As liquidity and interest rate risks settle, the examiner spotlight has turned toward credit risk, reflecting the growing economic uncertainty, rising household debt and delinquency trends. A comprehensive loan review service can help financial institutions stay ahead of regulatory examinations by providing an enhanced understanding of their portfolios and potential risk exposure.
An efficient, thorough loan review is a vital tool to reveal any gaps in underwriting and regulatory compliance in a financial institution’s loan portfolio.
The Importance of Loan Reviews
A robust annual loan review program is both a best practice and a regulatory expectation. The most effective programs help financial institutions verify the ongoing creditworthiness of borrowers, evaluate compliance with loan terms and covenants, and identify emerging risks.
An internal annual review program should be paired with an experienced loan review team that focuses on assessing risk management practices and expanding the portfolio penetration.
Loan Review Core Competencies
Loan reviews are typically performed by bank or credit union staff, or by third-party consultants. When reviewing commercial loan files and documentation, they may uncover vulnerabilities in the following areas.
Covenant Breaches
Evaluating borrower compliance with loan covenants often costs the lender significant time and resources. A loan review can help identify and analyze breaches of both affirmative and negative covenants in the loan agreement.
Documentation Exceptions
A thorough loan review can identify documents that are missing from files, check that mortgages and UCC filings are properly recorded, and ensure collateral is appropriately insured. Uncovering these issues as part of a loan review, as opposed to an examination, demonstrates that the bank has effective processes in place to identify documentation errors.
Underwriting Consistency
An evaluation of loan approval documents may identify underwriting discrepancies across the team or ineffective application of policy. Exceptions to policy should be well-disclosed with risk mitigants in any approval request. Loan review should ensure a consistent underwriting approach is taken. It should also confirm that policy exceptions are appropriately reported.
Lack of Robust Global Cash Flow Analysis
A lack of updated financials — or the lack of resources to analyze — could result in incomplete or stale global cash flow analyses. Outsourced loan review engagements should not only validate the work performed by the financial institution’s credit and underwriting teams but also request and spread the most recent financial information.
Loan Review Steps
A loan review is typically broken down into three steps: the pre-file review, the file review and the post-file review.
Pre-file Review
The first step in a loan review involves reviewing documents and selecting a loan sample. The loan review team will assess a variety of documents, including:
- Loan policy and underwriting guidelines
- Delinquent loan reports
- A list of outstanding loans
- A problem loan report
The loan review team will also choose the sample selection of loans to include in the review. Reviewing an entire portfolio is often impractical for a loan review team, so they will typically choose a sample of files to analyze that reflects the overall portfolio quality.
File Review
Once the loan sample is selected, the team will determine a file review schedule. This step centers around reviewing collateral and underwriting files, as well as meeting with lending staff to understand their process from intake to close. Throughout this step, the loan review team will also check for adherence to policies and procedures.
Post-file Review
After the file review, the loan review team will draft a report of its findings and recommendations for corrective actions or policy updates. Critical issues are also highlighted and escalated to senior management.
Elements of a Loan Review Report
A loan review report should contain analysis and insight gathered from conversations with lending staff during the review process. Ideally, the report will focus on high-level findings and trends within the portfolio, including:
- Summary of coverage and procedures performed
- Recommended risk rating changes
- Weaknesses identified within the loans
- Overall trends found in the portfolio
- Adherence to loan policy and administrative processes
At the conclusion of the loan review, a draft report can be provided to management, allowing them to respond to the recommendations. A final report that incorporates management’s input will then be issued.
Financial Examiner Focus
Undergoing a comprehensive loan review supports favorable regulatory examination outcomes. Loan reviews enable financial institutions to uncover vulnerabilities in their portfolios, allowing them to address these issues proactively before examinations.
Financial examiners recognize that acquiring deposits and making sound lending decisions is the core business model of most financial institutions. The exam team is not there to criticize every lending decision.
Examiners within financial institutions are principally responsible for:
- Evaluating the risk tolerance established by strategic plans and policies
- Identifying the actual risk profile of the portfolio
- Ensuring that appropriate risk management practices are implemented
In recent years, particular focus has been directed toward commercial real estate (CRE) concentrations and the extent of underwriting exceptions.
CRE Concentrations
In the eyes of an examiner, CRE lending equates to more risk on the balance sheet, meaning examiners are likely to place an emphasis on elevated concentration levels. With heightened risk, institutions are expected to have enhanced credit risk management practices. Any loan review team should be able to assess and opine on the effectiveness of these enhanced practices.
In addition to other forms of analysis, loan-level stress testing, market analysis and robust reporting are critical to managing concentrations. A loan review program that reviews concentration risk management will prepare institutions for regulatory examinations.
Underwriting Exceptions
Documentation, approvals and reporting of exceptions are three key attributes of sound credit risk management programs. Specifically, the financial institution’s loan review team should:
- Highlight any exceptions to policy in the underwriting document/annual review
- Identify risk factors associated with the exception
- Outline any mitigants as to why an exception should be made
- Ensure appropriate approvals are obtained
Finally, there should be comprehensive reporting on loan underwriting exceptions. A third-party loan review team can provide guidance on policy exception management, loan policy compliance and underwriting trends.
Enhanced Credit Risk Management Practices
In light of recent discussions and industry anecdotes, regulators are no longer focused solely on asset quality when assigning ratings. When assets perform strongly but are supported by weak credit risk management practices, institutions risk a potential downgrade in asset quality and management ratings.
Specific regulatory guidance is available for addressing credit concentrations, providing a playbook for strong ratings. However, this should not be the reason for implementing a sound credit risk management program.
Effective tools, on both the loan and portfolio levels, can help guide institutions to a more valuable loan portfolio in the long run and benefit all stakeholders.
Stress Testing
Stress testing is an essential tool that helps evaluate risk as it pertains to cash flow and collateral. During a loan-level stress test, an institution tests how individual loans could potentially perform under adverse economic conditions, such as rising interest rates, a change in cap rates, increased vacancy or higher operating costs.
Various methods are used to perform portfolio-level stress testing analysis, including bottom-up and top-down tests. A bottom-up portfolio stress test aggregates individual loan stresses and compiles the information on a portfolio-wide basis. A top-down portfolio stress test provides a less intrusive view into the portfolio by using loan type exposures to stress.
Regardless of the approach used, both provide additional insight into the risk that underlies the loan portfolio. The most successful stress tests:
- Ask “what if” questions about vulnerabilities (e.g. “what if interest rates, cap rates, vacancy, or expenses do this?”)
- Determine the impact a stress event could have on capital
- Incorporate the analysis into capital and strategic planning processes, making the necessary adjustments to maintain an effective risk management program
Loan-level Market Analysis
Loan-level market analysis goes beyond traditional underwriting or credit risk rating systems and evaluates individual loans within a financial institution’s portfolio. Effective analysis examines various market factors, including:
- Industry Trends
- Geographic Influences
- Economic Indicators
- Borrower-specific Market Positioning
Contextualizing each loan within the broader market environment can help financial institutions improve risk detection, enhance their portfolio management and achieve proactive compliance.
Portfolio-level Market Analysis
Market analysis from a portfolio perspective must go beyond general economic trends and evaluate the specific dynamics affecting the institution’s CRE exposure, including:
- Local and regional market conditions
- Property type performance
- Supply-demand imbalances that could impact asset values and borrower repayment capacity
Institutions should integrate this analysis into their portfolio risk management framework and use it to inform underwriting standards, stress testing scenarios and capital adequacy assessments. A strong market analysis helps identify emerging risks tied to geographic or sectoral concentrations and supports proactive adjustments to lending strategies.
Ultimately, this approach ensures that the institution’s CRE portfolio remains resilient under varying economic conditions. It also helps align the portfolio with the supervisory expectations for sound risk management practices.
Robust Reporting
Comprehensive management information system reporting that provides timely, accurate and actionable insights into portfolio risk should be the requirement for all institutions. These systems support regular reporting to senior management and the board of directors, including detailed analyses of:
- CRE exposures
- Concentration levels as compared to limits and sublimits
- Portfolio stratification (type, industry, DSCR, LTV, risk rating, geography, etc.)
- Stress testing outcomes
Reports must be sufficiently granular to identify emerging risks and support strategic decision-making, including adjustments to lending limits or risk mitigation strategies. An experienced loan review team can help institutions develop and identify the need for new reporting.
Guiding Financial Institutions Forward
While financial institutions face many challenges, spending valuable time and resources navigating the regulatory landscape should not be a hurdle. By using a third party to conduct a loan review and help assess portfolio risks, institutions can save time and energy.
With more than 75 years of experience advising banks and credit unions, Cherry Bekaert’s Financial Institutions industry team understands the increasingly complex operating environment and offers tailored services to reduce risk and drive sustainable growth.
Reach out to your Cherry Bekaert advisor today to schedule a free consultation and learn how we can help your financial institution proactively assess credit quality.
