The Fed’s loan sampling methodology
With an exam, an institution can expect some type of loan sampling to identify a portion of the bank’s loan and lease portfolio that will be scrutinized. Using that group of loans, examiners will assess the institution’s risk rating methodology and internal loan review function, reporting capabilities and representation of the broader portfolio, compliance with existing federal guidelines and finally the ability of the institution’s credit-risk procedures to identify and mitigate credit risk.
The Federal Reserve recently revised its policy for Examiner Loan Sampling in Supervisory Letter 14-4. While this letter specifically applies to institutions between $10-50 billion in total assets, it also suggests the proposed methodology can be applied to smaller institutions under the Federal Reserve.
The institution should plan to perform at least two internal loan-quality reviews during the supervisory cycle, and those reviews should prioritize at least one commercial loan segment by Call Report loan type. Over the course of the year, the four biggest (in terms of risk based capital) commercial loan segments should be analyzed. Coverage provided by the bank’s loan review program should be more extensive than coverage provided through an examiner’s sample, so the results of the internal loan review can be used as a starting point for examiners to help identify risk areas.
For commercial segments, examiners should review loans representing at least 10 percent of total dollar commitments within the segment and should include loans of varying delinquency levels. This 10 percent threshold may also be increased in the event of certain portfolio or process faults.
There is no similar threshold for retail loan coverage, but the Fed explains: “The goal of sampling is to assist examiners in making an informed assessment of all aspects of retail credit risk management. If applicable, examiners should evaluate and test secondary market origination and servicing practices and quality assurance programs.” In each annual review, examiners will assess at least one retail loan segment.
The Supervisory Letter also states that segments responsible for significant revenue should be included; if examiners deem that any loan category creates more than 25 percent of the bank’s revenue, it will be included in the sampling. Further, any concentration deemed to have extraordinary risk due to bank-specific characteristics or procedures (such as high growth, new products or inordinate delinquency) will be sampled. And, finally, a sample of loans to insiders will be included to ensure compliance with Regulation O.
The adequacy of the loan sample will be evaluated by examiners to ensure it accounts for asset quality, loan review effectiveness, results of internal stress tests and current financial trends. In the event an exam reveals inappropriate risk – in other words, the internal risk rating program is insufficient – the sample may be broadened so impact on the bank’s ALLL and capital adequacy can be assessed.
Read the letter in its entirety here: Examiner Loan Sampling Requirements for State Member Bank and Credit Extending Nonbank Subsidiaries of Banking Organizations with $10-$50 Billion in Total Consolidated Assets. Or, for recommendations on internal loan reviews, download the whitepaper Effective Loan Review.