Building a robust process allows for greater agility while managing risk.
Regulators consider an effective loan review system vital to financial institutions’ efforts to meet safety and soundness standards. In fact, banking regulators are in the process of issuing updated guidance on loan or credit risk review systems as a standalone document (rather than including it in guidance related to the allowance for credit losses, as it is now) to emphasize their importance in broader risk management efforts.
But beyond making it easier to withstand examiners’ scrutiny, is a strong loan review system good for your credit union’s business?
Effective Credit Risk Review Promotes Lending Agility
Absolutely, says Ancin Cooley, principal with Synergy Bank Consulting and Synergy Credit Union Consulting, Elgin, Illinois. Cooley is a former Office of the Comptroller of the Currency examiner who provides loan reviews, outsourced credit analysis, strategic planning and risk appetite consulting. A strong loan review function is especially important for helping financial institutions be nimble, he explained during the recent webinar, “Best Practices for Credit Analysts.”
Being able to move quickly is a business advantage. That’s true whether a credit union aims to take on loans with a certain type of risk or a higher probability of default or whether it is trying to pivot away from a certain type of loan or risk.
“When you have a strong loan review process, you’ll know the issues that are happening in your portfolio faster,” said Cooley. “And you’ll be able to react to changes in the market faster without concern that you have ‘bombs’ waiting for you in the portfolio.” Instead, he said, the sentiment at your institution will more likely be, “Hey, we have an amazing loan review team, and if [a bomb] was there, they will find it.”
Objectives of Effective Credit Risk Review Systems
The proposed Interagency Guidance on Credit Risk Review Systems says promptly identifying what Cooley calls “bombs” is one of the seven objectives of an effective credit risk review system—the system should identify “loans with actual and potential credit weaknesses so that timely action can be taken to strengthen credit quality and minimize losses.”
Other objectives outlined by the guidance, many of which also support business goals, are to:
- validate and, if needed, adjust risk ratings, especially for loans with potential or well-defined credit weaknesses;
- identify relevant trends affecting the loan portfolio’s quality and highlight segments that are potential problem areas;
- assess the adequacy of and adherence to internal credit policies and loan administration procedures and monitor compliance with applicable laws and regulations;
- evaluate lending personnel’s compliance with lending policies and the quality of their loan approval, monitoring and risk assessment;
- provide management and the board of directors with an objective, independent and timely assessment of the overall quality of the loan portfolio; and
- provide management with accurate, timely credit quality information that they can use for financial and regulatory reporting, including determining the allowance for loan and lease losses or the allowance for credit losses.
Keys to Effective Loan Review and Risk Mitigation
During the webinar, Cooley explained that the keys to an effective loan review function are independence, sufficient stature of the loan review officer to speak to the senior lender as a peer, and adequate funding for training as well as the hiring and retention of strong senior loan reviewers.
While the proposed guidance doesn’t explicitly say the credit risk review function is good for a credit union’s business, many community financial institutions derive a significant portion of income from lending. Furthermore, lending is a major source of risk for most credit unions. It makes sense, then, that a solid credit risk review function would help protect the institution against a material impact on the business.
Credit risk review, according to the guidance, evaluates an institution’s significant loans, loan products or groups of loans “at least 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.” Credit risk review serves as a monitoring system, too, in a sense. “The credit risk review function can also provide useful continual feedback on the effectiveness of the lending process in order to identify any emerging problems,” the guidance says.
In addition to protecting against credit risk, effective loan review can defend a credit union against other risks, each of which can affect a credit union’s revenues and bottom line:
- Liquidity risk: The credit review process helps protect against surprises in cash flow that can have a corresponding effect on the balance sheet.
- Strategic risk: Problem loans and portfolios can alter a credit union’s plans for allocation of resources and new products.
- Compliance and reputational risk: An independent credit review function provides oversight that heads off exposure to corrective actions, fines, civil money penalties and diminished reputation.
Certainly, a strong credit risk review function is important for making examiners happy. However, creating an independent, strong and adequately funded loan review function can also be good for your business.
Learn more about loan reviews from Abrigo's webinar, “Best Practices for Credit Analysts.”
Mary Ellen Biery is a senior writer and content specialist at Abrigo, a software company that offers technology that banks and credit unions use to manage risk and drive growth, headquartered in Austin, Texas.