What’s on the Radar?
On a weekly basis, we have the privilege of being invited by one of our clients to conduct a loan review. Inevitably, at some point during our visit, we’ll be asked, “What are the examiners focused on?” Not only are our clients trying to stay in line with examiner expectations, but the purpose of examiners in the first place is to maintain a sound banking system. If an examiner is focused on something in particular, wise management teams should be aware of it and focus on it as well.
Here are a few areas of focus as it relates to credit risk and examiner attention:
- Agricultural lending: There’s no question agricultural lending carries additional risk in the current environment. Commodity prices obviously have a direct impact on a borrower’s ability to repay the debt. This year in particular, international trade is having an impact. 2017 financial statements are arriving for analysis, and although there’s a slight sigh of relief that 2017 wasn’t as weak as originally expected, the current year might be the greater challenge. It’s important now more than ever to watch carry-over debt and ensure your borrower is preparing annual projections. See our most recent blog for additional information.
- Construction lending: Construction lending presents a unique risk profile for a financial institution. Various factors contribute to risk ratings, including changes in market dynamics from credit approval to property delivery, delays in the construction process, changes in materials costs, or risk in the management of a construction project such as the draw process. Construction and development loans have historically had a higher loss ratio.
- Commercial real estate: Non-owner occupied real estate frequently appears on the examiner’s radar, however the subcategories of this larger industry tend to fluctuate. Presently, multi-family real estate and retail developments appear to be receiving the highest amount of attention. Keep in mind, real estate is primarily driven by local market trends, so pay particular attention to these trends and lend in markets where you have a strong understanding.
- Multi-family developers, often more than any other property developer, continue building units until the market softens. Slower rental rate growth, longer stabilization periods, and incentives are key warning signs of inequity in supply and demand. Unfortunately, by the time these signs have made themselves known, additional units are in various stages of coming on line. Financial institutions should closely monitor market conditions when deciding to support a multi-family project.
- Retail properties are driven by industry-wide changes in the retail segment. Multi-unit retail properties are often originated at an occupancy rate below the projected stabilization level, a process which continues to add supply to a market. Additional supply can drive rents down. Financial institutions need to keep a close eye on capacity coming in to the market and vacancies throughout their banking footprint.
- Underwriting and credit structure: Examiners are always focused on the quality of underwriting. The current competitive environment has presented an opportunity for financial institutions to stretch their traditional comfort level in terms of underwriting guidelines or credit structure. Examples may include accepting a lower cash flow coverage, providing a higher advance rate, or not requiring personal guarantees. We understand it’s a competitive market, however make sure mitigating factors are in place for any underwriting or credit structure flexibility. In addition, keep in mind that many of the credit analysts who are preparing credit presentations or underwriting packages were not in the industry during the last downturn. This is a great opportunity for seasoned bankers to share experiences with newer staff members about risk in certain industries, especially in this environment when every deal seems like a good deal.
- Concentrations: Examiners are intently focused on concentrations, or financial institutions nearing concentration levels. Examiners expect additional due diligence as you approach or exceed this threshold, which can include additional stress testing and reporting.
Keep these areas in mind in your credit administration process and in preparation for any upcoming exam. Remember, maintaining a disciplined approach to credit administration pays dividends in the long haul and minimizes credit losses.
Peter Nugent is Director and founder of Enlighten Financial, a specialized consulting firm that focuses on providing loan review and risk management services to community banks and credit unions. Peter guides the company’s service offerings, which include in-depth loan reviews, commercial and personal underwriting/analysis, internal process improvement and workout services. To talk to Peter directly, please call: (920) 354-6797.