The proposed Member Business Lending (MBL) regulations do move from one that is prescriptive to one that is principal based. This gives more freedom, but the principles that must be used are sound lending guidelines and practices. The first place this must be used is in your loan policy.
Policy must be approved by you Board and must be examined at least annually and more often as necessary changes are required. They must provide for control, management, and measuring the commercial lending activities of the CU. The policies must make sure the CUs business lending is safe, that risks are assessed timely, and that operations are set up to properly monitor the portfolio. The new regulations also suggest a separation of duties between underwriting, portfolio monitoring, and collections when possible.
Each CU should have a comprehensive risk rating system to identify the risk to the borrower, the relationship, and the overall lending portfolio. We suggest that multiple risk rating models are needed, as it is next to impossible to use one model to capture relevant factors that are present in different types of commercial real estate, C&I, and agriculture loans. Also, the factors used in each model should be examined and changes made, when and indicator loses its effectiveness in identifying the credit risk or when a stricter or looser judgement is warranted.
The risk rating system also becomes a living history of the credit and there should be a way to monitor the rating from closing to payoff. It also can be used to gauge the risk in the commercial department. This, combined with an analysis of rate exposure, provide a good way to help determine possible upcoming issues to the CU’s assets.
Loan policy should identify the types of loans permitted, trade area, maximum loans amounts for loan category and borrowing group, qualifications of the lending staff (now this is an area that you can determine), the loan approval process, and underwriting standards. Underwriting should culminate in a loan write up that contains all relevant information of the credit and analysis of the borrower, guarantor, industry, and collateral in a logical format. The analysis should look at income and expense trends, debt service ability, balance sheet changes, and how these impact the ability to service debt.
All related parties should be looked at in order to determine if they provide additional strength to the credit or could be a possible drain on company liquidity. Global cash flow and stress testing are quite applicable here.
Due diligence requirements should be set forth in analyzing the loan. Requirements for financial reporting should also be established in order to make an informed credit decision. Policy minimums for financial reporting will differ depending upon the size, complexity, collateral, and repayment source of the loan. Requiring an audit for a single tenant office building may be overkill but an audit would be appropriate for a large manufacturing firm.
Next, LTV thresholds should be set based upon the type of collateral offered. An example here is the LTV with an asset with changing values, such as accounts receivable and inventory, should be lower than one with a more stable value, such as equipment or real estate. But even within more stable collateral, there will be variations. We will contend that all other things being equal, the prudent lender will be more comfortable with a higher LTV on an apartment building than on a specialized single-purpose property. Also, concern should be paid to real estate values in areas that are subject to sharp price increases.
The proposed policy also identifies different risk management processes that should be used to monitor the credit. The ones listed are using loan covenants, periodic reviews of the credit, using a risk rating system, and the approval and monitoring of loan exceptions. We contend that these are all valuable methods and are all used together to watch credit performance. The result of certain covenants, such as a Debt Service Coverage Ratio, or Debt to Asset Ratio, will be used as factors to assess the risk ratings. This way moves the often subjective method of risk rating to an objective measurement.
All of these items in the proposed loan regulations require that the CU grow up in its commercial loan policy, the handling of credit management, underwriting, and portfolio review. Gone will be the days that you can run a business department on a policy that can be read and digested within 10 minutes. And you also cannot just fall back on the regulations for your policy specifications. It requires the institution to come up with strong, thoughtful tools to manage and underwrite loans.
I would encourage everyone to read the proposed policy changes and make comments. There are a lot of items that should improve the commercial credit management over present regulations. Comments are due by August 31st. Also, we are Midwest Business are here to help. We have written policy, created risk rating systems, helped instill sound credit practices in institutions, and also serve as a backup piece for your credit administration. Contact us for help.