Advice

Annual Reviews – Practical and Effective

Posted on October 2, 2023 Published by

In the world of commercial lending, the annual review is a critical component of maintaining a healthy loan portfolio. It serves as a vital tool for assessing the ongoing creditworthiness of borrowers and managing credit risk effectively. However, the sheer size and diversity of loan portfolios makes it impractical to subject every borrower to a comprehensive analysis each year. This is where the concept of a risk-based annual review program comes into play. Let’s delve into the purpose of annual reviews and outline a two-step approach to conducting them efficiently.

The Purpose of Annual Reviews

Annual reviews are not just a regulatory expectation, they are also an essential part of sound credit risk management. Their primary purpose is to:

  1. Assess Ongoing Creditworthiness: As borrowers’ financial conditions and economic environments change, it’s crucial to ensure that they remain creditworthy. Are they capable of fulfilling their obligations?
  2. Manage Credit Risk: By regularly reviewing loan relationships, financial institutions can minimize their losses. They can protect their capital by proactively identifying and addressing potential risks.

At the very least, annual reviews should confirm or update the risk rating assigned to borrowers and test covenants. These basic checks help in determining if there have been any significant changes in the borrower’s financial health and if they are adhering to the terms of their loan agreements.

An effective annual review program needs to be risk-based, practical, and flexible.

  • Risk-based: Prioritize riskier loans for review, using factors such as credit exposure level and risk rating to determine which loans to include. Not all borrowers pose the same level of risk, so allocate resources accordingly.
  • Practical: Completing a full-blown credit analysis for every borrower annually is often unfeasible. By focusing on key components of an annual review, including cash flow, covenants, and risk rating, you can determine if further analysis is necessary.
  • Flexible: Portfolios change over time, influenced by market dynamics and economic conditions. Your annual review program should have the flexibility to adapt to these changes. For instance, consider the impact of changing interest rates on commercial real estate loans.

Practical Approach to Annual Reviews

While conducting a comprehensive analysis of all borrowers in a commercial loan portfolio might seem ideal, it’s neither practical nor effective.  A good practice is to cover approximately 75%-80% of your commercial loan portfolio by credit exposure on an annual basis. Do this either through standard credit actions or annual reviews.  You can achieve this by first determining how much of your portfolio is covered by standard credit actions like renewals, quarterly asset quality analyses, and other routine processes.  If your standard processes cover 50% of the portfolio, for example, aim to cover the remaining 30% through the annual review program to reach the target of 80%.

To streamline your annual review process, consider adopting a two-step approach:

  1. Abbreviated Annual Review: Upon receiving borrower financial information, start with an abbreviated annual review. This involves spreading financial statements, conducting a cash flow analysis, and testing covenants. If the borrower’s financial performance is stable or improving, and they are compliant with covenants, they pass this initial review.
  2. Detailed Analysis if Needed: If the abbreviated review raises concerns, such as deteriorating financial trends, payment issues, covenant violations, or delinquent property taxes, proceed with a more detailed analysis to determine the borrower’s risk rating.

Annual reviews are a practical and effective means of managing credit risk in a commercial loan portfolio. By adopting a risk-based, practical, and flexible approach, financial institutions can ensure that their resources are focused on the borrowers who require the most attention. Furthermore, a two-step approach to annual reviews allows for efficient evaluation of borrower creditworthiness while minimizing unnecessary administrative burden. In an ever-changing financial landscape, a well-executed annual review program is indispensable for sound risk management.

Enlighten Financial can help!  Our team of consultants and underwriters can assist you in developing your annual review program or completing your annual reviews.  Contact us, and we’ll provide a thorough consultation on the annual review process.

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“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection