Loan documentation dangers: Incomplete financials
The loan portfolio can be the biggest source of risk for a bank or credit union’s safety and soundness, but that risk does not end with underwriting and origination. Proper monitoring of the portfolio is necessary to keep good loans from going bad. And while it’s rare that a bank overlooks prudent loan administration, the process may seem like a less urgent source of risk than other sources and receive less attention than it requires.
Ineffective loan administration can pose many common documentation dangers for banks and credit unions, one of which is discovering incomplete financials or credit files during exams or audits.
In the 2013 Sageworks Bank and Credit Union Examination Survey, a common criticism that institutions admitted to hearing during recent exams was inadequate documentation for the portfolio, more specifically, documentation in loan files, including updated financial statements and appraisals.
What are examiners looking for? The specifics required for each credit file will differ among an institution’s loan types. But once documentation policies have been set, it’s critical that each credit file contains the pertinent information.
Documents for a commercial and industrial loan might include:
1. Financial information, including business and guarantor financials when appropriate, that is used to establish repayment capacity.
2. Collateral identification and valuation, including agreements and appraisals.
3. Loan structure information, such as loan terms, pricing information and relationship profitability data.
4. Loan agreement, including covenants and requirements for future submission of financial data.
5. Supplemental information, such as risk rating or recommended risk rating.
While most of these items pertain specifically to the financial performance or standing of the borrower, there may be additional documentation requirements, like proof of insurance, that must be tracked and updated throughout the client relationship.
Given how many documents may be required for this type of loan or for the typical mortgage, it is easy to see why the documentation for hundreds or thousands of loans can be difficult to organize and track over time. During an onsite examination, simply locating the right document upon examiner request could be a challenge.
Ensure consistency in your credit analysis and documentation.
Assuming the correct documents were collected at origination, a bigger danger is failing to update that information throughout the lifetime of the loan according to covenants and underwriting policies.
If a document cannot be located or was never received, it becomes an exception, and it is often the loan officer’s responsibility to collect this information. Identifying documentation exceptions before the loan closes is obviously preferable, but sound loan administration means that the loan officer’s responsibility is ongoing.
On the surface, documentation exceptions may seem minor. Yet, missing documents can jeopardize the enforceability of a loan agreement. In order for a loan agreement to remain valid, certain financial conditions as dictated by loan covenants must be upheld, but it is impossible to confirm they have been upheld if documentation is missing. Similarly, if a financial institution fails to renew a UCC financing statement to give notice of its interest in a debtor’s property, the credit could transition from secured to unsecured. Either scenario increases the bank’s or credit union’s risk.
For more information on other, common documentation dangers for banks and credit unions, download the whitepaper: Dangers of Deficient Loan Administration.