructive monitoring of the bank’s credit quality.

Bank boards have several options when choosing how to implement the commercial credit/loan review function. This includes outsourcing the function to an expert third party loan review service provider, building out their own loan review department internally staffed or blending the two approaches for a hybrid, co-sourced arrangement. Each model has elements and considerations that executives should explore before making final decisions, including the cost to the bank, regulatory expectations, overhead, internal staffing issues and quality of work. Some bank executives are also sensitive to perceptions that institutions above a certain size should internalize the loan review function.

According to high-level members of bank regulatory agencies we have talked with, there is no regulatory expectation for a bank’s loan review model based on the bank’s asset size and no expectation of rotating outsourced loan review providers. The factors most important to the regulators are independence from the internal lending and approving function, the expertise of the loan review analysts, the supportability of loan review’s conclusions and the quality of the entire process. The bank and its board has great freedom to shape the department and its scope to accomplish these objectives.

Outsourced Loan Review
The outsourced loan review model has a number of advantages over internal models. It is almost always the most cost-effective approach. A competent outsourced provider can typically review borrowers in the portfolio more quickly than internal staff, due to their use of best practices and concise analytical approach. Third-party experts usually have deep expertise in a wider range of credit specialty areas, such as commercial real estate segments, agriculture, commercial and industrial, leveraged lending or leasing. An outsourced provider with a broad view of the industry and into similar institutions’ portfolios can add valuable perspective, such as best practices, regulatory intelligence and general peer information. Additionally, the tight labor market has underlined the difficulty of attracting and maintaining staff; loan review departments have had significant issues finding and keeping people. Outsourcing avoids that issue completely, leaving the efforts of hiring, training and retaining competent staff to the provider.

Internal Loan Review
Setting up and maintaining an internal loan review department can help executives build stronger team interaction and relationships within the bank. Internal staff can attend meetings like loan committees and special assets to better understand the bank’s risk appetite. Continuously monitoring the lending portfolio internally can enable the bank to more easily detect shifts in underwriting quality or patterns of emerging risk. A loan review department manager with effective internal staffing can build relationships and set expectations for resolving conflicts. In most cases, the most efficient and effective internal loan review departments use specially developed loan review automation software to enable better staff management, perform more efficient exams and provide consistent results. The competition for seasoned loan review staff can also make effective internal staffing difficult.

Hybrid Loan Review
Using a “hybrid” loan review model where internal staff works with external third-party loan review experts can offer some of the best of both models. Hybrid models can have various configurations: the third party can function like an extension of the internal staff in an arrangement sometimes called “co-sourcing,” or can work independently, reporting to the outsourced provider’s management when working on specific segments of the portfolio. These segments could be the larger or smaller borrower relationships, special problem assets or borrowers in specialized industries or loan types.

The advantages of this model include being able to quickly scale up or down in department size and scope while gaining the benefit of external knowledge from the third-party provider. The hybrid approach works best when all exam work — internal and external — is performed on automated loan review software. Software ensures that the results and findings of the exams are reasonably consistent in nature and the work product and other reports are comprehensive, regardless of whether internal or external resources do the analysis.

Bank boards should leverage loan review resources constructively, no matter what model they choose, being mindful of pitfalls and expense along the way. An effective loan review program protects the bank’s safety and soundness, its customers and shareholders — as well as the board, no matter what model they used.

Is Your Bank Ready for Loan Review 2.0?

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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.

Is Your Bank’s Loan Review Good Enough?

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lending-2-27-17.pngFor almost three decades, regulators have mandated independent loan review of commercial loans. So what could be needed to improve this time-tested concept? Well, for one, like all other aspects of banking, loan review must evolve and modernize to retain its effectiveness. This is more pertinent given that, statistically speaking, we may be in the fourth quarter of the credit cycle, which could be problematic as loan officers may pursue growth at the expense of loan quality. Also, there’s a growing dependence on loan review to facilitate accurate portfolio credit marks in mergers and acquisitions. Many loan reviews, whether in-house or externally contracted, remain too subjective, too random, are outdated technologically, lack collaborative processes, and, perhaps most importantly in the modern era, lack holistic linkage to the more quantitative and dynamic macro aspect of portfolio risk management.

So, for a board of directors, this may be a good time to assess your bank’s loan review processes. Here are some timely tips to push this evolution along:

  • Remember credit quality assessments—including those of regulators—typically are trailing, not leading indicators. There’s a perception that community banks have been beaten up enough over the past few years and that some of the regulatory credit dogs have been called off; thus, be vigilant to dated reports indicating stable credit quality. Additionally, historical loan performance indicates loans made at the end of credit cycles are sometimes made for the purpose of enhancing growth, and have proven to be more problematic.
  • Embrace updated—and secure—technologies to enable remote reviews and eliminate travel expenses. With the availability of imaged loan files, loan review can be done remotely; however, it must be done securely. Too many contract reviewers are putting banks at risk using their own porous laptops.
  • Ensure more file coverage and promote more collaboration within the bank’s risk management forces. Remember that loan review’s primary mission is to validate original underwriting, post-booking servicing, adherence to policies and ultimate agreement with risk grading—not to re-underwrite each sampled loan. An effective reviewer must always be willing to defend his or her work in a collaborative, non-defensive manner.
  • Be aware that industry-wide commercial real estate concentrations have recovered and now exceed pre-crisis levels. Given that highly correlated loan types exacerbated bank failures during the financial crisis, and that higher interest rates will likely put pressure on income properties, loan reviews should go well beyond the blunt concentration percentages by using smart sampling techniques. Peeling the onion on loan subset growth and performances will be critical in defending against and mitigating any significant concentrated exposures.
  • Explore hybrid loan review approaches. Even larger banks with internal loan review staffs are supplementing their work with external groups in order to effect efficiencies, broader coverages, and validations of their own findings. On the other hand, smaller banks relying exclusively on out-sourced loan review vendors should employ credit function policing arms to quick-strike areas of concern. Being totally dependent on a semi-annual loan review is akin to the fire department being open only a couple of weeks a year.
  • Understand the relationships among documentation exceptions, weaker risk grades and larger credit losses. Test technical documentation (capacity to borrow/collateral conveyance) proportionate to the weakness of the risk grade. After all, a lot of weakly documented loans go through the system unnoticed until a credit default occurs.
  • Go deeper than fee comparisons. While it’s understandable to consider fee structures when deciding on a loan review vendor, take the added steps of discussing loan review protocols and requiring examples of deliverables. All too many vendors provide only simplified spreadsheets and write-ups only of criticized-classified loans, in many cases, re-inventorying what the bank already knows. An effective loan review warns of problems about to happen; it doesn’t rehash those already acknowledged. Also, be mindful of the contractor: employee ratio as employee-based firms tend to offer more consistency and quality control.
  • Make loan review a viable bridge between the traditional, transactional analysis and aggregate, macro-portfolio risk management. While you can’t ignore the former, where it all begins, modern portfolio management requires a more quantitative and credible assessment of the latter, the sum of the parts. Thus, loan review emerges from an isolated, one-off engagement to a dynamic informer of all aspects of managing a bank’s credit quality.