Vital Function for Community Banks May Be Outsourced if Care is Taken

By Dan Horan

The loan review function is a tool that monitors the quality of the respective institution’s loan portfolio as it relates to internal lending policies, the effectiveness of the credit administration function, and is thus a tool to be utilized by senior management and the board. The loan portfolio is typically the asset that presents the greatest potential risk for loss exposure to banks. The board of directors of each financial institution has the legal responsibility to formulate appropriate lending policies and to supervise ongoing implementation thereon. Although smaller institutions are not expected to maintain separate loan review departments, it is essential that an effective loan review system be in place at all regulated financial institutions.

This system will provide vital and objective information to senior management and the board regarding overall credit quality, trends in the various portfolio segments, adequacy of the ALLL, identification of loans with well-defined weaknesses, and adherence to and/or deviations from established loan policies and procedures – all of which is critical for financial and regulatory reporting purposes. This continuous evaluation of the quality of the bank’s loan portfolio must be specifically outlined within the bank’s lending and collection policies, as approved by the board.

Any lending policy should not be a static document, but rather one that is reviewed periodically, and revised accordingly, to reflect changing conditions within the community served. A separate loan review policy or system should be incorporated within the lending or credit policy manual, which should include a written description of the overall credit grading process, frequency and scope of reviews and qualifications, and independence of loan review personnel. Any loan review function, whether it is internal or via an independent loan review service like CEIS Review Inc. (CEIS), should be designed to address the following objectives:

  • Promptly identify loans with well-defined weaknesses so that timely action can be taken to minimize the bank’s credit loss.
  • Provide essential information to assess the adequacy of the bank’s ALLL.
  • Assess the adequacy of and adherence to the bank’s loan policy and procedures and that the loan portfolio is in compliance with federal and state regulations.
  • Provide management and the board of directors with an objective assessment of the overall portfolio quality.
  • Identify relevant trends that might affect the collectability of the loan portfolio and isolate certain potential problems.
  • Identify weaknesses in loan documentation and credit file reporting and provide appropriate corrective recommendations.
  • Monitor collateral on secured loans for adequacy thereon (based on the guidelines set forth within the bank’s credit policy) and for perfected collateral liens.
  • Ensure that appraisals on troubled real estate and other secured loans are maintained on a timely basis.
  • Review all troubled problem loan reports for appropriateness of the plan of action, risk rating designation and loan loss reserve allocation.

Many regional banks across the country that are not sufficient in size to maintain a separate and distinct loan review department commonly outsource this function. While outsourcing, an institution should ensure that the loan reviews are conducted by experienced professionals that have senior or executive level banking experience, as opposed to junior level individuals that may not recognize potential issues before they arise.

Whether the loan review function is internal or external department, that department should be able to produce a professional and decisive report for the institution’s management to utilize to better manage their respective institutions. In order to do so, the report should elaborate on the overall portfolio’s quality, trends, administrative process, and policy adherence.

A loan review audit by an independent professional firm experienced in the business is not just another internal management tool – it is a necessity for the establishment of credibility to external entities that review and supervise the respective organizations. Financial institutions should strive for “satisfactory” or better ratings, so as not to be restricted in their individual business models or platforms that are used on an ongoing basis to serve the local communities within which they reside.

Dan Horan is an executive consultant with CEIS Review, providing commercial loan review and related consulting services for clients.