What’s up Doc?
The following is the third and final installment in a series on the topic of credit administration. In the first, we explored different organizational structures. The second looked at the importance of adequate oversight of borrowers. This article will look at some important aspects of internal control and documentation.
My dog loves dried liver treats. There’s not much she wouldn’t do to get one of these tasty little morsels. It seems a bit odd that a really dried out piece of meat can be that appealing. But, with that in mind, we will attempt to cover a topic that, for most of us, would have about the same level of appeal as a dried liver treat: documentation. In a way, documentation is the internal equivalent of what we looked at last month that was outwardly focused on managing our borrowing relationships.
When most of us think of documentation, our first thought probably goes to preparing loan documents for a closing. While this is certainly one of the more important elements, documentation is really a series of steps in a (potentially lengthy) process. Let’s look at some of these steps and their importance in the overall documentation process.
Although most of us former lenders and credit officers don’t necessarily think about it, the credit file is the first documentation step. Building and maintaining an appropriate credit is essential for managing credit relationships. The file needs to include the obvious contents like business and personal financial statements, loan closing documents, compliance certificates, and reporting requirements. But it also needs important notes and memos from in-person meetings and phone conversations as well as letters and e-mail correspondence. Maintaining all of this in a complete, coherent and consistent manner is (usually) a thankless job but, as a person who spends many hours reviewing both paper and electronic files, it is (always) absolutely essential. It seems that organizations rarely appreciate the importance of good credit files until they are faced with a humorless regulatory examiner or a legal proceeding of some kind (collection or other). My hat is off to those persons tasked with this responsibility.
A second critical aspect of documentation is the credit approval document. One of the toughest parts of this step is balancing the need to be complete in terms of laying out the following information:
- the thought process and analysis of key credit risks and mitigants,
- essential financial information and the expectations for ongoing performance (covenants),
- reporting (compliance certificates, borrowing base reports, personal and business financial statements), and
- note terms (rate, maturity, amortization)
In some sense, the easiest part of the documentation process is the actual preparation of loan documents. The difficulty tends to be in that sticky area of cost. As discussed in a previous blog entitled the Milking Stool, this discussion usually comes down to three choices: good, fast, or cheap. Pick any two. However, in this step is a concern which is often overlooked and difficult to police: assuring that the loan documents accurately reflect all the terms and conditions required/expected per the loan approval.
Given that negotiation is common as final documents are prepared, what process is in place to assure that changes to any terms and conditions are approved at the appropriate level in the organization and that approval finds its way to the credit file? In my experience, while it is rare that a lender would unilaterally make changes to a credit approval, it is not unprecedented (although usually career limiting). Most generally, there are a number of “tweaks” or “loose ends” that do not significantly change the original approval. Some organizations, depending on the nature of the changes, choose to document modifications through a Change in Terms (CIT) approach, others through a closing memorandum, and still others through a revised credit approval document. In any event, a third party should be able to track changes made to the original approved loan structure and terms and find appropriate signoffs/approvals.
Even if the credit documents reflect the credit approval, closings can be notoriously incomplete. Documents may not be properly executed or not signed at all. Documents may be missing. Perhaps something as simple as a missing insurance certificate, or a signature on a guaranty. Depending on the nature of the exception (critical exceptions), the closing and disbursement of funds should be delayed. It is very important that lending institutions’ credit policy and procedures clearly spell out the type and nature of exceptions that can be allowed and what can NOT be left to the judgement of the lending officer. Further, if a closing does occur with documents to follow, it is imperative that the organization have a system to track the missing items and provide regular notification to credit and lending personnel until all exceptions have been cleared.
As a post-closing function, an institution may choose to “audit” all or selective relationships to assure that all required documents have been properly executed and are in the file, and that the documents accurately reflect the terms of the approval including any subsequent approved modifications. Some organizations include this as a standard practice post booking, while others leave this to an internal audit function. Personally, the shorter the time between the review and the actual closing is preferred as it does not depend upon someone’s distant memory of terms, conditions and negotiations.
Over the past several blogs we have looked at several facets to a well-functioning credit administration process. If there is a single take-away it is that there is no perfect manner to administer credit but, in the end, all good programs will include the crucial elements of a well formulated lending policy and procedures, properly trained lending and credit personnel and strong systems and controls. Well, I guess if it were easy …
Richard Rudolph is Senior Consultant at Enlighten Financial, 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 Rick directly, please call: 920.264.9150.