By: Mr. Daniel Horan
CEIS recently received the most recent (April 18, 2014) supervisory letter, SR 14-4 from the Board of Governors of the Federal Reserve setting forth loan sampling expectations for examinations of state member banks and credit extending nonbank subsidiaries of banking organizations. This guidance targets those financial institutions with $10-$50 Billion in total assets. However, examiners will have the flexibility to utilize this guidance for those financial institutions with total assets below $10 Billion. Being so, it is important that every lending institution understand the rationale behind the regulators’ requests for loan sampling in order to be to be prepared and to be responsive in a timely manner.
As such, this article will break down the SR-14-4 components in an effort to provide a guide for anticipating specific sampling requests. This guidance was implemented upon issuance and it is currently in effect.
The supervisory letter states: “A thorough review of a bank’s loan and lease portfolio remains a fundamental element of the Federal Reserve’s examination program for State Member Banks. Such credit reviews are a primary means for examiners to (1) evaluate the effectiveness of a bank’s internal loan review program and internal grading system for determining the reliability of internal reporting of classified and Special Mention credits, (2) assess compliance with applicable guidance and regulations, and (3) determine the efficacy of credit risk management and credit administration processes.”
The examiners also use the findings from these credit reviews to identify the overall thematic credit-risk management issues, to assess asset quality, to assist in the assessment of the adequacy of the allowance for loan and lease losses (ALLL) and to facilitate their analysis of an institution’s capital adequacy.
LOAN SAMPLING METHODOLOGY
The release outlines that the annual loan sampling should provide coverage of all material exposures. The reviews will focus on material commercial loan segments exposures by Call Report loan type and should cover the four highest concentrations for commercial credits in terms of total risk-based capital for any Call Report loan type from Schedule RC-C. Loan segments that generate substantial revenues are generally likely to entail higher risk. This guidance states that the examiners should sample those loan categories that contribute 25 percent or more to annual revenues. It is also stated that examiners should also sample other loan segments that either the examiners or the bank’s internal loan review department have identified as exhibiting high risk characteristics. These high risk characteristics are identified as being liberal underwriting, high levels of policy exceptions, high delinquency trends, rapid growth, new lending products, concentrations to industry or other specific concentrations, significant levels of classified or Special Mention credits.
In addition to these risk-focused samples, a sample of loans to insiders (Reg O) must be reviewed. The annual loan sampling coverage should take into consideration the severity of the asset quality component rating, the effectiveness of the internal loan review program, the results of internal loan review portfolio stress testing and the current asset quality financial trends.
During the examination scoping phase, the Reserve Bank staff will analyze the results of recent loan review reports or audits prepared for an institution’s internal use and the Reserve Bank’s most current assessment of credit risk management to help establish the size and composition of loans to be selected for review. Examiners will review the findings and recommendations of the financial institution’s internal loan review program to help identify areas of risk. In selecting loans from each segment of the loan portfolio to review, examiners will include a section on the largest loans, problem loans (past due 90 days or more, nonaccrual, restructured, Special Mention, watch list, or internally classified loans), and newly originated loans. Examiners will ensure the sample includes a robust coverage of classified, Special Mention and watch credits.
At a minimum, loans selected for review from commercial loan segments should represent 10% of the committed dollar amount of credit exposure within the loan segment. Examiner sample size should be increased beyond the 10 % minimum when the examination scoping process or the internal loan review program has identified:
- Deficiencies with credit risk management and administration practices
- Loan growth has been unusually high
- Credit quality or collateral values have been adversely affected since the prior review by volatile local or national economic conditions
- Unreliable internal credit risk rating
Conversely, sample size should adhere to 10 % minimum under the following circumstances:
- Previous examinations concluded that internal loan review and credit risk identification is effective
- Internal loan review has reviewed a loan segment within the last 12 months and noted no material weaknesses
- The examination scoping process reveals no significant credit risk management issues
Examiners will determine classification amounts for retail credits using the Uniform Retail Classification Guidance (SR letter 00-8, “Revised Uniform Retail Credit Classification and Account Management Policy”). On an annual basis examiners will focus on one or more material retail loan segment exposures by Call Report loan type. Examiners will determine the appropriate sample of retail loans from material segments based on risk to be tested for compliance with internal credit administration policies and underwriting standards.
While there is no minimum coverage expectation for retail portfolios or segments, the goal of sampling is to arrive at an informed assessment of all aspects of retail credit risk management. If applicable, examiners will evaluate and test secondary market origination and servicing practices and quality assurance programs. Examiners will also sample other retail loans segments, as needed, from segments the examiners or internal loan review identify as exhibiting high risk characteristics such as liberal underwriting, high delinquency trends, rapid growth, new lending products, or significant levels of classified credits.
FOLLOW-UP EXPECTATIONS FOR EXAMINATIONS WITH ADVERSE FINDINGS
During the scoping of the examination oftentimes the Loan Review reports are utilized in determining the levels of portfolio coverage the examiners will select. Whenever examiners determine that 10% of the loans selected for review, or 5% of the loan dollars selected for review are showing risk rating variances they will deem the risk rating system unreliable. When a bank’s risk rating system is determined to be unreliable, examiners may need to expand the sampling to better evaluate the effect of rating differences on the bank’s ALLL and capital. In such instances the examiners will direct the bank to take corrective action to validate its internal ratings and to evaluate whether the ALLL or capital should be increased.
Obviously, these are additional regulatory steps that should be avoided if at all possible. Financial Institutions can avoid this additional oversight by regulators by implementing the following: (a) have appropriate policy and procedures in place to support the loan review program, (b) staff the loan review function with experienced credit officers and to (c) monitor the internal and external loan review findings specifically regarding risk rating variances.
To learn more about establishing an effective internal or outsourced loan review program contact us to discuss.
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- On Saturday June 14th, 2014
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