Should Directors Approve Loans?

One of the most controversial topics we’ve ever addressed at a Bank Director conference is whether directors should be approving loans. I once moderated a panel that included two bank audit committee chairs and the debate back and forth between them—one bank had a board level loan committee and the other did not—was fascinating. Audit committee issues are usually pretty cut and dry, but they were actually very impassioned in their defense of their respective practices. 

Every bank has a loan approval process at the operating subsidiary level, and the bigger the loan the greater the scrutiny it receives. Every bank also has a loan or credit committee at the operating level. And while every loan or credit committee functions a little bit differently, they all take basically the same approach. The committee checks to see whether the loan has been underwritten to the bank’s stated credit standards and complies with all of its loan policies. Sometimes there will be heated debate over exceptions to the policies involving an individual loan to a good customer—a loosening of the terms and conditions, perhaps, or maybe a little higher loan-to-value ratio if it’s a commercial real estate loan. All banks also have a legal lending limit, which is the maximum amount the bank can lend to a single borrower or group of borrowers. And since the regulators don’t want their banks making too many loans at their legal limit, there is effectively a “house lending limit” which is set well below the legal limit.

The point is, every bank has a group of experienced professionals with lending and credit skills, and these people are paid to evaluate loans and make the tough calls. It’s hard for me to see how directors who have never been bankers, or have never been trained how to evaluate a loan from a credit perspective, bring much to the process. I think it’s fair to say that board level loan committees are generally found at small banks, and one could argue that directors at such an institution might have a good sense of who to lend to—and not lend to—in the community. But any benefit that most directors would bring to the loan approval process is offset by the increased liability they assume when they insert themselves into the loan approval process. During the financial crisis, the Federal Deposit Insurance Corp. specifically targeted directors at failed banks who had been involved in approving loans that later went bad and helped sink their bank. 

The board is required by law to approve loans to the bank’s executives, directors or principal shareholders under Regulation O. Beyond that, I think the most appropriate role for directors in the lending activities of their bank is to make sure that sound lending policies are in place, and then monitor management’s performance to make sure the guidelines are met.  The board, most likely through its audit or risk committee, should also keep a close watch on the bank’s loan quality trends to verify that management is staying within the risk appetite parameters it has laid out. In other words, the bank’s directors should govern, which is the proper role of the board, rather than execute, which is the role of management. If you can’t trust the pros in your organization to make good credit decisions—backed up by appropriate board oversight—then you need a new team.

Directors who are really plugged into their communities can always make suggestions about good prospects, and those suggestions will probably be well received. They just shouldn’t be approving them.