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Lending & Credit Risk Portfolio Risk & CECL Loan Review and Due Diligence

A risk-based, time-saving approach to annual loan review

Kate Randazzo
Kent Kirby
November 13, 2023
Read Time: 0 min

Streamline your annual review process

Which loans need them, what processes to avoid, and how to save time working with borrowers' complex credit needs.

Read the 2023 Loan Review Survey results for expert analyses of emerging trends

WATCH WEBINAR

Takeaway 1

Annual loan review is separate from covenant testing and underwriting, but many banks conflate these processes.

Takeaway 2

Determine which loans need a separate annual review and create a plan for what to include in your financial institution's assessment.

Takeaway 3

Utilize guidance lines to streamline the approval process for customers with fluctuating credit needs

Fine-tune annual review

Keeping annual review simple

Annual loan reviews are a critical component in monitoring the health of a credit after it is initiated. How is it distinguished from the loan review process (credit risk review), and what common pitfalls can impede an effective annual review process?  

What is interesting about annual reviews is that there is no standard process or method that all banks follow. However, in a recent poll, 47% of banks reported that they require annual review for all loans above a certain threshold, while 54% of banks perform a full-blown analysis—as if underwriting new money—during an annual review. 

The 2020 Interagency Guidance on Credit Risk Review Systems recommends that loan review should occur "typically annually, on renewal, or more frequently when internal or external factors indicate a potential for deteriorating credit quality or the existence of one or more other risk factors.” Regulators expect financial institutions to develop loan review or credit review systems tailored to their specific risks and circumstances. This means that loans that are already examined throughout the year do not necessarily need a scheduled annual review. Credit risk review is ongoing, and the annual review component is intended for loans that would otherwise not be touched from year to year.

Director of Abrigo Advisory Services Kent Kirby says many financial institutions waste time on overly robust annual loan review processes. Kirby and Abrigo Senior Advisor Rob Newberry recently provided guidance on the annual review process during the webinar “Navigating annual reviews: How should you approach them?”  The following can help your financial institution develop a more efficient, effective annual review framework. 

What annual review isn't

Processes to avoid in annual loan review

By taking a comprehensive approach to annual reviews, many financial institutions end up duplicating work that would have been (or will be) performed during other cyclical processes, such as the processes in the following examples: 

Covenant testing on loans is typically performed quarterly to ensure that covenants are not breached. Instead of performing a covenant test as part of an annual review, keep this process separate.  

Underwriting financial transactions involves a level of detail that does not belong in your annual review process. The annual review process needs to be treated with the same gravity as the underwriting process, but it needs to be treated with less attention to detail. 

Problem loan processes are unique at each financial institution, but typically, problem loans are isolated, documented and discussed, analyzed for root problems, and frequently reevaluated. As a result, a separate annual review does not need to be performed on these loans.  

Kirby emphasized that what these “don’ts” have in common is they involve loans that are being analyzed far more frequently than annually. Spending time doing an annual review on loans already on your institution’s radar is unnecessary. So, what should you be doing for an annual review? 

An annual review/assessment is meant to be conducted on customers with an outstanding credit facility where there is no financial transaction on the near horizon. An independent annual review isn't necessary to conduct separately on loans that will soon be examined anyway.

“If you’re doing a financial transaction such as a renewal, you can let that renewal act as part of the annual review,” Kirby said. “It sounds like semantics, but it’s a big deal because otherwise, you’re duplicating work by performing the entire annual review process and then doing the financial transaction.”  

Perfect your assessment

Elements of an effective annual review

Once your institution has established which loans need a separate annual review, create a plan for what to include in their assessment. The following are actions to consider incorporating into the annual review: 

  • Risk rating assessment and grading. If a loan’s rating is on the decline, add the details of the problem into its assessment. Stable loans don’t necessarily require the same amount of work and detail. In any case, address whether or not the borrower is performing as expected and mention any threats to a loan’s rating.
  • Evaluation of the history of the transaction(s) since the last review. Look at patterns in customers’ businesses, whether seasonal or otherwise, so you know what is typical for them and understand the red flags to watch for. This may also include performing a collateral analysis if you are working with a collateral-dependent loan
  • Assessment of general credit history since the last review. Address any issues from prior annual reviews and consider assessing the borrower’s credit outside your institution. Kirby recommends performing a record search through a third party to understand your borrower better. “Record searches can be very enlightening. If your customer is borrowing money from other creditors or is involved in any type of lawsuit, you will find that information through a simple records search. You can use it to see the trajectory of their financial situation.”
  • Review of outstanding documentation exceptions. “While a late financial statement isn’t unimportant, banks typically don’t lose money from policy exceptions,” Kirby said. But they can lose significant money quickly on lien documentation exceptions if they are not perfected. “I’ve seen a lot of special assets situations where forbearance has been put in place because the documentation wasn’t perfected, and they needed to get through the preference period to be able to do something. You don’t want to be in that situation.” Perform documentation in a centralized operations function so controls are in place to generate exceptions. Make sure to look at lien perfection, tax payments, and insurance.
  • Profitability analysis. High transaction accounts are not always the most profitable, and even if the bank is excited about a significant deal, analysis should always be done to ensure that the deal will be profitable.

Tracking the progress of an annual review and related correspondence can get confusing. Automating the process with loan review software may help your financial institution make better decisions faster with summaries of reviews, exceptions, and portfolio concentrations.

Stay up to date on loan review best practices.

Which loans need review?

Decision-making tips for annual review

Your credit systems should warn you 30, 60, or 90 days out that an annual review is coming up so that you know when to expect the additional work. A good first step in the process is risk rating assessment and grading, which will help you determine which loans need review. 

Once the risk rating is complete, you need to decide whether a financial transaction is coming up, such as a renewal, new money, or a restructuring. If a transaction is being contemplated, the loan will not continue through the annual review process. It should go straight to the regular underwriting process, which counts as its annual review.  

The next fork in the road is deciding what kind of annual review to perform. Sometimes, a risk rating and assessment could be all you need on the loan. If the loan needs more than just a risk rating and assessment, use some or all of the elements of an effective loan review above. But regardless of whether or not the loan review will be very involved, there should be no reason to re-underwrite the loan. “If you have a three-rated credit to an established company, there is no need to do a full-blown review,” said Kirby. “Don’t re-underwrite perfectly acceptable credit.”   

 

Justifying guidance lines 

How guidance lines can help the annual review process along

If your bank is used to performing annual review on all of its loans regardless of how often they are touched, a risk-based approach can be a huge timesaver. But managing annual reviews for customers with fluctuating credit needs can be tricky. In these situations, Kirby recommends utilizing guidance lines to streamline the approval process for businesses that undergo frequent changes.

A guidance line is a line of credit approved by the financial institution but never disclosed to the borrower. Rather, it is an internal accounting facility that transfers loan authority from a higher lending source to a lower one for a specific period of time under specific conditions.  

A guidance line allows you to approve certain facilities ahead of time. For example, during a conversation with the bank’s account officer, a real estate development company indicates it wants to purchase properties to renovate and sell. It does not have specific properties in mind, but it wants the flexibility to move quickly when an opportunity presents itself. The bank approves the developer for a $1 million guidance line. The line is fixed for a set term (usually one year), and there are specific conditions that have to be met (get an appraisal, rent rolls, debt-service coverage covenant, and so on). When the developer comes to the bank asking for credit, the approval process is greatly compacted since the internal approval is already in place and the focus is simply fulfilling the conditions of that approval.   

Guidance lines may be appropriate for businesses that know they will have multiple financing or refinancing needs in a given period. Not only do they help you quickly make moves for customers who meet specific requirements, but guidance lines also provide an excellent opportunity to talk to customers about their financing needs for the year in advance (so you can be ready). Guidance lines can also be a good marketing tool because you can give customers approval faster within certain parameters. 

Conclusion

Risk-based annual reviews save time

An annual review is a yearly assessment of an existing credit, not a re-underwriting of a loan. Keep elements of an annual review distinct from the underwriting process to save your staff valuable time. Taking a risk-based approach to which loans need a complete annual review can help your financial institution be more efficient with its time without compromising the safety and soundness of the bank. And for an extra time-saving measure, consider guidance lines as an effective way to manage the credit needs of specific customers. 

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About the Authors

Kate Randazzo

Content Marketing Manager
Kate Randazzo is a Content Marketing Manager at Abrigo, where she works with industry thought leaders to create digital content that helps financial institutions better serve their customers. Before joining Abrigo, Kate managed social media and produced articles for Campbell University’s quarterly magazine and other university content initiatives. She earned

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Kent Kirby

Director, Advisory Services
Kent Kirby is a retired banker with 40 years of experience in all aspects of commercial banking; lending, loan review, back-room operations, portfolio management, portfolio analytics and credit policy. He currently serves as a Director on the Abrigo Advisory Services team where he works with banks and credit unions across

Full Bio

About Abrigo

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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