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Food for thought: A policy on credit exceptions

Kent Kirby
September 5, 2023
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When and how to cite credit exceptions

A policy on credit exceptions can address many factors that can lead financial institutions to diverge from loan policy and miss signs of potential trouble.

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Challenges of exceptions

Too many credit exceptions can cloud risk

I hate credit exceptions.

I don’t mean the fact that they exist (“we broke the rules”). Rather, all too often they become an end unto themselves instead of an indicator of risky behavior. In such instances, credit exceptions are too frequently cited without real merit. This plethora of exceptions tends to cloud true problems in a sea of obfuscation. Having a policy on exceptions can address many of the factors that can obscure potential trouble and lead to divergence from loan policy.

In this article, I'll cover what a credit exception is, recommendations for creating loan/credit exceptions, and tips for developing an exception policy for the financial institution.

Examples of "except"-ional problems

I have seen cases where something is an exception even though there is a policy or guidance specifically allowing instances for what is being cited as an exception. On the opposite extreme, an exception may exist, but the policy or guidance that would generate the exception does not (“pet peeves”). One that particularly annoys me is when an exception is being cited because it’s the only way to effectively track a portfolio segment due to a dearth of data in the bank’s information systems.

Portfolio segments should be monitored and managed, not get buried in exception counts. Finally, while there may be a distinction in the severity of risk of the credit exception, that assessment tends to be inherent in the exception itself rather than the subject of the exception (e.g., unsecured lending is bad rather than unsecured lending should only be extended to high pass risk rated credit).

Defining, citing exceptions

3 characteristics of a credit exception

So, what is a credit exception and when should it be cited?

A credit exception should have the following three characteristics:

  1. It is specific
  2. There is a well-defined risk justification for the exception to loan policy
  3. The path to clear an exception and how long it will exist is clearly articulated

Let’s look at each of these in more detail.

Loan/credit exception requirements

Specific – One of my favorite movies is “Casablanca.” At the end of the movie, Rick shoots Major Strasser right in front of Captain Renault, the local police chief. When other policemen show up and see the body, Renault instructs them to “round up the usual suspects.” This tends to be how we treat exceptions.

For example, the lack of a loan agreement on a term loan is a common credit exception. Yet, far too often, it is cited when it is not relevant (e.g., a simple 3- to 5-year equipment loan). Rather, a loan agreement is needed when the extension of credit results in a “significant” downgrade in the risk rating subsequent to the financing transaction (depending on the number of levels in your risk rating system, two or more ratings). At that point, the loan agreement should outline expectations (covenants) the bank has for the customer getting back to the risk rating that existed prior to that extension over a reasonable time frame (and in a reasonable manner). If that does not occur, an exception would be cited. When you want to cite an exception, the specific instances where it is relevant must be taken into account.

Well-defined risk justification - If it can be articulated at all, a common reason for a credit exception is “charge offs.” Yet the vast majority of banks have very low charge-off levels, and they typically tend to be for reasons other than a specific exception.

You need to examine the true root cause for the exception and if that cannot be ascertained, it needs to be eliminated. For example, the lack of guarantee may not cause a charge-off, but it limits options in the event of a workout. This is a legitimate risk factor justifying the existence of the exception. As a side note, the lack of an appraisal or funding a loan prior to the receipt and review of an appraisal is a violation of law, not a loan exception.

Path to removal – Sometimes an exception is like the Hotel California – you can check out anytime you like, but you can never leave. It just stays on forever. This is particularly true of credit exceptions related to account management (e.g., late financials cited in one period, followed by subsequent financials arriving on time – the late financials exception still exists). In addition to being specific as to when an exception can be cited, it is equally important to note when it can be cleared and how. Sometimes the clearance will be only with the repayment of a loan (e.g., lack of a loan agreement). BUT the path forward needs to be clearly articulated.

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Credit exception categories

Tips for creating an exception policy

Having a policy on exceptions makes it very clear what is an exception, when it can be cited, how long it lives, and how to clear it.

As the FDIC said recently:

Exceptions to policy should be few in number and properly justified, approved, and tracked. If actual practices vary materially from the written guidelines and procedures, the source of this discrepancy should be identified, and either actual practices or the written policy should be changed. Management may conclude that specific sections of the written policy are no longer relevant. A case is then made to the board of directors to amend the policy to reflect different, but still prudent, procedures and objectives.


3 categories of credit exceptions

I would divide exceptions into three categories: structural credit exceptions, account management exceptions, and documentation exceptions. There probably should be no more than 3-5 exception types in each of those major categories. For example, documentation would encompass perfection, administrative (insurance, UCC-11s, etc.), and property tax payments.

For each specific exception that is defined in the credit exception policy, each of the three characteristics noted above needs to be articulated.

The following is an example of how I would address the structural exception of non-recourse lending.

Non-recourse loans

While the bank historically has not experienced excessive levels of charge-offs due to loans not having one or more guarantors, there is considerable evidence to show that the options available to resolve a problem situation, as well as the costs incurred to exercise such options, are adversely affected by the lack of guarantees.

Generally speaking (subject to Regulation B), business loans should be guaranteed by the principals of the borrower. Corporate guarantees and guarantees from trusts are acceptable if approved by the Loan Committee or the Senior Credit Officer. A guarantee generally should be unlimited and continuing. A limited guarantee is acceptable so long as the principals have provided sufficient mitigants (e.g., a significant capital injection into the borrower, or other collateral such as liquid assets). The lack of a guarantee is considered an exception. The exception will remain in place until the debt is modified (and the deficiency corrected) or extinguished.

There are certain instances where, for structural or competitive reasons, a guarantee is difficult to obtain. These circumstances are recognized and are not considered exceptions.

These include (not exhaustive):

  • Secured by properly margined cash, commodities or marketable securities
  • Not-for profit
  • Government (all levels)
  • ESOP
  • Cooperative
  • Publicly traded (major exchanges)
  • SNC
  • Privately held companies with an investment grade public debt rating
  • Privately held companies with at least 2 of the following:
    • Risk rating 5 or better
    • EBITDA greater than $15 million
    • TNW greater than $15 million and leverage under 2:1

In this example, when the credit exception exists is clearly articulated (paragraph around the lack of a guarantee plus the exemptions), the risk justification for the exception is noted (cost to resolve) as well as the path to clearance (repayment or refinance – typically a structural exception, by its nature, cannot be cleared except with another financial transaction).

One of the many benefits of a policy on exceptions is that it is self-contained. When a change is made, it stays in that policy. I cannot tell you how many times I had to review a credit policy (or multiple policies) to make sure that it (they) remained consistent when a change was made that created, modified, accommodated, or destroyed an exception. And you don’t always catch everything, which can (and does) lead to confusion. A separate credit exception policy resolves this conundrum. Of course, for this to work, there can be no references to exceptions in other credit policies in the institution. That has the benefit of causing the writer(s) to reflect mindfully when writing a policy that is succinct, clear, and free of references to exceptions.

And mindful reflection and policy is a topic for another day.

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About the Author

Kent Kirby

Director, Advisory Services
Kent Kirby is a retired banker with 39 years of experience in all aspects of commercial banking; lending, loan review, back-room operations, portfolio management, portfolio analytics and credit policy.  As Director, he oversees the implementation of the loan review platform (CQS) for new clients as well as upgrading existing clients

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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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