Independent Loan Review & Credit Risk Review System Objectives

Mary Ellen Biery
August 9, 2021
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Independent Systems for Loan Review in Banking  

Banking regulators have outlined expectations for effective, internal loan review and credit risk review functions. 

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This article is substantially updated from a 2013 blog post.

An effective independent loan review system has always been critical for managing a financial institution’s credit risk and accurately estimating the allowance for loan and lease losses, or ALLL.

A sound system of independent loan review on an ongoing basis is especially vital for banks and credit unions navigating the uncertainty of the coronavirus pandemic. It’s also critical for reinforcing that management and the board of directors are able to receive accurate and timely updates about the health and performance of the financial institution’s portfolio.

Financial institutions with strong, independent loan review and, more broadly, credit risk review, can react more quickly to changes in the market, according to Ancin Cooley, principal of Synergy Bank Consulting and Synergy Credit Union Consulting. Cooley, who provides advisory services on process improvement, including the internal loan review function, says effective challenge in loan or credit review allows institutions to react with confidence that they have an accurate view of the current portfolio.

Being able to change course allows financial institutions to avoid issues – for example, by moving away from loans with a certain type of risk (whether that’s interest, credit, or liquidity). The ability to pivot rapidly additionally allows banks and credit unions to capture opportunities their peers might miss, such as taking on more loans of a specific type or adding a new loan product, Cooley says.

2020 Interagency Guidance
Recommendations for independent loan reviews

The 2020 Interagency Guidance on Credit Risk Review Systems includes updated recommended practices related to independent loan review and credit risk review systems. The update incorporates changes related to the current expected credit loss (CECL) accounting standard, including breaking out the loan review guidance (previously attached to guidance on the ALLL) into a standalone document.

As regulators described “practices generally considered consistent with safety-and-soundness standards,” they revised loan review guidance to reflect the broader importance of credit review to risk management. In many ways, they also provided more general guidance to financial institutions.

Prescriptive phrases such as “Loan review personnel should review significant credits at least annually, upon renewal, or more frequently” were replaced in the latest guidance with less specific advice or qualifying descriptions, such as “typically annually.” The change reflects regulators’ expectations that financial institutions will develop loan review or credit review systems tailored to their specific risks and circumstances. “This guidance outlines principles that an institution should consider in developing and maintaining an effective credit risk review system,” regulators said.

The Federal Reserve, the OCC, the NCUA, and the FDIC repeatedly pointed out that the nature of loan review or credit risk review at a given bank or credit union will vary. Indeed, some banks or credit unions might call it loan review, while others might call it credit review, or asset quality review, or another name, if the institution chooses, according to the guidance. However, regulatory agencies said credit risk review systems should always be “based on an institution’s size, complexity, loan types, risk profile, and risk management.”

As in previous loan review guidance, agencies in the 2020 credit risk review guidance say variations in review systems could mean that in a smaller, less complex institution, loan officers, other officers, or directors who are independent of credits being reviewed might be part of the credit risk review system. Larger or more complex institutions might have credit risk review functions entirely separate from their lending functions. Other banks or credit unions might outsource the credit risk review function to a third party.

Identifying Credit Weaknesses
7 Objectives of credit risk review

Although regulators haven’t provided specifics for what every financial institution’s loan review or credit risk review system should look like, there are seven objectives every effective credit risk review system should accomplish:

  1. An effective credit risk review system promptly identifies loans with actual and potential credit weaknesses so that the financial institution can act in a timely way to strengthen credit quality and minimize losses.
  2. An effective credit risk review system “validates and, if necessary, adjusts risk ratings,” particularly for loans with potential or well-defined credit weaknesses that may put repayment in jeopardy.
  3. An effective credit risk review system identifies relevant trends that affect the quality of the loan portfolio and highlights portfolio segments that are potential problem areas.
  4. An effective internal loan review function or credit review function assesses “the adequacy of and adherence to internal credit policies and loan administration procedures.” It also monitors compliance with applicable regulations and laws.
  5. An effective credit risk review system evaluates the activities of lending personnel and management, including compliance with lending policies and the quality of their loan approval, monitoring, and risk assessment.
  6. An effective credit risk review system provides management and the board with an “objective, independent, and timely assessment of the overall quality of the loan portfolio.”
  7. An effective credit risk review system provides management with accurate and timely credit quality information for financial and regulatory reporting, including the determination of an appropriate allowance for loan and lease losses (ALLL) or allowance for credit losses (ACL).
Independent Assessment
Reviewing lending staff’s risk ratings

Timely risk ratings are critical to independent credit risk review, according to the guidance. An effective credit risk rating framework is one that monitors loans and retail credit segments or portfolios that have similar risk characteristics. It also provides important information on the collectability of each portfolio to aid in calculating the ACL or ALLL.

Regulators said lenders with effective credit risk rating frameworks generally place primary reliance on the lending staff to assign accurate and timely risk ratings and identify emerging loan problems. However, the lending staff’s assignment of risk ratings is

“typically subject to review by qualified and independent: (i) Peers, managers, or loan committee(s); (ii) part-time or full-time employee(s); (iii) internal departments staffed with credit review specialists; or (iv) external credit review consultants. A risk rating review that is independent of the lending function and approval process can provide a more objective assessment of credit quality.”

Small or rural institutions with few employees or resources can adopt modified review procedures and still achieve a proper degree of independence if “more robust procedures and methods are impractical.”  The guidance suggested that loan officers or other officers or directors “who are not involved with originating or approving the specific credits being assessed and whose compensation is not influenced by the assigned risk ratings” might be used.

“Institution management and the board, or a board committee, should have reasonable confidence that the personnel chosen will be able to conduct reviews with the needed independence despite their position within the loan function.”

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Annual Approval
A written credit risk review policy is key

Want to know how to develop an effective independent loan review or credit risk review system? It all starts with a written credit risk review policy.

What is a credit risk review policy? 

A credit risk review policy, which some institutions might refer to as a loan review policy or loan review charter, is outlined in detail in the regulatory guidance. But in general, the financial institution’s credit risk review policy should include a description of the overall risk rating framework and establish responsibilities for loan review. It should also address:

1. The qualifications and independence of credit risk review personnel

2. The frequency, scope, and depth of reviews

3. The review and follow-up of findings

4. Communication and distribution of results.

This policy is reviewed and typically approved at least annually by the bank or credit union’s board of directors or an appropriate committee. The periodic approval shows evidence of the board’s “support of, and commitment to, maintaining an effective system,” according to the guidance.

The board or the appropriate board committee also typically approves the scope of the credit risk review annually or whenever significant changes are made “in order to adequately assess the quality of the current portfolio.”

Credit risk from activities not specific to lending?

Like the entire credit risk review system, determining an effective scope for an institution’s credit risk review process begins with focusing on the institution’s specific risk characteristics. An effective scope for the review typically includes various types of loans, such as loans over a certain size, past-due loans, loans with high credit lines, etc., the new guidance says. A new addition to the guidance is that an effective scope for the review typically also includes “exposures from non-lending activities that pose credit risk.”

Some financial institutions commenting on the addition have argued that adding non-lending activities to the list of exposures that should be within the scope of a loan review would significantly expand the standard’s reach and replicate some audit areas. Nevertheless, the final guidance retained the reference, and regulators again pointed to the need for institution-specific credit risk review planning.

“The agencies recognize that credit risk may arise from activities that are not specific to lending and encourage institutions to consider whether such activities should be included in the scope of the credit risk review function,” regulators said in comments accompanying the guidance. “For example, institutions that hold investment securities or engage in capital markets, treasury, or automated clearinghouse activities may elect to include the credit risk related to these activities in the scope of a review.  While the examples of non-lending credit activities cited here are not exhaustive and may not apply to all institutions, they illustrate other areas that management and the board of directors may consider in the development of a review plan that reflects the risk profile of the institution.”

Credit risk review helps with CECL

As it relates to CECL-connected changes, the guidance, in general, clarified that credit risk review helps make sure that the allowance adequately reflects the bank or credit union’s risks. When applicable, loans and portfolio segments selected for review are typically evaluated for, among other things, “the appropriateness of credit loss estimation for those credits with significant weaknesses including the reasonableness of assumptions used, and the timeliness of charge-offs.’’

“The calculation of estimated ACL or ALLL is not the role of credit risk review,” regulators said. “However, effective credit risk review results help ensure that the ACL or ALLL adequately reflects risk in the credit portfolio. In performing its assessment of reasonableness, credit risk review can leverage work performed in this area by other functions, such as internal audit.”

 

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About the Author

Mary Ellen Biery

Senior Writer and Content Specialist
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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