Bank exam “hot spot”: Inflating policy limits to avoid scrutiny
The desire to avoid examiner scrutiny may tempt some financial institutions to set the bar high when it comes to credit and liquidity risk management policy limits, but regulators are discouraging this approach.
Instead, the Federal Reserve said in a recent supervision news flash, boards should ensure that policy limits align with the institution’s true strategy and risk appetite – at both the board and management level. In addition, regulators encouraged directors to ensure processes are in place to flag and address circumstances where upper bounds are breached for policies such as maximum loan/core deposits ratios, wholesale funding limits or various portfolio concentration limits.
Do established policy limits reflect true risk tolerance?
The Fed News Flash said:
“During a number of recent examinations, examiners have questioned the reasonableness of established policy limits in various areas such as credit and liquidity risk management. In doing so, examiners posed the question to management of whether the established limits reflected the true risk tolerance of their board of directors and management. In several cases, management acknowledged that the policy limits really didn’t reflect the true risk tolerance of their board and management and instead had been set expansively to avoid breaching the limits and being scrutinized by examiners.
“This acknowledgement resulted in healthy dialog with examiners who explained that policy limits should be set to serve as early warning indicators to spur director and management discussion, as well as trigger appropriate remedial actions when warranted. That means limits should be properly aligned with the true risk tolerance of your board and management.”
“Policy limits should be set to serve as early warning indicators to spur director and management discussion”
The Fed noted that establishing policy limits at “unreasonable levels” could backfire in a couple of ways:
1. It could compromise institutions’ risk management effectiveness and ultimately hurt the institution.
2. The unreasonable levels might “telegraph a higher risk tolerance than intended, which could result in greater regulatory scrutiny than warranted.”
How examiners assess “reasonableness” of policy limits
What factors do examiners consider when assessing whether policy limits are reasonable? The Richmond Fed listed five considerations:
• Current operating practices
• Historical values or levels
• Projected values or levels indicated in strategic plans and/or budgets
• The institution’s overall financial condition (including earnings and capital levels)
• Discussions with management about risk appetite and strategic initiatives.
FDIC officials in March also cited excessive, unsupported or the absence of board-approved limits for CRE portfolios or portfolio segments when the regulator outlined some of the weaknesses its examiners were seeing in oversight, loan administration and underwriting at some banks with CRE portfolios.
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