As the financial crisis deepened, regulatory requirements for financial institution's loan portfolios, both banks and credit unions, are much more stringent. The thought is that institutions can no longer book loans and forget about them; they must go back regularly and revisit the value of the asset backing the loan and the credit worthiness of the borrower as well as other items that may change. Considering the national financial crisis, many people have experienced changes in their personal and business finances.
As financial institutions prepare for or respond to an examination, questions around the loan portfolio are asked: what are the examiners asking for? How deep do they want the bankers to drill to find issues with the loan portfolio? What kind of data do they want from the institution? You may say, "but my institution is clean with very few problem loans, I won't need to do any of this research" - think again. They are also looking for loans that could go bad or the data to defend a clean portfolio.
Below are a few items taken from a regulatory agreement between a financial institution and their regulator, these are by no means comprehensive, nor are they the same for each regulatory agency, but each is similar in their requests:
"The Board shall develop, implement, and thereafter direct the Bank's management to ensure the Bank's adherence to systems which provide for effective monitoring of:
(a) early problem loan identification to assure the timely identification and rating of loans and leases based on lending officer submissions;
(b) statistical records that will serve as a basis for identifying sources of problem loans and leases by industry, size, collateral, division, group, indirect dealer, and individual lending officer;
(c) adequacy of credit and collateral documentation"
The regulators are asking for probable loss modeling of the loan portfolio, which loans are likely to go bad based on objective statistical data. Along with stratification analysis based on loan officer, industry, size, collateral, division, group, indirect dealer; additionally the institution may need to show the stratification of loan grading, FICO scores, FICO migration, zip code, branch office, loan size, or any other important data point. The institution should know its loan migration, how many "A" grade loans in a portfolio have shifted over time to "B" or "C" or lower grade loans.
They also want the assets backing the loans reanalyzed to make sure there is still enough value behind the loan if a foreclosure or repossession is necessary. Real-time asset valuations combined with stress testing the portfolio will be the key; how does the financial institution get objective real-time values on the assets that back a diverse loan portfolio that includes consumer, residential and commercial real estate for thousands of loans?
The Agreement goes on to state that the financial institution will...
"The Board shall within sixty (60) days employ or designate a sufficiently experienced and qualified person(s) or firm to ensure the timely and independent identification of problem loans and leases.
"The Board shall within sixty (60) days ensure that the Bank's management is accurately analyzing and categorizing the Bank's problem loans and leases.
"The Board shall establish an effective, independent and on-going loan review system to review, at least semi-annually, the Bank's loan and lease portfolios to assure the timely identification and categorization of problem credits. The system shall provide for a written report to be filed with the Board after each review and shall use a loan and lease grading system consistent with the guidelines set forth in "Rating Credit Risk" and "Allowance for Loan and Lease Losses" booklets of the Comptroller's Handbook. Such reports shall include, at a minimum, conclusions regarding:
(a) the overall quality of the loan and lease portfolios;
(b) the identification, type, rating, and amount of problem loans and leases;
(c) the identification and amount of delinquent loans and leases;
(d) credit and collateral documentation exceptions;
(e) the identification and status of credit related violations of law, rule or regulation;
(f) the identity of the loan officer who originated each loan;
(g) loans and leases to executive officers, directors, principal shareholders (and their related interests) of the Bank; and,
"The Board shall ensure that the Bank has processes, personnel, and control systems to ensure implementation of and adherence to the program developed pursuant to this Article.
In addition to the above requirements, this will require stress testing of the portfolio across several data points including, loan to value compression, FICO score movement, as well as interest rate adjustments. How will each type of loan portfolio respond to multiple, simultaneous stresses?
The board of directors has a lot of work to do in assisting the management team of the institution. The regulators are asking for more involvement with the institution and its problem loans requiring, objective defensible grading and stratification analysis, along with probable loss modeling, stress test simulations, and real-time asset valuation, of 100 percent of the portfolio. Moreover, if you think that your institution is completely clean - you are not on a problem list or don't have very many problem loans - well now you will have to prove it to the regulators.
Real, defensible, comprehensive portfolio analytics will be the solution - it will take a banker/CFO weeks or months to develop such a custom model for your institution in an excel spreadsheet. Or will it require anew strategy?