IN GOOD TIMES AND IN BAD …
Bankers are, by the very nature of what they do, risk managers. I was given a fairly straight-forward definition of how a financial institution works when just starting in the industry. My manager laid it out in a perfectly clear way: We use other people’s money to lend into our community. We pay an interest rate on customer’s deposit accounts and earn interest on loans we’ve issued. The spread, less administrative and operating costs, is our profit. This all means we did a good job of picking the right deals and structuring them in a way that was good for the borrower, but prudent for our organization. I was hooked.
A good credit culture will assess the risk of the lending opportunity and apply a fair rate of return (interest rate) on the credit extended to the borrower. Although every institution experiences loan losses, the higher success rate you have in picking the right lending opportunities, the more profitable your organization will be. Since all money is green (or electronic now days), picking the right opportunities comes down to discipline. Considering the recent history of low charge-offs and strong balance sheets, it’s easy to forget that credit losses are the largest risk for a financial institution. One miscalculation can erase years of profits and have a significant impact on the balance sheet. The discipline maintained by financial institutions during the good times, will allow the organization more flexibility in the down times. For this reason, in good times and in bad, loan review is a prudent practice.
Loan review provides an independent assessment of how well the financial institution analyzed or managed a credit relationship and confirms loan policy guidelines were adhered to. How well the loan relationship was structured and the strength of the collateral position are also components of a sound loan review program. Furthermore, loan review provides industry best practices for financial institutions in their daily management of the loan portfolio or business development efforts, and helps prepare for examiner visits. Of course, the environment is always changing. As a result, loan review shouldn’t only target a standard set of objectives, it should be customized to the specific needs and risk tolerance of the financial institution.
Many financial institutions have fairly static loan review requirements. It’s one of those “this is the way we’ve always done it” things. In some cases, loan review is addressed in the loan policy. But even then, the expectation is fairly static. Considering the ever-changing environment we operate in, this policy should provide minimum standards and guidelines to management, but also provide flexibility to address current market trends or changes in economic conditions.
The board of directors is ultimately responsible for the risk management and strategic direction of a financial institution. The plan to carry out the board’s direction rests in the hands of senior management. Everyone within the organization, however, is responsible for maintaining the desired credit culture. If anyone in the organization sees something that does not look right, it is his or her duty to bring it to the attention of others. This really is a team sport (we talk about that a lot in our organization).
As part of the general responsibilities of the board, establishing and approving various policies is essential. Although a financial institution’s loan policy will include things such as loan structures, geographic footprint and concentration guidelines, having a loan review component within the loan policy helps set expectations and guidelines from the board of directors. The entire policy, including the loan review statement, should be reviewed and updated as needed, but at least annually. The board should consider current market conditions in setting the policy including the loan review component.
The loan review component of a loan policy should include the frequency of reviews, range of portfolio coverage over a specific period of time and specific areas of interest the board may feel contains a higher level of risk to the organization. This policy could also include higher risk transactions to the financial institution, such as loan size, industry type, loan type and other loan concentrations. By spelling this out in the loan policy, the board continues to maintain its place as bearing the ultimate responsibility for the risk management practice of the organization, and helps set clear objectives and direction for management, who maintain the responsibility of carrying out the action plan.