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.
