What Objectives Should Loan Review or Credit Risk Review Systems Address?

Mary Ellen Biery
December 18, 2013
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(This post is a substantial update to an older article titled, “10 objectives loan review systems should address.”)

Key Takeaways:

 

An effective loan review system has always been critical for managing portfolio risk at financial institutions and for accurately estimating the allowance for loan and lease losses, or ALLL. As regulators are updating guidance related to loan review systems, their significance is getting fresh attention, and increased emphasis is being placed on their importance to risk management more broadly.

Banking regulators are incorporating changes in their guidance that relate to the current expected credit loss, or CECL, accounting standard. But at least two other notable differences in the guidance reflect the new emphasis on reviewing portfolio risk:

  • Regulators are breaking out guidance for loan review systems into a standalone document. Previously, direction on loan review was attached to guidance on the ALLL.
  • They’ve replaced the term “loan review systems” with a broader phrase: “credit risk review systems.”

“The agencies recognize that credit risk review systems have a broader application in risk management programs than just providing information on the collectability of an institution’s loan portfolio for determining an appropriate level” for the ALLL, wrote the OCC, the Federal Reserve, the FDIC, and the NCUA.

Indeed, the American Bankers Association in a Dec. 16 letter expressed an overarching concern about the new guidance: “[T]he scope and depth of the independent credit risk review proposals … will significantly change the scope of the current standards and may replicate other areas of audit.” One example cited by the ABA was that the proposed guidance indicated an effective credit risk review would include reviewing “[e]xposures from non-lending activities that also pose credit risk.”

“We believe that this is too broad to be included in the loan review process,” the ABA said in its letter to regulators. “This is not something that is currently reviewed by loan review; it is addressed in other audit or risk management areas.”

Comments on the proposed guidance closed Dec. 16, and the agencies will be reviewing them in 2020 for potential changes.

Objectives of an effective credit risk review system

Banking and credit union regulators don’t provide specific rules for what every financial institution’s loan review or credit risk review system should look like, either in current or proposed guidance. The nature of credit risk review systems vary “based on an institution’s size, complexity, loan types, risk profile and risk management practices,” regulators said in the latest proposal.

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“For example, in smaller or less complex institutions, a credit risk review system may include qualified members of the staff, including loan officers, other officers, or directors, who are independent of the credits being assessed,” according to the proposed guidance. “In larger or more complex institutions, a credit risk review system may include components of a dedicated credit risk review function that are independent of the institution’s lending function. A credit risk review system may also include various responsibilities assigned to credit underwriting, loan administration, a problem loan workout group, or other organizational units of an institution.”

In some cases, all or some of the credit risk review function might be outsourced to a third party.

Regardless of the structure, effective credit risk review systems should accomplish seven objectives that regulators have outlined in the proposed guidance:

  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 credit risk review system assesses “the adequacy of and adherence to internal credit policies and loan administration procedures,” and monitors compliance with applicable regulations and laws.
  5. An effective credit risk review system evaluates lending staff activities, including their 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 “objectively, independent, and timely assessment of the overall quality of the loan portfolio.”
  7. An effective credit risk review system provides management with credit quality information for financial and regulatory reporting, including the calculation of the appropriate ALLL or allowance for credit losses, or ACL, as it will be called under CECL.

The language regarding objectives hasn’t changed that much from previous guidance. However, several commenters have asked regulators for clarification, especially as it relates to responsibilities that should belong to credit risk review teams vs. those that belong to enterprise credit management or audit functions.

For example, the ABA expressed concern that the proposed guidance implies credit risk reviewers should identify in real time any loans with actual and potential credit weaknesses. Credit management functions in financial institutions typically perform that role, while credit reviews typically apply a sample-based approach, the ABA said.

Other industry representatives are concerned that the guidance will be onerous for smaller financial institutions.

“[W]e are concerned there will be instances where its application to certain credit unions is simply not feasible or appropriate,” the Credit Union National Association (CUNA) wrote. It urged the NCUA to treat the guidance as just that: something credit unions could look to for assistance, rather than as exact instruction that credit unions might be examined for their strict adherence.

To learn more about best practices for loan review based on current regulatory guidance, watch the on-demand webinar, “Effective Loan Review.”

About the Author

Mary Ellen Biery

Mary Ellen Biery is a Senior Writer and Content Specialist at Abrigo.

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