The causes of the recent financial crisis are well known – the tremendous expansion of subprime mortgages and their proliferation through the international financial system via securitization, for example. Yet, when one considers the number of bank defaults since 2008, the question presents itself: couldn’t these institutions have reduced their chance of failure by using a well-developed early detection system such as stronger loan review practices?
The obvious answer is, yes; if these financial institutions had implemented a more robust loan review system, the risks in their portfolio would have been on their “radar” and this defensive tactic would have allowed them to make proactive course corrections to avoid complete collapse.
Here are three key weaknesses that must be fixed in order for loan review practices to be more effective:
Improper Segregation of Duties. As a best practice, your internal auditor or audit committee should implement a loan review function, whether establishing an internal committee or outsourcing the function to an outside firm who specializes in loan review. However, at many banks, the loan review personnel (whether external or internal) reports to the senior lender. This creates an independence issue, as the senior lender is responsible for the portfolio and the loan review personnel is tasked with making an objective assessment of the portfolio’s quality.
It is imperative that your loan review personnel is able to communicate important findings and risk rating changes directly to the internal audit function or audit committee to ensure clear and objective updates of the status of the loan portfolio.
Improper Scope, and Depth of Reviews. Your institution is unique and so is your risk; your distinct needs and specifications should drive the scope and depth of your loan review. Although it’s important for your loan review personnel to review your 10 largest loans every year, you aren’t getting your money’s worth if they don’t drill down deeper. As best practice, the scope should be driven by the composition of your portfolio. For example, if in 2012 a financial institution decided to expand their commercial and industrial (C&I) lending, the loan review function should in turn take a larger sample of those C&I loans to ensure these loans are being underwriting in a safe and sound manner.
Assigning Incorrect Risk Ratings to Credit Facility. Loan reviewers are only human and none are correct 100% of the time. Even the phrase “correct risk rating” is subjective in and of itself at times. This means that, in all cases, the prudent approach is to ensure the reviewer supports their conclusions with a detailed analysis of both the primary and secondary sources of repayment as well as the collateral.
Of course, the best way to keep these and other practices front and center on your radar is by using a properly designed loan review process to help limit and identify problem loans. If you already have a process in place, remember to routinely recalibrate and rethink your loan review function to ensure the scope of reviews match your credit concentrations. Your review process should remain in tune with conditions in the market and you should customize it to address specific areas of risk in your portfolio.
When managing credit and regulatory risk, you don’t know what you don’t know. Put knowledge on your side by choosing a defensive, preventive strategy like loan review and avoid getting blindsided by the risks not on your radar.
Mr. Cooley is a principal of Synergy Bank Consulting Inc., a risk management advisory firm based in Chicago, IL., and can be reached at firstname.lastname@example.org. Mr. Bayer is risk management consultant for Sageworks, a financial information company and software provider in Raleigh, N.C. and can be reached at email@example.com.