Loan Review Scope and Depth
Part 2 of 3
In the first part of this series, we discussed the significance of the Audit or Supervisory Committee regarding its role in the loan review process. We noted that it is imperative the Board of Directors is actively involved in the oversight of the loan review process within the financial institution. One of the Board’s critical functions is the development and review of the overall loan policy including the review and development of a loan review policy.
The loan review policy should address both the scope and depth requirements for the loan review process. The exact scope and depth criteria of the loan review are generally maintained in a document separate from the policy, as the scope may change or be adjusted in response to various factors that could expose the loan portfolio to additional or changing risk factors. The Audit or Supervisory Committee should be engaged in the planning and documentation of the loan review requirements on an annual basis. The annual planning will include details of the scope and depth for the review plan year and address areas of concern of additional risk within the loan portfolio.
The scope for a loan review will vary between institutions depending upon several factors. Items to consider when developing a scope for loan review include: the composition of the loan portfolio, growth rates of segments within the portfolio, new product offerings, loan officer turn-over, lending authorities, concentrations, Reg. O loans, past-due, criticized and classified assets, purchased participations, and acquired loan portfolios. Each organization’s needs are different and require the identification of the critical factors within the loan portfolio to determine the appropriate scope.
Stratifying the loan portfolio based upon different factors such as loan type and risk rate may provide additional insight regarding the appropriate scope for the loan review. A portfolio can be sliced in many ways to draw out both the obvious and less obvious data to guide the scoping process.
One of the frequent questions we address with our customers is: How many files should a review encompass? This is a good question and can be addressed in various ways. The first is to understand the expectations of the scope of the loan review provided by the Board of Directors. Has the Board or the Audit Committee provided explicit requirements for either the number of files to be reviewed or, better, the percentage of the portfolio or portfolios to be reviewed? Next, have there been any changes with either internal or external factors that could impact the risk in the loan portfolio? In addition, prior loan reviews and regulatory exams may provide insight into the sufficiency of the amount of the portfolio to be reviewed.
Ideally, the scope should consider a percentage coverage of the portfolio based upon the quality of the loan portfolio and other risk factors. We prefer to address the quantity based upon a percentage of the total portfolio or percentages of segments that provide for a total coverage percentage of the loan portfolio. The number of files included in a review may not be an appropriate gauge for risk management purposes, as the size and complexity of relationships can vary and skew the overall coverage of the portfolio. A percentage coverage metric based on the size of the portfolio provides for greater consistency in the scope of the review over as taken over a number of periods. Targeted reviews can also be accomplished if management identifies or determines changing risk factors in a specific segment of the loan portfolio.
As a rule of thumb, we consider the asset quality component of the CAMELS rating to be good starting point for the appropriate loan review coverage. An asset quality rating of 3 may lead to an initial discussion of a loan review scope of 50% of the portfolio. This level should then be adjusted based upon other risk factors impacting the portfolio. An asset quality rating of 2 may lead to an initial loan review coverage of 30% with this level also being adjusted up or down for other risk factors.
The depth of a loan review addresses the components that should be reviewed for each credit relationship included within the scope of the loan review. Loan review components can include some or all of the following:
- Credit quality – including adequacy of repayment sources and trends in the borrower’s financial condition and financial performance.
- Approval – proper loan approval and adequate underwriting.
- Collateral – including adequacy of collateral and proper lien perfection and position.
- Documentation – including security perfection and critical documentation that is in accordance with the approval
- Monitoring – adherence to loan agreement and covenants; exception management and tracking
- Policy – compliance with internal loan policy and procedures, as well as applicable laws and regulations.
- Risk Rating – appropriateness and timeliness of assigned credit grades.
The determination of the appropriate scope and depth for your institution can be a complex and evolving process. A good starting point is to develop a loan review policy to include components of both scope and depth. The policy should be reviewed and updated based upon the learning curve experienced with the loan review process along with the key risk factors impacting the loan portfolio over time.
We are pleased to review and discuss your existing loan review policy with you to identify any material gaps or deficiencies. We can also work with you to assist you in developing your initial loan review policy.
Enlighten Financial is a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to us directly, please call: (920) 445-8881.