Financial institutions conduct one as first-line risk management to identify emerging risk tied to a borrower. The other is an independent function evaluating portfolio credit risk "from the ground up."
Key topics covered in this post:
In credit risk management, few distinctions are more frequently blurred—or more consequential —than the difference between the processes known as annual review and loan review. The terms are often used interchangeably at financial institutions, leaving many people confused.
But words matter. Annual reviews of loans and the loan review process represent fundamentally different concepts, performed by different parties, for different purposes.
An annual review is a first-line risk management activity conducted by lenders or portfolio managers on a borrower with one or more outstanding credit facilities. The goal of an annual review of a borrower should be to identify emerging risk factors as part of ongoing monitoring of lending and assess whether mitigation is possible.
An annual loan review may coincide with a renewal or new extension of credit. In other cases, the review is a standalone activity. An example of the latter is a review in the second year of a multi-year term loan where no financial transaction (i.e., renewal, new loan, etc.) transpires.
When tied to a loan renewal or new debt, the annual review process is typically a full underwriting of the new exposure, including an evaluation of existing facilities. When an annual review stands alone, however, re-underwriting is neither necessary nor efficient.
This is where confusion and wasted effort often arise. Unless a loan is in default, the bank or credit union’s ability to materially change the credit during an annual review is limited so long as the borrower is performing as agreed. The purpose of an annual review, therefore, is not to recreate underwriting. Again, lenders or portfolio managers should be trying to detect any emerging risk factors and, if found, determine whether mitigation is possible.
That means the yearly review process should be risk-based:
In all cases except renewals or extensions, the annual review remains a review of the current condition; it is not a full underwriting. There is nothing new to underwrite.
Once a credit is placed on the problem loan report (“Special Mention” or worse), the annual review process should be suspended. These credits are already subject to far more intensive and more frequent monitoring. When and if the credit returns to pass status, the annual review process can resume.
Loan review, also known as credit risk review, is something entirely different from the annual review.
It is a second-line, independent function of risk management at a financial institution. Typically reporting to the board, loan review is performed by trained specialists who were not involved in underwriting or approval. The loan review program or team assesses the portfolio “from the ground up” by sampling portfolio segments and aggregating the results of the review of individual borrowers in those segments to find patterns and trends that deserve management and board attention.
Loan review’s purpose is clearly articulated in the FFIEC’s Interagency Guidance on Credit Risk Review Systems (May 2020), including:
Loan review may be conducted through periodic, point-in-time examinations or continuous monitoring of targeted segments, such as recent originations. The best practice is to employ both methods, with continuous monitoring augmented by the deeper dive of the examinations. Most financial institutions tend to focus on their commercial lending activities, but the institution’s investment portfolio and Wealth Management group (i.e., the credit risk associated with fiduciary activities) may also be subject to credit risk review.
Conducting loan review at a bank or credit union typically involves:
As part of its review of individual credit, loan review should not involve re-underwriting credit. Rather, its focus is on the adequacy of the underwriting process undertaken at the time the credit was originated or renewed, including any updates identified through the annual review. Further, loan review is not the simple acceptance of the institution’s credit risk management framework (policies, guidance, risk rating framework, etc.) and only focusing on the adherence of the underwriting process to that framework. Rather, loan review must assess that the framework itself is adequate and recommend changes to ensure the institution operates in a safe and sound manner. Remember, at the end of the day, effective loan review is portfolio review from the ground up.
To summarize:
Annual review of a loan is:
Loan review is:
Both functions are essential. They are complementary, not interchangeable.
Sound credit risk management depends on clarity of roles, discipline of purpose, and proportionality of effort. When each function does the job it was designed to do, the institution is far better positioned to spot trouble early, respond intelligently, and preserve both capital and credibility.
Getting the words right is not semantics. It is risk management.
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