Loosening terms underscore importance of thorough loan review

Financial institutions' hard work following the financial crisis has paid off with improved credit. Based on the FDIC Quarterly Banking Profile for 3Q 2015:

  • Community banks (93 percent of all insured institutions) reported a 7.5 percent increase in net income (compared to 5.1 percent for all FDIC insured institutions) over the prior year due to improved net interest income and noninterest income and lower loan-loss provisions
  • 5.2 percent of community banks were unprofitable in 3Q 2015, the lowest level since the third quarter of 1998
  • All FDIC insured institutions showed asset quality improvement with net losses declining for the 21st consecutive quarter, noncurrent loan balances declined for the 22nd consecutive quarter, and loan-loss reserves were reduced in the 3Q 2015 for the 21st consecutive quarter

Unfortunately, these positive trends may come at some systemic costs. Expense cutting to boost profits may be negatively impacting regular reviews of loan portfolios and asset quality, especially for commercial loans.  In fact, the FDIC has warned it sees riskier loans as institutions accept more risk and appear to loosen credit standards. FDIC Chairman Martin Gruenberg said, “As loan growth has picked up, supervisory surveys have noted a relaxation in underwriting standards in some loan portfolios, including auto and multifamily housing portfolios. We have also seen growth in riskier loan categories, such as loans to leveraged commercial borrowers.”

One of the biggest issues found in loan reviews is missing borrower documentation. Financial instutitions can remedy this by imposing strict rules about clients submitting documentation on time, declining commercial line of credit renewals until documentation is submitted or adding fees if deadlines are not met.

Financial institutions should also take time to rate and downgrade distressed loans if necessary. Smaller institutions may rely on internal staff who are familiar with the institution, policies and culture, as well as the local economy and marketplace. Internal reviews also provide an opportunity for loan officers and relationship managers to stay current on their portfolios and reach out to clients to advise of possible future credit issues and offer advice on early corrective action. However, those some staff members could be biased or lack adequate expertise, making outside consultants a better option for an unbiased opinion. Yet again, loan officers may push back on external auditors because they don’t want certain credits downgraded.

Each financial institution needs to evaluate its own situation and act accordingly to identify and manage credit risk through a robust and comprehensive origination, underwriting and loan review process.

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