by Jeff Stone, VP, Regulatory & Compliance, CU Business Group
As we navigate uncertain economic times, having a well-developed credit risk review system in place to manage risk in your commercial lending portfolio is crucial.
The NCUA has named credit risk as one of its top supervisory priorities for 2023. In 2020, the NCUA and its sister agencies released Interagency Guidance on their expectations for how financial institutions should monitor credit risk within their portfolios.
The Interagency 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, and although this guidance is designed for all types of lending, it is especially relevant for commercial lending operations.
Consistent with these federal guidelines and industry best practices, CUBG recommends lenders focus on 5 key areas to ensure your credit union stays ahead of the curve during these turbulent and uncertain times. It is also important to mention that for each of these areas, independence from the lending process is the true key to complying.
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 historical loss experience for each segment of the portfolio is identified. Also, don’t forget to document your workout processes in your policy and procedures.
Lastly, it’s a good practice to review and update your risk rating system every few years. Once your program has grown, you should review your system based on your current loan portfolio to ensure it is complex enough or whether it needs to evolve. You should also review the system to ensure it has stayed current with the latest risks, industry concentrations, and local economic conditions.
If your credit union uses a CUSO or third party for underwriting and relies on their risk rating model, it’s important to be sure you fully understand that model and that it is suitable to your credit union’s loans and risk management and assessment philosophy.
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 is especially important now to gather the latest financial information and updated collateral valuations from your borrowers, as business conditions that may have looked rosy a year ago might have deteriorated in recent months.
Performing stress testing on a loan and portfolio basis is also important. At underwriting (and annual reviews) it will help you determine the property’s ability to absorb additional vacancies or reduced rents. On the portfolio, you should determine which loans and/or property types might be increasing in risk due to economic issues or higher interest rates. This is particularly important in areas where you have a higher concentration of loans.
Global debt service coverage is another good source of analysis. As business revenues have declined in certain sectors, it allows you to assess the borrower’s ability to ride out the storm through other sources of revenue (such as from owners and related entities). However, while global cash flow is an important part of credit analysis, business and owner/guarantor liquidity should be closely scrutinized and monitored.
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.
Do not 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 diligently:
Lastly, be sure to stay in tune with the NCUA’s board reporting requirements. According to the Interagency Guidance, an effective credit risk 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.
Additionally, credit unions should track the status of their CRE portfolio by inputting updated cap rates and NOI numbers, as determined at each annual review, into their host system in order to calculate updated DSCRs and LTVs. These updated numbers can be used to generate quarterly reports that identify potential problem loans by showing which loans have moved outside of policy requirements. These reports should be shared with management and the board.
CUBG can perform an independent portfolio review to help your credit union prepare for an upcoming audit or exam and meet examiner expectations for complying with this guidance. Contact us today to learn more.