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Development and Maintenance of an Effective Loan Policy: Part 2*
by James L. Adams, Supervising Examiner, Federal Reserve Bank of Philadelphia

This article explores how lending activities can be administered and controlled through appropriate and sound underwriting criteria and practices that are governed by a sound loan policy.¹ A loan policy must establish who is responsible for ensuring that the underwriting criteria (financial capacity, collateral, pricing, and terms) are appropriately structured, analyzed, and monitored. This article also touches upon the incorporation of documentation requirements and the ongoing maintenance of the credit files.

Underwriting Criteria

A loan policy must address key credit decision criteria and underwriting factors such as the purpose of the loan, required financial information, collateral, risk ratings (borrower and facility), pricing, and policy exceptions. It may include metrics that make a particular borrower, industry, or loan type acceptable; for example, the policy may note debt-to-income or specific debt service coverage (DSC) ratios, interest coverage ratios, loan-to-value requirements, or appropriate amortization periods. The policy should also address postorigination activities, such as ongoing monitoring and credit administration, including postorigination monitoring of loan covenants, obtaining financial information, and assessing the borrower's ongoing ability to service the debt and ultimately repay the loan.

In its simplest form, the underwriting criteria and loan approval process will drive the bank's assessment and determination of a borrower's creditworthiness. When underwriting criteria are strong, the loan portfolio should perform better and credit losses should be minimized. It is not uncommon, especially in larger or more complex banks, to have separate policies, guidelines, and documentation requirements that correspond to different loan types (such as commercial real estate, land acquisition and development, residential tract development, asset-based loans, and commercial and industrial).

Smaller banks or banks offering fewer loan products may wish to include key type-specific underwriting criteria or standards within the general loan policy. No matter where policy underwriting criteria are included, the analysis of any borrowing request should address the basics of extending credit, including character (integrity), capacity (sufficient cash flow to service the obligation), capital (net worth), collateral (assets to secure the debt), and conditions (borrower and the overall economy).

Financial Information

The decision to lend should be based on a borrower's ability to repay an obligation. Obtaining and reviewing loan applications along with the appropriate borrower information, both financial and collateral-related, are a vital part of determining creditworthiness. For lenders to appropriately analyze borrower information and support the loan approval, the information must be accurate and obtained in a timely manner.

The loan policy must establish what financial information is required from a borrower and/or any guarantors both during the application process and while the credit remains outstanding. The frequency (monthly, quarterly, or annually) with which the information will be collected must be established, and the personnel responsible for obtaining the information should be identified.

The information required to make a sound lending decision will be dependent upon what type of credit extension is requested and who the borrowing entity is (for example, a corporation or an individual). A corporate borrower will typically be required to supply more information than an individual borrower applying for a personal loan. Key sources of financial information for either party include tax returns, financial statements, and/or cash flow statements. For corporate borrowers, financial documents should typically be prepared by an accountant. For individual borrowers, personal financial statements should be as complete and thorough as possible. The bank may also require additional or more detailed information to assess the borrower's financial condition. Any additional or special reporting requirements should also be articulated in the loan policy. The policy should specifically address the frequency of obtaining and refreshing borrower credit reports from credit reporting agencies. The loan policy should also outline what type of financial information is required for each type of borrower and extension of credit.

Collateral

When extending credit on a secured basis, lenders need to ensure that appropriate collateral valuations are obtained. When collateral is taken to enhance a credit and/or secure the ultimate repayment source of a loan, lenders must ensure that an appropriate lien is filed (perfected) and that the value of the collateral is sufficient to cover the outstanding balance of the loan. Collateral valuation is required at origination and should be repeated on an ongoing basis to ensure that the assets maintain their value. Appropriately trained staff must be available to perform ongoing collateral monitoring. The loan policy should discuss the types of collateral that are acceptable and unacceptable for each loan type. The policy should also discuss documentation requirements for various types of collateral that may support the lender's ability to exercise perfected liens.

Real Estate Collateral

A common form of collateral for many loans is some form of real estate. There are federal regulations and specific supervisory guidance that set standards for real estate lending and the valuation of real estate collateral.² The most important element of managing real estate collateral is obtaining a credible appraisal of the underlying property. The Federal Reserve's appraisal regulation requires institutions to obtain an appraisal for federally related transactions in excess of $250,000.³ An evaluation is allowed for transactions of less than $250,000. The regulation further establishes when appraisals are required, gives minimum standards for acceptable appraisals, and outlines the requirements for appraiser independence. Management must ensure that the regulatory requirements for real estate lending and appraisals are incorporated into their banks' lending policies. Regulatory agencies have also provided comprehensive supervisory guidance with additional detail for managing real estate collateral. The "Interagency Appraisal and Evaluation Guidelines" were issued in December 2010 to assist institutions in establishing safe and sound appraisal programs.⁴

Other Collateral Types

Other common types of collateral that often secure borrowings include accounts receivable, inventory, equipment, and investment securities. In some cases, the loan policy may allow the approval of less-common collateral such as specialty vehicles, boats, or precious metals. Regardless of the type of collateral, the loan policy should outline acceptable procedures for valuing and monitoring the collateral. It should also require that the valuations be performed by individuals with the appropriate skill sets and credentials. As with all collateralized financing, the underlying collateral value serves as the basis for determining how much money should be advanced; therefore, the controls over the preservation and maintenance of the collateral should be outlined within the policy. Lenders should determine the collateral value at the time the loan is originated and then perform periodic inspections to determine the collateral condition and location, as well as whether any curtailments (reduction or paydown of outstanding advances) are needed to keep the loan balance in line with collateral values.⁵ The policy should also require that borrowers regularly report information about any collateral that is securing a loan (for example, the composition of the collateral as well as its dollar value, location, and compliance with established advance rates). Loan documents should also ensure that banks are able to gain access to collateral at their discretion.

The policy should clearly describe how frequently collateral valuations will be performed. Typically, the frequency of valuations depends on the size of the exposure, the type of collateral, the location, and the established controls over the collateral. The borrower's overall financial condition can also be a key factor in the timing of a collateral valuation. When a borrower's financial condition deteriorates, the borrower may not be adequately maintaining the collateral, or a bank may find that collateral has been sold. This can have a negative impact on the bank's ability to rely on the collateral for repayment.

Perfection of Collateral

When collateral other than real estate is taken to secure a loan, a lien on the collateral is filed with the appropriate local or state authority. Most transactions secured by personal property and fixtures are governed by Article 9 of the Uniform Commercial Code.⁶ The loan policy and procedures should clearly specify the filing requirements, since timing differences and filing locations vary from state to state. Failure to file a financing statement in a timely manner and/or in the proper filing location can compromise the security interest in the collateral.

Unless the collateral is in the possession of the secured party, there must be a written security agreement that describes the collateral, and the agreement must be signed by the debtor. Institutions should regularly monitor lien filings to ensure that lien positions are maintained or that the perfected security interest in the collateral remains intact.

Risk Ratings

Management should establish an accurate and reliable risk rating system to help lenders make appropriate lending decisions and also establish sound monitoring criteria of the borrower's financial and managerial condition. Risk ratings should significantly influence the ultimate lending decision and help management determine if additional covenants and/or controls should be implemented. Risk rating definitions and scales will vary among banks, but the risk rating framework should be sufficiently granular to assist lenders in determining pricing, fees, covenants, provisioning, and specific capital allocation. Risk ratings should also play a vital role in determining overall portfolio administration.

Risk rating systems have evolved significantly over the past few years, including the implementation of dual risk ratings (separate borrower and facility ratings) and the significant increase in the granularity of the pass rating scale. While the details surrounding risk ratings may vary significantly among institutions, the risk rating process and philosophy should be clearly defined and incorporated into the loan policy.

Pricing

Elements of the loan policy may also influence pricing. Final pricing decisions can be complicated by competition from other lenders and the determination of appropriate premiums for default risk. Using a simple cost-plus loan pricing model requires that all related costs associated with extending credit are known before establishing interest rates and fees. A typical cost-plus model will consider the following four components:⁷

• The cost of the funds
• Operating costs associated with servicing the loan(s)
• Risk premium for default risk (considering the borrower risk rating and facility risk rating)
• A reasonable profit margin on capital

Management should be able to establish a pricing baseline using such a model but will be required to make the appropriate adjustments to be competitive and to receive an appropriate return.

Numerous other variables beyond those previously discussed affect pricing decisions, including loan type, payment structure, and borrowing and deposit relationships. This article does not discuss different pricing strategies but stresses that management must ensure that an appropriate pricing structure is established and implemented for each type of loan product offered. Management should continuously evaluate and adjust rates in response to changes in costs, competitive factors, or risks of a particular product type.⁸

Policy Exceptions

Exceptions to policies and procedures should receive the appropriate level of approval and should be documented in writing.⁹ Even fundamentally sound credits may contain policy exceptions; such credits may not always conform to all aspects of the loan policy, but there may be mitigating circumstances that would justify the loan's approval. The loan policy should establish processes and procedures for presenting nonconforming or exception loan requests received from creditworthy borrowers. After careful analysis, the exceptions that would give the lender comfort to approve the request may be approved or alternative structures may be presented.

To ensure compliance with regulatory guidance,¹⁰ the policy needs to establish review and approval procedures for exception loans, including loans with loan-to-value percentages in excess of supervisory limits. Policy exceptions and any mitigating circumstances should be well documented and presented to the designated committee for approval. All approved exceptions should be appropriately tracked and monitored on an individual and collective basis.

Frequent policy exceptions may indicate a loosening of credit underwriting criteria and/or a policy that is too restrictive. The underlying reasons behind frequently granted exceptions should be assessed and appropriate actions should be taken to ensure the policy is appropriately conveying the desired risk profile.

Loan Commitments

Loan approvals should be made in accordance with established underwriting guidelines and should be conveyed to the borrower in a formal commitment letter. While a commitment letter is not a promissory note, it is the document that contains the terms and conditions under which a bank will agree to extend credit. The commitment letter should be based on the approved terms of the loan and should be signed by both parties. It also should include, at a minimum:

• Borrower(s)
• Guarantor(s)
• Amount of credit facility
• Interest rate and methodology used to calculate the interest rate
• Term or tenor
• Security or collateral
• Distribution of proceeds
• Borrower warranties
  • Financial statements
  • Appraisals
  • Inspections
• Covenants
• Expiration or termination of commitment
• Acceptance and closing

Loan Approval and Closing

Once the commitment letter is returned with the borrower's signature and all the necessary negotiations have been completed, formal loan documents can be generated. Borrowers should sign a new commitment letter if any changes that differ from the original approval are negotiated.

The approval may also require the borrower and guarantors to submit (at least annually) financial information during the term of the loan. This will assist in the ongoing monitoring and review of the borrower's financial condition and in determining the continued appropriateness of the credit and whether to grant renewals or extensions.

Once signed, a loan approval or commitment letter can be routed to either the bank's internal loan documentation team or to an outside attorney for the preparation of the formal loan documents. After the loan documents are prepared and the borrower (or the borrower's attorney) has reviewed them, the bank and the borrower will meet for a formal loan closing during which all documents are signed and proceeds are advanced. Institutions should also have policies that govern the proper procedures for the disbursement of loan proceeds.

Maintaining Appropriate Credit Files and Documentation

The credit file is the repository for all information (financial and collateral) pertinent to the credit extension for the entire period that the credit extension remains outstanding.

Within the credit file, lenders should appropriately document the entire credit relationship and provide internal and external reviewers with all information necessary to analyze the credit during its life. The policy should identify who is responsible for collecting and maintaining all the required information during the life of the loan and specify who is responsible for reviewing the adequacy of the loan documentation. The policy should also contain procedures for identifying, citing, and correcting documentation exceptions and the parties responsible for carrying out these tasks.

The credit file should adequately document and confirm every aspect of the established underwriting criteria. For example, credit files should include all financial statements, credit reports, collateral inspection documents, past loan applications, memoranda, correspondence, and appraisals. Documentation requirements will vary according to the type of loan, borrower, and collateral.¹¹

Conclusion

Community banks are expected to have and maintain policies and procedures that provide an effective framework to control credit risk through sound underwriting criteria, appropriate credit file management, and sound documentation. While numerous loan policy topics and examples have been presented in this article and the previous one, the importance of tailoring the policy to banks' activities cannot be overstressed. The underwriting criteria along with the credit file maintenance and documentation recommendations presented within this article are by no means all-inclusive.