One of the benefits of having so many financial institutions as clients is our ability to stay constantly informed regarding regulatory “hot-button” issues.
Much of those issues have revolved around stress testing, credit underwriting support and enterprise risk management.
But a recent shift by regulators has been a sudden white-hot focus on loan policy exceptions. This issue was touched upon in the December 2015 interagency joint statement titled “Statement on Prudent Risk Management for Commercial Real Estate Lending”, which included the following language:
“The agencies…have observed certain risk management practices at some institutions that cause concern, including a greater number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risks associated with these concentrations.”
What can you do to satisfy these heightened expectations specific to loan policy exceptions? Below are some suggested best-practices:
- First and foremost, you must ensure that your institution has the proper reporting platform in place. This means that you have the reporting and loan operating system tools to accurately capture loan policy exceptions across the portfolio in a timely manner so that trends may be recognized.
- Next, you must aggregate your policy exceptions across the portfolio (ideally both your commercial and residential in-house portfolios, measured separately) and report on them periodically (either monthly or quarterly are typical measured periods), depending upon loan volume. Policy exceptions should be measured based on: loans originated with exceptions, total number of exceptions (as some loans have more than one) and loan dollars originated with exceptions.
- That data should then be measured in comparison to overall lending volume. In other words, if your institution generated 15 loans over a quarter and 5 had policy exceptions, your exception ratio would be 33% on a per loan basis. Likewise, if you generated $10MM in new loans and $5MM had policy exceptions, your exception ratio would be 50% on a per dollar basis.
- As a next step, these exception ratios should be measured and compared against historical performance, say a trailing six-quarter or twelve-month period, in order to identify performance trends. This data is best presented in both tables and graphs.
- The long-term performance noted above should be accompanied by narrative analysis that highlights both steady trends (upward or downward) as well as noted concentrations of exception areas (for example, exceptions on minimum debt service coverage ratios, maximum loan-to-value ratios or loans generated on a non-recourse basis).
- As a separate lens of reporting, your institution should also measure the overall percentage of loans in the portfolio with policy exceptions (on both a per loan and per dollar basis) at a given point in time (i.e. quarter or month-end) and then measure those levels against historical performance.
- As a last (and most crucial step), this policy exception reporting should be provided to both senior management and the Board of Directors and should be discussed in depth during Board meetings during which the data is presented. These robust discussions should be captured in the Board minutes.
Following these steps should position your institution favorably in this area. Institutions that have fallen short have been subject to varying regulatory actions, including MRAs (Matters Requiring Attention).
Reach out to our credit experts at Cobblestone Management with any questions on this or any other areas of risk management. We have been engaged by several institutions to assist in the building of prudent policy exception reporting platforms and we are at your service to do the same.