There have been a lot of conversations around loosening underwriting standards in banks nationwide and regulators raising the issue at their safety and soundness exams at individual banks. The adage that we approve our worst loans in good times comes to mind. It is when credit officers face their biggest challenges as production goals and overconfidence take precedence over credit risk management.
Credit risk is typically defined as the risk that a financial institution’s earnings and/or capital is at risk due to losses from the decline or elimination of the value of assets (including off-balance sheet assets such as letters of credits, counter party agreements, etc.) due to a deterioration in the financial condition of a borrower or relationship to which credit is provided and any collateral pledged.
Bank management should take the opportunity to ensure the development and establishment of a system for credit risk management is current, including strong policies and procedures and a credit risk rating system that produces accurate and timely risk ratings, ensuring the soundness and appropriateness of a financial institution’s risk profile and complexity in changing times.
Management should be charged with, and responsible for, taking the initiative in developing, establishing and implementing the proper checks and balances, taking into consideration both the bank’s strategic objectives as well as safety and soundness. The Board should assure risk management systems are not only in place but are routinely reviewed in times of economic (and other) change.
Management should determine in the good times, not the bad, that the credit risk management system is functioning effectively and performing as outlined and approved in policy. Policy should be forward looking and not just in the rear-view mirror, which is what affected many banks in the “Great Recession” just 10-11 years ago. If policy has not been reviewed for current issues and concerns, we recommend that changes need to be made in the near term to assure profitability and safe and sound practices have been addressed.
When regulations and economic changes occur, management should assure policies and procedures and other internal controls are changed to promptly comply with the new rules and economic conditions. Further, when regulations change, management should not just do “what is required”. Thought must be put into the changes looking forward and not backward. Ardmore hears routinely from banks “we have never done it that way” or “we have never had that issue” or the “regulators are not forcing us to do it so why should we?” We do not believe this thought process is beneficial to producing a proactive response to change.
As an example, regulations regarding appraisal and appraisal reviews have changed, allowing banks to have higher thresholds for obtaining appraisals vs. evaluations. This could conceivably allow banks to take on additional risk unintentionally if not properly monitored and changed in policy. Let’s review an example of how this could play out in a bank.
Effective April 9, 2018, minimum thresholds under FIRREA appraisal requirements were raised as follows:
The appraisal threshold for commercial real estate (CRE) transactions increased to $500,000, up from $250,000:
CRE transactions below $500,000 now require an evaluation rather than an appraisal.
Banks may use appraisals even below the $500,000 threshold in appropriate circumstances such as for higher-risk transactions.
Single Family 1-to-4 residential property, including a construction loan for that property, remains subject to the $250,000 threshold.
The threshold for qualifying business loans (i.e., owner occupied real estate, or C&I loans secured by real estate that is relied upon and not taken as an abundance of caution) remains at $1,000,000. (Smaller loans require an evaluation.)
Ardmore has been hearing from clients and others that regulators are now more focused on evaluations than they have been historically, and it seems reasonable to expect that, given the higher threshold for appraisals, there will be even more attention on the quality of evaluations going forward. It is critically important that banks follow existing guidance on evaluations, including their content and the fact that they, like appraisals, must be reviewed. But are banks following that process? We are not confident they are in many cases.
The existing guidance on evaluations provides that they should contain sufficient information detailing the analysis, assumptions, and conclusions to support the credit decision. At a minimum, an evaluation should contain:
Property description, current and projected use
Estimate of market value as is, with any limiting conditions
Method used to confirm actual physical condition and extent of inspection
Analysis performed and supporting information
Description of supplemental information considered
Sources of information used
Preparer name and contact information (when a person)
Ardmore has seen a spate of examples of banks not being familiar enough with, or not putting into practice, the guidance issued in 2010 on appraisals, evaluations and appraisal reviews. It appears that the regulatory agencies have been observing that as well. A new FIL was issued addressing many of the examples that Ardmore has been observing including:
An appraisal must be obtained and reviewed before a final credit decision.
An appraisal is required for all CRE transactions > $500M and C&I transactions secured by RE > $1MM (with certain exemptions):
Farmland counts as C&I if repayment comes from sale of crops or livestock; it’s CRE if the land is rented to a third party.
There is a fairly long list of exemptions in FIRREA, but the most common are size and abundance of caution.
For transactions below these thresholds, an evaluation is required in lieu of an appraisal.
The FIL addresses abundance of caution requirements for documenting the sufficiency of sources of repayment other than the real estate but does not address term/amortization, which we have seen regulators use also to determine that something is not really abundance of caution. If it is structured like a real estate loan, there is a chance it will be considered non-AOC.
Every appraisal or evaluation obtained must be reviewed. That can be done internally, but whoever performs the review must be qualified and independent of the transaction, including not voting on approval. For complex and/or large transactions the bank is urged to consider a third-party review.
Appraisals prepared for another bank may be accepted, if they meet regulatory requirements and the bank’s policy – but they must be reviewed by the bank. Another review cannot be accepted.
Every renewal or modification requires assessment of whether market conditions or the collateral may have deteriorated. The regulatory Q&A has a very good decision tree (set out in examples) as to whether an appraisal or evaluation is required in each case – and then points out that an existing appraisal or evaluation may still be valid, and how the bank should document that it has made that decision.
The above example of regulatory change and the lack of compliance at some banks raises the question of whether your bank has adjusted policies and procedures and internal controls to ensure regulators do not find issues in your next exam. Not just the appraisal, evaluations and reviews but an overall look at where the bank is and needs to go.
Ardmore recommends the following for bank management and board consideration:
Prompt Policy and Procedures Review to assure they meet industry best practices and regulatory changes.
Determine if the bank’s risk rating matrix is sufficient for the risk profile and complexity of the bank.
Determine if you will meet the CECL guidelines in a timely manner including data collection.
Review of Roles and Responsibilities for:
Board of Directors
Review strategic objectives of the bank:
Review exceptions to policy and ascertain how they are performing vs. loans with no exceptions:
Approving exceptions to policy is considered loosening standards.
Increasing levels of policy exceptions can be a red flag to regulators, especially if there is more than one exception granted in a loan approval.
Evaluate Board Reporting:
Has the Board of Directors appropriately specified matters that require reporting and those that require approval?
Is Management reporting the current status to the Board of on a regular and timely manner?
Does the Board of Directors review whether the reporting system is sufficient for the bank’s risk profile?
Is there a clear and demonstrable balance between the Line Lenders and Credit Administration?
Roles and Responsibilities of Credit Risk Management.
Roles and Responsibilities of Lending Management.
Roles and Responsibilities of the Board in the credit process.
Roles and Responsibilities of Problem Loan Management Division.
Roles and Responsibilities of the Loan Review function and its ultimate reporting line.
Management of Credit Concentration Risk parameters defined.
Ardmore’s team of experienced professionals would be happy to discuss the above recommendations with your management group and or the Board, prior to the bad times coming at some point in the future. We encourage you not to wait for the economy or the loan portfolios to deteriorate or until the Regulators tell you it is time to change.
Lou Dunham is a Senior Vice President & Senior Director of Credit Risk Management at Ardmore Banking Advisors. Suzanne Storm is a Vice President of Credit Policy & Risk Management.