For almost three decades, regulators have mandated independent loan review of commercial loans. So what could be needed to improve this time-tested concept? Well, for one, like all other aspects of banking, loan review must evolve and modernize to retain its effectiveness. This is more pertinent given that, statistically speaking, we may be in the fourth quarter of the credit cycle, which could be problematic as loan officers may pursue growth at the expense of loan quality. Also, there’s a growing dependence on loan review to facilitate accurate portfolio credit marks in mergers and acquisitions. Many loan reviews, whether in-house or externally contracted, remain too subjective, too random, are outdated technologically, lack collaborative processes, and, perhaps most importantly in the modern era, lack holistic linkage to the more quantitative and dynamic macro aspect of portfolio risk management.
So, for a board of directors, this may be a good time to assess your bank’s loan review processes. Here are some timely tips to push this evolution along:
- Remember credit quality assessments—including those of regulators—typically are trailing, not leading indicators. There’s a perception that community banks have been beaten up enough over the past few years and that some of the regulatory credit dogs have been called off; thus, be vigilant to dated reports indicating stable credit quality. Additionally, historical loan performance indicates loans made at the end of credit cycles are sometimes made for the purpose of enhancing growth, and have proven to be more problematic.
- Embrace updated—and secure—technologies to enable remote reviews and eliminate travel expenses. With the availability of imaged loan files, loan review can be done remotely; however, it must be done securely. Too many contract reviewers are putting banks at risk using their own porous laptops.
- Ensure more file coverage and promote more collaboration within the bank’s risk management forces. Remember that loan review’s primary mission is to validate original underwriting, post-booking servicing, adherence to policies and ultimate agreement with risk grading—not to re-underwrite each sampled loan. An effective reviewer must always be willing to defend his or her work in a collaborative, non-defensive manner.
- Be aware that industry-wide commercial real estate concentrations have recovered and now exceed pre-crisis levels. Given that highly correlated loan types exacerbated bank failures during the financial crisis, and that higher interest rates will likely put pressure on income properties, loan reviews should go well beyond the blunt concentration percentages by using smart sampling techniques. Peeling the onion on loan subset growth and performances will be critical in defending against and mitigating any significant concentrated exposures.
- Explore hybrid loan review approaches. Even larger banks with internal loan review staffs are supplementing their work with external groups in order to effect efficiencies, broader coverages, and validations of their own findings. On the other hand, smaller banks relying exclusively on out-sourced loan review vendors should employ credit function policing arms to quick-strike areas of concern. Being totally dependent on a semi-annual loan review is akin to the fire department being open only a couple of weeks a year.
- Understand the relationships among documentation exceptions, weaker risk grades and larger credit losses. Test technical documentation (capacity to borrow/collateral conveyance) proportionate to the weakness of the risk grade. After all, a lot of weakly documented loans go through the system unnoticed until a credit default occurs.
- Go deeper than fee comparisons. While it’s understandable to consider fee structures when deciding on a loan review vendor, take the added steps of discussing loan review protocols and requiring examples of deliverables. All too many vendors provide only simplified spreadsheets and write-ups only of criticized-classified loans, in many cases, re-inventorying what the bank already knows. An effective loan review warns of problems about to happen; it doesn’t rehash those already acknowledged. Also, be mindful of the contractor: employee ratio as employee-based firms tend to offer more consistency and quality control.
- Make loan review a viable bridge between the traditional, transactional analysis and aggregate, macro-portfolio risk management. While you can’t ignore the former, where it all begins, modern portfolio management requires a more quantitative and credible assessment of the latter, the sum of the parts. Thus, loan review emerges from an isolated, one-off engagement to a dynamic informer of all aspects of managing a bank’s credit quality.