By Jeff Stone, featured in the Credit Union Times

The economic fallout from the COVID pandemic is driving a concerning rise in credit union commercial loan risk. To address this challenge, the NCUA and its sister agencies released new Interagency Guidance in June 2020 to reinforce their expectations for how financial institutions should monitor credit risk within their portfolios.

The guidance provides a broad set of practices that can be used to form a credit risk review system consistent with safe and sound lending practices. Although this guidance is designed for all types of lending, it is especially relevant for commercial lending operations.

The Small Business Administration has also released new guidance for underwriting 7(a) loans during the COVID-19 pandemic, providing a solid structure for managing risk in non-SBA lending, as well.

Consistent with these federal guidelines and industry best practices, CU Business Group recommends lenders focus on five key areas to ensure your credit union stays ahead of the curve during these turbulent and uncertain times.

1. Build credit risk management into your policies and procedures.

The NCUA and state regulators have scrutinized lending policies more closely in recent exams. The good news is that through the course of hundreds of credit union commercial portfolio reviews performed over the past few years, CUBG has found that on the whole, credit union commercial lending policies and procedures are now more robust, detailed and appropriate to the level of risk present in the portfolio.

According to the Interagency Guidance, “An effective credit risk review system starts with a written credit risk review policy that is reviewed and typically approved at least annually by the institution’s board of directors or appropriate board committee to evidence its support of, and commitment to, maintaining an effective system.”

Make sure your credit risk review policy addresses the following areas, per the guidance:

  • Qualifications of credit risk review personnel
  • Independence of personnel
  • Frequency of reviews
  • Scope of review
  • Depth of transaction or portfolio review
  • Review of findings and follow up
  • Communication and distribution of results.

Also, it’s important your maximum loan limits and thresholds are listed correctly and consistently throughout your policy and procedures, and are updated accordingly when changes are made.

2. Implement a Credit Risk Rating System.

According to the guidance, your independent credit risk review team is responsible for creating a Credit Risk Rating (or Grading) Framework.

This framework should include a formal description of the components of each rating grade and be documented in your policy. Lending staff is responsible for assigning accurate and timely risk ratings and identifying emerging problems.

The framework should ensure that problem loans are identified and included in a Watch List, that approved workout plans are evaluated for effectiveness, and that historical loss experience for each segment of the portfolio is identified. Also, don’t forget to document your workout and troubled debt restructuring (TDR) processes in your policy and procedures.

Finally, it’s a good practice to review and update your risk rating system every few years to ensure it stays current with the latest risks, industry concentrations and local economic conditions.

3. Tighten your underwriting and credit analysis.

Although not specifically laid out in the Interagency Guidance, the underwriting and credit analysis stage is a crucial step in managing risk in your commercial portfolio, especially during times of economic turbulence.

It’s especially important now to gather the latest financial information and updated collateral valuations from your borrowers, as business conditions that may have looked rosy at the end of 2019 were likely to have deteriorated in the first half of 2020.

CUBG recommends using uniform credit analysis (UCA) cash flow to analyze how a business utilizes cash in its operations, and examiners are now homing in on this tool as a key determinant of a borrower’s ability to repay the loan.

Global debt service coverage is another important source of analysis. As business revenues have declined in certain sectors, the ability to ride out the storm through other sources of revenue (such as from owners and related entities) is imperative.

The SBA has published a list of additional factors lenders should consider in analyzing new requests during the COVID pandemic, including whether the industry sector has been severely impacted by the crisis, the reliability of historical financial information, and how diversified the business is with regard to its supply chain. CUBG also recommends creating a customized COVID statement for each business or industry, and including it with all annual reviews and credit memos for the foreseeable future.

4. Ensure reviews are done annually.

Although NCUA regulations state that credit unions must conduct “periodic reviews” on their member business loans, examiners are strongly suggesting these reviews be done on an annual basis.

The purpose of such reviews is to reevaluate the risk of the transaction to see if it is still reasonable and appropriate for the size, type and nature of the loan.

Don’t get too hung up on timing the annual review exactly with the anniversary of when the loan was originally booked. If possible, schedule the review around 90 days after the borrower files their taxes or releases their financial statements to ensure the freshest information is available.

Portfolio reviews should also be conducted annually, to help reveal weaknesses in loan operations or structural risks like consistent violations of internal policy and procedures.

The scope of your annual portfolio review is important, and should cover all individual credits over a specified size representing a diverse cross-section of the portfolio. The review should evaluate various criteria including credit quality and underwriting, borrower performance and adequacy of sources of repayment, guarantor creditworthiness, and the effectiveness of account management and credit mitigation strategies.

Examiners are paying close attention to portfolio reviews, and many lenders retain an independent, third-party firm for these engagements. This ensures the review is performed with objectivity and no conflict of interest, and helps bring industry best practice and expertise to bear.

5. Report out diligently.

Finally, be sure to stay in tune with the NCUA’s board reporting requirements. According to the Interagency Guidance, an effective credit management system includes a process to identify any deficiencies or weaknesses in the portfolio or individual loans, and mandates effective and regular communication to the credit union’s board, relevant internal committees and management of all credit risk reviews. The guidance requires credit unions to report this information to the board on at least an annual basis, but CUBG suggests reporting with greater frequency, such as quarterly, given the current economic volatility.

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