Interagency guidance on credit risk review systems

New guidance indicates growing regulatory attention

By Giulio G. Camerini, Wayne Gniewkowski, and Steve Krase
Interagency Guidance on Credit Risk Review Systems

Federal financial regulators are soliciting final comments on proposed new “Interagency Guidance on Credit Risk Review Systems.” Banks, credit unions, and other regulated institutions should begin now to familiarize themselves with the new guidance and prepare to adopt and comply with its provisions.

The guidance is a clear indication of regulators’ continuing and intensifying focus on credit risk issues. Financial institutions should take this opportunity to revisit their existing loan review processes – regardless of whether they are handled internally or outsourced – to identify ways they can make this critical function more dynamic, responsive, and efficient.

Overview: The new guidance at a glance

The proposed new “Interagency Guidance on Credit Risk Review Systems” will supersede the previous “Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL),” which was most recently updated in 2006. It is intended to reflect current industry credit review practices and procedures, including the Financial Accounting Standards Board’s recent adoption of the current expected credit losses (CECL) methodology for calculating allowances for credit losses. The new guidance also is designed to align with the “Interagency Guidelines Establishing Standards for Safety and Soundness.”

Broadly speaking, the guidance outlines principles that regulated institutions should use in developing and maintaining their credit risk review systems. It will apply to all financial institutions supervised by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., or the National Credit Union Administration.

Goals and objectives: What a credit risk review system achieves

The new guidance acknowledges that the nature of credit risk review systems will vary based on an institution’s size, complexity, loan types, risk profile, and risk management practices. The update is intended to be appropriate for institutions of all sizes, and it describes a broad set of risk review practices that can occur either within a dedicated unit or in multiple units throughout an institution.

Regardless of the structure, the guidance directs that an effective credit risk review system should accomplish a number of critical objectives, including the following:
  • Promptly identify loans with actual and potential credit weaknesses so that timely action can be taken.
  • Validate and adjust risk ratings for loans with weaknesses that could jeopardize repayment.
  • Identify relevant trends that affect the quality of the loan portfolio and highlight segments of the portfolio that are potential problem areas.
  • Assess the adequacy of internal credit policies and loan administration procedures, as well as the organization’s adherence to these policies.
  • Monitor compliance with applicable laws and regulations.
  • Evaluate compliance with lending policies as well as the quality of loan approvals, monitoring, and risk assessments.
  • Provide management and the board of directors with objective, independent, and timely assessments of the overall portfolio quality, along with quality information for financial and regulatory reporting.

One of the foundational elements for achieving these objectives is an effective credit risk rating framework. The guidance spells out essential attributes this framework should possess, including a documented credit risk rating system, grouping of loans that warrant special attention, and information on the organization’s historical loss experience for each segment of the loan portfolio.

The framework also should include explanations of why certain loans warrant management attention, evaluations of the effectiveness of approved workout plans, and a method for communicating this information to senior management and the board.

System components: Critical elements of a credit risk review system

In addition to an effective credit risk rating framework, the new guidance also lists other critical elements that regulators expect to see in credit risk review systems, beginning with a written credit risk review policy that is reviewed and approved by the board of directors at least annually. This policy should include a description of the overall risk rating framework and establish responsibilities for loan review. More specifically, it should address:

  • Qualifications of credit risk review personnel. Those carrying out this function should be knowledgeable in both sound lending practices and the institution’s particular lending guidelines. They also should possess knowledge of relevant laws, regulations, and supervisory guidance.
  • Independence of credit risk review personnel. An independent assessment of risk should be performed by personnel who are not part of the loan approval process. While larger institutions might establish a separate department staffed with credit review specialists, smaller organizations might rely on an independent committee of outside directors or on qualified officers and staff who are not involved with the specific credits being assessed. In either case, the credit risk review function should report directly to the board of directors or a board committee.
  • Frequency and scope of reviews. Significant loans, loan products, or groups of loans should be evaluated at least annually, on renewal, or more frequently if there are indications of deteriorating credit quality or other risk factors. The guidance also spells out a variety of specific factors such as size, risk indicators, and related-party or affiliate loans that could trigger the need for review.
  • Depth of transaction reviews. Loans selected for review should be evaluated for specific indicators of credit quality, along with a broad range of other issues such as collateral, repayment capability, adherence to covenants, and credit loss estimation.
  • Discussion of findings and follow-up. Risk rating differences between loan officers and loan review personnel should be resolved according to a prearranged process. Identified deficiencies, weaknesses, and existing or planned corrective actions should be reviewed with appropriate officers or management, with an effective system for resolving issues.
  • Communication and distribution of results. Results of the credit risk reviews should be communicated to the board or appropriate board committee at least quarterly, along with a review of comparative trends that identify any significant changes in the overall quality of the loan portfolio.

In a sense, the proposed new guidance can be viewed as a welcome development, providing banks and credit unions with long-awaited clarity and direction regarding current regulatory expectations. By familiarizing themselves with the pending provisions, lending organizations can help simplify and streamline their compliance effort. Even more important, they can use this event as an opportunity to implement a comprehensive review of their credit review systems within the context of their overall risk management capabilities.

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Guilio Camerini
Giulio Camerini
Principal, Financial Services Consulting
Wayne Gniewkowski
Principal, Financial Services Consulting
Steve Krase
Steve Krase
Principal, Financial Services Consulting