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Summary Table of Contents
Chapter 1: The Importance of the Loan Review
Chapter 2: Risk Management and the Lending Process
Chapter 3: Reviewing the Credit File
Chapter 4: Reviewing the Document File
Chapter 5: Commercial Real Estate Loans
Chapter 6: Reviewing Appraisals
Chapter 7: Specialized Commercial Loans
Chapter 8: Analyzing the Commercial Loan Portfolio
Chapter 8A: Allowance for Loan and Lease Losses (ALLL)
Chapter 9: Problem Loans
Chapter 10: Preparing for Bank Examinations
Chapter 11: Compliance Issues and Trends That Impact Commercial Lending
Chapter 12: Basel I, Basel IA, and Basel II
Chapter 13: Special Issues Facing Foreign Banks
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Contents
Acknowledgments....................................................................................................................................... iii
About the Authors........................................................................................................................................ v
How to Use This Manual ........................................................................................................................... vii
Summary Table of Contents ....................................................................................................................... ix
Chapter 1
The Importance of the Loan Review
Overview.............................................................................................................................................. 1—1
The Corporate Structure Supporting Oversight ................................................................................... 1—1
Board of Directors and Senior Management .................................................................................. 1—1
Audit Committee ............................................................................................................................ 1—2
Internal Auditing............................................................................................................................. 1—2
The Loan Review Process.................................................................................................................... 1—3
Scope .............................................................................................................................................. 1—3
Risks Associated with Lending....................................................................................................... 1—4
Benefits of a Loan Review................................................................................................................... 1—5
Identifying and Managing Deficiencies.......................................................................................... 1—5
Maximizing the Benefits of the “Feedback Loop” .............................................................................. 1—6
Chapter 2
Risk Management and the Lending Process
Structure of the Risk Management Process ......................................................................................... 2—1
The Lending Loop .......................................................................................................................... 2—1
Testing the Plan ......................................................................................................................... 2—2
Feedback Loops......................................................................................................................... 2—3
Developing a “Circle of Control” ................................................................................................... 2—4
Coordinating Loan Reviews ...................................................................................................... 2—5
Assessing Internal Controls ....................................................................................................... 2—6
Management’s Commitment to Internal Controls ..................................................................... 2—7
Role of the Board of Directors........................................................................................................ 2—7
A Director’s Oath vs. Reality .................................................................................................... 2—8
Establishing Good Communications ......................................................................................... 2—8
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Audit Committee ............................................................................................................................ 2 — 9
Statutory Requirements ............................................................................................................. 2 — 9
Responsibilities........................................................................................................................ 2 — 10
Internal Audit Responsibilities of the Audit Committee ......................................................... 2 — 10
Regulatory Review of an Internal Audit Program................................................................... 2 — 12
Structure of the Internal Audit Function.................................................................................. 2 — 15
The Loan Committee’s Responsibilities.................................................................................. 2 — 15
Management of the Loan Function............................................................................................... 2 — 16
The Chief Lending Officer (CLO)........................................................................................... 2 — 17
Role of Loan Officers .............................................................................................................. 2 — 18
The Loan Approval Process.......................................................................................................... 2 — 18
Underwriting and Risk-Based Pricing..................................................................................... 2 — 19
Contents of the Loan Proposal................................................................................................. 2 — 19
Loan Administration..................................................................................................................... 2 — 20
Monitoring the Commercial Loan Portfolio ............................................................................ 2 — 20
Training and Communication.................................................................................................. 2 — 21
Identifying Risk ............................................................................................................................ 2 — 22
Early Identification of Portfolio Problems .............................................................................. 2 — 22
Working Within Established Parameters................................................................................. 2 — 23
Assessing Credit Risk in the Portfolio.......................................................................................... 2 — 23
Scrutiny of Products New to the Bank .................................................................................... 2 — 24
Loan Review Reports ................................................................................................................... 2 — 25
Loan Generation and Management .................................................................................................... 2 — 26
Duty of Prudence .......................................................................................................................... 2 — 26
Scenario ................................................................................................................................... 2 — 26
Loan Approval Procedures ........................................................................................................... 2 — 27
Identifying Risk and Assigning Loan Grades............................................................................... 2 — 27
Loan Grades and Anticipated Changes ................................................................................... 2 — 27
Loan Concentrations................................................................................................................ 2 — 28
Managing Concentrations........................................................................................................ 2 — 28
Deficiencies in Loan Documentation ........................................................................................... 2 — 29
Policy and Underwriting Exceptions....................................................................................... 2 — 29
Pooling Policy Exceptions....................................................................................................... 2 — 30
Stress Testing................................................................................................................................ 2 — 30
Allowance for Loan and Lease Losses ......................................................................................... 2 — 31
Management Information Systems ............................................................................................... 2 — 31
Reports Should “Tell It Like It Is” .......................................................................................... 2 — 31
Loan Controls..................................................................................................................................... 2 — 33
Risk Assessment and Control ....................................................................................................... 2 — 33
The Loan Review Function .......................................................................................................... 2 — 34
The Internal Audit Function ......................................................................................................... 2 — 34
Applicable Laws/Regulations.................................................................................................. 2 — 34
Compliance Risk ..................................................................................................................... 2 — 35
Loan Review ...................................................................................................................................... 2 — 37
Audit Charter or Policy................................................................................................................. 2 — 38
Prioritizing Risk....................................................................................................................... 2 — 38
Independent Lines of Communication .................................................................................... 2 — 39
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Function of Minutes...................................................................................................................... 2 — 39
Oversight by Audit Committee..................................................................................................... 2 — 40
Contents of the Engagement Letter .............................................................................................. 2 — 41
Loan Review Samplings ............................................................................................................... 2 — 42
Scope of Loan Review ....................................................................................................................... 2 — 43
The Audit Function ............................................................................................................................ 2 — 44
The Regulators’ Focus.................................................................................................................. 2 — 45
Checklist 2.1: Audit Committee Assessment Checklist .......................................................... 2 — 46
Checklist 2.2: Loan Processing Checklist (For Loan/Account Officers) ................................ 2 — 50
Exhibit 2.1: Internal Audit Review Worksheet ....................................................................... 2 — 52
Exhibit 2.2: Board/Audit Committee Oversight Worksheet.................................................... 2 — 59
Exhibit 2.3: Sample Loan Approval Guidelines (Real Estate-Oriented)................................. 2 — 68
Exhibit 2.4: Sample Credit Policies/Procedures...................................................................... 2 — 70
Exhibit 2.5: Credit Underwriting Standards and Portfolio Risk Management
(Available Only on CD) ........................................................................................................ 2 — 112
Exhibit 2.6: Directions for Using the Loan Grade Rating Sheet (Available Only on CD).... 2 — 113
Exhibit 2.7: Interagency Proposal on the Classification of Commercial Credit
Exposures (Available Only on CD)....................................................................................... 2 — 114
Exhibit 2.8: Concentrations of Credit (Available Only on CD) ............................................ 2 — 115
Exhibit 2.9: Update on Accounting for Loan and Lease Losses (Available Only on CD).... 2 — 116
Exhibit 2.10: Operating a Risk Management Unit (Available Only on CD)......................... 2 — 117
Exhibit 2.11: Strategic Risk (Available Only on CD) ........................................................... 2 — 118
Exhibit 2.12: CEO Questionnaire — Internal Control and Audit (Available Only
on CD) ................................................................................................................................... 2 — 119
Exhibit 2.13: Loan Portfolio Management (Available Only on CD) .................................... 2 — 120
Exhibit 2.14: Interagency Policy Statement on Internal Audit and Internal Audit
Outsourcing (Available Only on CD).................................................................................... 2 — 121
Chapter 3
Reviewing the Credit File
Contents of the Credit File ................................................................................................................... 3—1
What to Look for in the Credit File...................................................................................................... 3—2
Identification of the Borrower ........................................................................................................ 3—3
Credit File Problems ....................................................................................................................... 3—3
What Is Missing?....................................................................................................................... 3—4
Sources of Repayment ......................................................................................................................... 3—5
Cash Flow ....................................................................................................................................... 3—5
Asset Contraction............................................................................................................................ 3—6
Refinance ........................................................................................................................................ 3—6
Risk Identification .......................................................................................................................... 3—7
Risk Assessment ............................................................................................................................. 3—7
Effectiveness of Mitigants .............................................................................................................. 3—8
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Appropriateness of Loan Structure ................................................................................................. 3 — 8
How to Evaluate the Credit Analysis................................................................................................... 3 — 9
Financial Statement Analysis.......................................................................................................... 3 — 9
Income Statements................................................................................................................... 3 — 10
Balance Sheet .......................................................................................................................... 3 — 13
Cash Flow Statement............................................................................................................... 3 — 17
Projections: The Underutilized Tool............................................................................................. 3 — 19
Evaluation................................................................................................................................ 3 — 19
Context and Comparisons .................................................................................................................. 3 — 21
A Final Caveat: Profits vs. Risk......................................................................................................... 3 — 22
Chapter 4
Reviewing the Document File
Contents of a Complete Document File............................................................................................... 4 — 2
Adequacy of Documentation ............................................................................................................... 4 — 3
Identity and Authority..................................................................................................................... 4 — 3
Scenario ..................................................................................................................................... 4 — 3
Loan Agreement ............................................................................................................................. 4 — 4
Collateral/Security/Guarantees/Support ......................................................................................... 4 — 7
Comfort Letters ......................................................................................................................... 4 — 7
Guarantees ................................................................................................................................. 4 — 7
Standby Letters of Credit .......................................................................................................... 4 — 9
Subordination Agreements ...................................................................................................... 4 — 10
Collateral ................................................................................................................................. 4 — 10
Pledges of Accounts Receivable and Inventory ...................................................................... 4 — 11
Perfection................................................................................................................................. 4 — 13
Attachment and Perfection ...................................................................................................... 4 — 14
Issues of Time and Priority...................................................................................................... 4 — 15
Special Items...................................................................................................................................... 4 — 16
Consistency of Documentation with Approvals and Policies ............................................................ 4 — 18
Checklist 4.1: Commercial Loan Structure Checklist........................................................................ 4 — 20
Chapter 5
Commercial Real Estate Loans
Policy ................................................................................................................................................... 5—2
Diversification ................................................................................................................................ 5—3
Underwriting Standards .................................................................................................................. 5—4
Supervisory Loan-to-Value Limits ................................................................................................. 5—5
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Excluded Transactions............................................................................................................... 5 — 6
Calculating LTV Ratios............................................................................................................. 5 — 6
Lax Underwriting............................................................................................................................ 5 — 8
Loan Administration....................................................................................................................... 5 — 9
Monitoring Compliance................................................................................................................ 5 — 11
Scenario ................................................................................................................................... 5 — 11
Project ................................................................................................................................................ 5 — 13
Evaluating Borrowers and Guarantors.......................................................................................... 5 — 13
Completion Risk ........................................................................................................................... 5 — 14
Land Loans ................................................................................................................................... 5 — 15
Loans for Construction of Residential Real Estate ....................................................................... 5 — 16
Owner-Built............................................................................................................................. 5 — 16
Professional Residential Construction..................................................................................... 5 — 16
Commercial Construction ............................................................................................................. 5 — 17
Assessment of the Players ....................................................................................................... 5 — 17
Assessment of the Project........................................................................................................ 5 — 18
Valuing the Project .................................................................................................................. 5 — 19
Takeout Commitments ............................................................................................................ 5 — 20
Financing Completed Projects or Improved Property .................................................................. 5 — 21
Owner-Occupied Buildings ..................................................................................................... 5 — 21
Income-Producing Property.......................................................................................................... 5 — 22
Stress Testing........................................................................................................................... 5 — 23
Practice............................................................................................................................................... 5 — 25
Controlling the Outcome .............................................................................................................. 5 — 25
Scenario ................................................................................................................................... 5 — 25
Forms ............................................................................................................................................ 5 — 26
Regulatory Compliance ................................................................................................................ 5 — 26
Consistency.............................................................................................................................. 5 — 26
Insiders and Affiliates.............................................................................................................. 5 — 27
Anti-Tying Provisions .................................................................................................................. 5 — 28
Loan Administration..................................................................................................................... 5 — 28
Document Control ................................................................................................................... 5 — 28
Records .................................................................................................................................... 5 — 29
Transaction Processing ............................................................................................................ 5 — 30
Inspections .................................................................................................................................... 5 — 30
Benefit of Training ....................................................................................................................... 5 — 31
Guidance on Commercial Real Estate (CRE) Loan Concentrations and Best Practices.................... 5 — 31
Commercial Real Estate Lending Regulations ............................................................................. 5 — 31
Historical Context.................................................................................................................... 5 — 31
Basis for Current Regulatory Concerns................................................................................... 5 — 32
The 2006 Interagency Guidance ................................................................................................... 5 — 33
Guidance on CRE Loan Concentrations.................................................................................. 5 — 33
CRE Concentration Thresholds ............................................................................................... 5 — 34
Development of a Credible CRE Lending Program ..................................................................... 5 — 35
Evaluation of CRE Concentration Risk................................................................................... 5 — 35
Components of a CRE Lending Program ................................................................................ 5 — 35
Elements of Effective Risk Management ..................................................................................... 5 — 37
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Management Oversight ........................................................................................................... 5 — 38
Underwriting Standards........................................................................................................... 5 — 38
CRE Underwriting Policies ..................................................................................................... 5 — 39
Underwriting for CRE Construction Loans............................................................................. 5 — 39
Documenting Underwriting Exceptions .................................................................................. 5 — 39
Portfolio Management ............................................................................................................. 5 — 40
Role of Management Information Systems ............................................................................. 5 — 40
Design of an Effective MIS ..................................................................................................... 5 — 41
Loan Review and Risk Rating Functions ................................................................................ 5 — 42
Desired Qualities of Risk Rating and Review Processes......................................................... 5 — 42
Market Analyses...................................................................................................................... 5 — 43
Components of a Market Analysis .......................................................................................... 5 — 43
Market Data and the Feedback Loop....................................................................................... 5 — 44
Adjustments Based on Market Studies.................................................................................... 5 — 44
Risk Management in a Slowing CRE Cycle................................................................................. 5 — 44
Market Predictors .................................................................................................................... 5 — 45
Stress Testing and Sensitivity Analysis................................................................................... 5 — 46
Recommendations for Stress Testing ...................................................................................... 5 — 46
Transactional Sensitivity Analysis .......................................................................................... 5 — 46
Benefits of Aggregating Individual Transactional Stress Tests .............................................. 5 — 47
Stressed Loss Rates ................................................................................................................. 5 — 47
Scenario Analysis .................................................................................................................... 5 — 48
Ratings Migration Analysis ..................................................................................................... 5 — 48
Capital Adequacy.......................................................................................................................... 5 — 49
Capital as a Buffer in CRE Lending........................................................................................ 5 — 49
Evaluation of Capital Adequacy.............................................................................................. 5 — 49
ALLL Calculations.................................................................................................................. 5 — 50
In Conclusion................................................................................................................................ 5 — 50
Checklist 5.1: Application Checklist Term Real Estate Loan ...................................................... 5 — 52
Checklist 5.2: Loan Officer Checklist .......................................................................................... 5 — 54
Exhibit 5.1: File Memorandum on On-Site Review by Account Officer................................ 5 — 56
Exhibit 5.2: Term Real Estate Loan Analysis Form................................................................ 5 — 57
Exhibit 5.3: Status Report on Term Real Estate Loan Follow-Up .......................................... 5 — 58
Exhibit 5.4: Annual Term Real Estate Review........................................................................ 5 — 59
Chapter 6
Reviewing Appraisals
Appraisals and Reviews as Internal Controls ...................................................................................... 6—2
Scope of Appraisals and Appraisal Reviews .................................................................................. 6—3
The Relation of Risk to the Scope of Appraisals....................................................................... 6—3
Complete and Limited Appraisals ............................................................................................. 6—3
Market Value Appraisals ........................................................................................................... 6—4
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Engagement Letters and Report Formats .................................................................................. 6 — 4
Built-In Controls........................................................................................................................ 6 — 5
Qualifications of Appraisers and Reviewer .................................................................................... 6 — 5
Independence Requirement ....................................................................................................... 6 — 5
The Appraiser’s Competency .................................................................................................... 6 — 6
The Reviewer’s Job ................................................................................................................... 6 — 7
Internal vs. External Appraisals, Evaluations, and Reviews ..................................................... 6 — 8
Mitigation of Risk........................................................................................................................... 6 — 8
Compliance with Interagency Regulations and the USPAP ........................................................... 6 — 8
Exempted Loans Eligible for Evaluation................................................................................... 6 — 9
Parameters Established by Regulation................................................................................................. 6 — 9
Mandated Practices ....................................................................................................................... 6 — 10
Practices That Ensure Independent, Unbiased Appraisals ...................................................... 6 — 10
Availability of the “Evaluation” Option.................................................................................. 6 — 11
Valuations................................................................................................................................ 6 — 13
Differences Between State/Federal Laws and Regulations .......................................................... 6 — 13
Administrative Procedures............................................................................................................ 6 — 14
Assessing the Appraisals.................................................................................................................... 6 — 15
Compliance Review Programs...................................................................................................... 6 — 15
Purposes Served....................................................................................................................... 6 — 15
Appraisal Review Policy and Procedures................................................................................ 6 — 16
Documenting the Review Process ........................................................................................... 6 — 18
What an Appraisal Review Tells the Examiners .......................................................................... 6 — 18
Quality of Risk Management................................................................................................... 6 — 18
Evaluating the Appraisers........................................................................................................ 6 — 18
Basic Training for Staff ........................................................................................................... 6 — 18
Potential Penalties ................................................................................................................... 6 — 19
Exhibit 6.1: USPAP Table of Contents ................................................................................... 6 — 20
Exhibit 6.2: Independent Appraisal and Evaluation Functions (Available Only on CD)........ 6 — 22
Exhibit 6.3: Appraisal Regulations and the Interagency Statement on Independent
Appraisal and Evaluation Functions (Available Only on CD) ................................................ 6 — 23
Exhibit 6.4: Statement on Appraisal Standards for Federally Related Transactions
(Available Only on CD) .......................................................................................................... 6 — 24
Exhibit 6.5: The Appraisal Foundation White Paper: Privacy Regulation and the
Appraiser (Available Only on CD).......................................................................................... 6 — 25
Chapter 7
Specialized Commercial Loans
Basic Loan Types................................................................................................................................. 7—1
Credit Lines .................................................................................................................................... 7—1
Short-Term Lending ....................................................................................................................... 7—2
Scenario ..................................................................................................................................... 7—3
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Long-Term Lending........................................................................................................................ 7 — 3
Interest Calculations ....................................................................................................................... 7 — 4
Participations, Syndications, and Shared National Credits.................................................................. 7 — 5
Participations .................................................................................................................................. 7 — 5
Assignments.................................................................................................................................... 7 — 8
Syndications.................................................................................................................................... 7 — 8
Shared National Credits .................................................................................................................. 7 — 8
Accounts Receivable and Inventory Financing.................................................................................... 7 — 9
Eligibility Criteria and Advance Rates ......................................................................................... 7 — 10
Inventory ................................................................................................................................. 7 — 10
Accounts Receivable ............................................................................................................... 7 — 11
Monitoring ARIF Facilities .......................................................................................................... 7 — 13
Planning a Liquidation.................................................................................................................. 7 — 15
Floor Planning .............................................................................................................................. 7 — 15
Equipment Finance ............................................................................................................................ 7 — 16
General.......................................................................................................................................... 7 — 16
Valuing the Equipment ................................................................................................................. 7 — 16
Structuring the Transaction........................................................................................................... 7 — 17
Amortization............................................................................................................................ 7 — 17
Covenants ................................................................................................................................ 7 — 18
Leasing.......................................................................................................................................... 7 — 18
Capital or Operating Leases .................................................................................................... 7 — 18
Bank Leasing Characteristics .................................................................................................. 7 — 19
Leveraged Leasing................................................................................................................... 7 — 20
Japanese Leveraged Leasing......................................................................................................... 7 — 20
Bridge Loans/Warehouse Facilities ................................................................................................... 7 — 21
Bridge Loans................................................................................................................................. 7 — 22
Warehouse Facilities..................................................................................................................... 7 — 22
Lending Involving Securities ............................................................................................................. 7 — 23
Lost, Stolen, or Cancelled Securities ............................................................................................ 7 — 24
Complex Structured Finance Transactions ........................................................................................ 7 — 24
Scope of Proposed Guidelines ...................................................................................................... 7 — 25
Red Flags ...................................................................................................................................... 7 — 25
Framework for CSFT Risk Control .............................................................................................. 7 — 26
Policies and Procedures ........................................................................................................... 7 — 27
Role of Credit Review in CSFTs .................................................................................................. 7 — 29
Special Purpose Entities..................................................................................................................... 7 — 30
Government-Related Loans ............................................................................................................... 7 — 30
Country Risk................................................................................................................................. 7 — 30
Community Development Lending.................................................................................................... 7 — 32
Consistency with Business Strategies........................................................................................... 7 — 32
Focus of CD Lending .............................................................................................................. 7 — 32
Staffing Requirements .................................................................................................................. 7 — 32
Planning a CD Finance Program ............................................................................................. 7 — 33
Multifamily Affordable Housing Loans ....................................................................................... 7 — 34
Affordable Housing Construction................................................................................................. 7 — 34
Anticipating Pitfalls................................................................................................................. 7 — 35
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Investing in Standardized Documentation............................................................................... 7 — 35
Investing in Federal Low-Income Housing Tax Credits............................................................... 7 — 35
Small Business Loans ................................................................................................................... 7 — 36
Competing for Market Share ................................................................................................... 7 — 36
Small Business Lending in the CD Arena ............................................................................... 7 — 37
Effective Strategies for Small Business and CD Lending ....................................................... 7 — 37
Varied Small Business Needs and Products ............................................................................ 7 — 39
SBA Loans and Partnerships with CD Intermediaries ............................................................ 7 — 39
Trade Finance..................................................................................................................................... 7 — 39
Definitions .................................................................................................................................... 7 — 40
Documentary Collections and Letters of Credit ........................................................................... 7 — 41
Export Support Agencies......................................................................................................... 7 — 42
Credit Review Issues .................................................................................................................... 7 — 43
Leveraged Finance ............................................................................................................................. 7 — 44
Policy ............................................................................................................................................ 7 — 44
Enterprise Value ...................................................................................................................... 7 — 45
Practice ......................................................................................................................................... 7 — 45
Project Finance................................................................................................................................... 7 — 46
Project Types ................................................................................................................................ 7 — 47
Exhibit 7.1: Intermediate Small Institution Examination Procedures ..................................... 7 — 49
Exhibit 7.2: Joint Statement on 100 Percent Loan Participations (Available Only on CD).... 7 — 60
Exhibit 7.3: ABA Press Release: FASB’s Decision on Sales Treatment of Loan
Participations (Available Only on CD) ................................................................................... 7 — 61
Exhibit 7.4: 12 CFR 23 — Leasing (Available Only on CD) ................................................. 7 — 62
Exhibit 7.5: Statement of Purpose for an Extension of Credit Secured by Margin Stock
(Federal Reserve Form U-1) (Available Only on CD) ............................................................ 7 — 63
Exhibit 7.6: Statement of Purpose for an Extension of Credit Secured by Margin
Stock by a Person Subject to Registration Under Regulation U (Federal Reserve
Form G-3) (Available Only on CD) ........................................................................................ 7 — 64
Exhibit 7.7: Interagency Statement on Sound Practices Concerning Complex Structured
Finance Activities (Available Only on CD) ............................................................................ 7 — 65
Exhibit 7.8: CBA Regulatory Compliance Bulletin: New CRA Exam for “Intermediate
Small Banks” (Available Only on CD) ................................................................................... 7 — 66
Exhibit 7.9: OCC Community Developments Newsletter (Available Only on CD) ............... 7 — 67
Exhibit 7.10: Example: Financing an Affordable Multifamily Housing Project
(Available Only on CD) .......................................................................................................... 7 — 68
Exhibit 7.11: Example: Small Business Loan Transaction (Available Only on CD).............. 7 — 69
Exhibit 7.12: Partnership Resources for Small Business Lending (Available Only on CD)... 7 — 70
Exhibit 7.13: Government Contacts (Available Only on CD)................................................. 7 — 71
Exhibit 7.14: Sound Risk Management Practices (Available Only on CD)............................ 7 — 72
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Chapter 8
Analyzing the Commercial Loan Portfolio
Assessing the Current Situation ........................................................................................................... 8 — 1
Risk and Return .............................................................................................................................. 8 — 2
Migration Analysis .................................................................................................................... 8 — 3
More Than Just Stress Testing................................................................................................... 8 — 5
Tracking Concentrations................................................................................................................. 8 — 6
By Industry ................................................................................................................................ 8 — 6
By Related Companies .............................................................................................................. 8 — 7
By Geography............................................................................................................................ 8 — 7
The Nine Elements of Loan Portfolio Management ....................................................................... 8 — 7
The Preferred Portfolio ........................................................................................................................ 8 — 8
Strategy ........................................................................................................................................... 8 — 8
Strengths, Weaknesses, Opportunities, Threats......................................................................... 8 — 8
Positioning the Bank.................................................................................................................. 8 — 9
Risk and Return ............................................................................................................................ 8 — 10
Investing in the Circle of Control ............................................................................................ 8 — 10
Loan Mix ................................................................................................................................. 8 — 11
Credit Culture ............................................................................................................................... 8 — 12
Getting to Where We Want to Go...................................................................................................... 8 — 13
Chapter 8A
Allowance for Loan and Lease Losses (ALLL)
New Policy Statement....................................................................................................................... 8A — 1
Conceptual Overview .................................................................................................................. 8A — 1
Loans Not Included in FAS 5 & FAS 114 Guidance................................................................... 8A — 2
Process Chart ............................................................................................................................... 8A — 3
New Guidance ............................................................................................................................. 8A — 4
Written Policies and Procedures .................................................................................................. 8A — 4
Effective Loan Review System.................................................................................................... 8A — 5
Data Capture and Reporting Systems .......................................................................................... 8A — 6
Exercising Judgment.................................................................................................................... 8A — 7
Board of Directors Checklist ....................................................................................................... 8A — 7
Frequently Asked Questions........................................................................................................ 8A — 9
Exhibit 8A.1: SR 06-17 (ALLL) .......................................................................................... 8A — 15
Exhibit 8A.2: Interagency Policy Statement on the Allowance for Loan
and Lease Losses .................................................................................................................. 8A — 18
Exhibit 8A.3: Questions and Answers on Accounting for Loan and Lease Losses ............. 8A — 40
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Chapter 9
Problem Loans
The Management of Problem Loans.................................................................................................... 9 — 1
Account Officer’s Responsibility to Monitor Loans ...................................................................... 9 — 2
Problem Indicators..................................................................................................................... 9 — 2
Loan Reviews Performed by the Account Officer .................................................................... 9 — 4
Action on Identified Problems................................................................................................... 9 — 6
Temporary Parking for “Special Mention” Loans .......................................................................... 9 — 6
Referrals to Special Assets ............................................................................................................. 9 — 6
Negotiation and Collection........................................................................................................ 9 — 7
Rehabilitating the Loan and Relationship ................................................................................. 9 — 7
Loan Guarantees........................................................................................................................ 9 — 8
Foreclosures............................................................................................................................... 9 — 8
Repossessions ............................................................................................................................ 9 — 9
Bankruptcy ................................................................................................................................ 9 — 9
MIS Reports.................................................................................................................................... 9 — 9
Weekly Reports ....................................................................................................................... 9 — 10
Monthly Reports...................................................................................................................... 9 — 10
Quarterly Reports .................................................................................................................... 9 — 10
Board’s Responsibility for the Circle of Control.......................................................................... 9 — 10
Problem Banks and Corrective Actions ............................................................................................. 9 — 11
Problem Bank Identifiers .............................................................................................................. 9 — 11
Aggressive Growth Strategies ................................................................................................. 9 — 11
Economic Factors .................................................................................................................... 9 — 12
Poor Oversight......................................................................................................................... 9 — 13
Failure to Stop Asset Quality Deterioration ............................................................................ 9 — 13
Fraud and Other “Red Flags”........................................................................................................ 9 — 15
The Regulators’ Risk Assessment Systems .................................................................................. 9 — 16
ALLL Issues ............................................................................................................................ 9 — 16
Communication Between Management and the Regulators .............................................................. 9 — 18
During the Examination Process................................................................................................... 9 — 18
Exit Meetings........................................................................................................................... 9 — 19
Reports of Examination ........................................................................................................... 9 — 19
Enforcement Actions .................................................................................................................... 9 — 19
Range of Regulatory Actions .................................................................................................. 9 — 20
Follow-Up and Rehabilitation ................................................................................................. 9 — 20
Problem Resolution ...................................................................................................................... 9 — 20
Credit Risk Issues and Implications ........................................................................................ 9 — 21
Capital Impairment Problems.................................................................................................. 9 — 21
Problems in Federal Branches and Agencies................................................................................ 9 — 21
Credit Culture..................................................................................................................................... 9 — 22
Checklist 9.1: Foreclosure Documents .............................................................................................. 9 — 23
Exhibit 9.1: Problem Loan Review ......................................................................................... 9 — 24
Exhibit 9.2: Special Mention Quarterly Action Plan Report................................................... 9 — 26
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Exhibit 9.3: Example Special Mention Follow-Up List .......................................................... 9 — 28
Exhibit 9.4: Special Assets Transmittal Report....................................................................... 9 — 29
Exhibit 9.5: Delinquency Letter .............................................................................................. 9 — 30
Exhibit 9.6: Payment Demand................................................................................................. 9 — 31
Exhibit 9.7: Special Assets Checklist ...................................................................................... 9 — 32
Exhibit 9.8: Classified Loan Review Memorandum and Update Report ................................ 9 — 33
Exhibit 9.9: Foreclosure by Senior Lienholder ....................................................................... 9 — 35
Exhibit 9.10: Bankruptcy Overhaul — 2005........................................................................... 9 — 36
Exhibit 9.11: Guidance for Supervising Banks Experiencing Rapid Growth ......................... 9 — 45
Exhibit 9.12: Update on Accounting for Loan and Lease Losses ........................................... 9 — 49
Chapter 10
Preparing for Bank Examinations
Know What to Expect........................................................................................................................ 10 — 2
Risk Management Evaluations ..................................................................................................... 10 — 2
Deviations from Policies and Procedures ..................................................................................... 10 — 2
“The Regulators Are Coming!” ......................................................................................................... 10 — 3
Getting It Together ....................................................................................................................... 10 — 3
Avoid Playing “Hide and Seek” .............................................................................................. 10 — 3
Dig Up the Docs ...................................................................................................................... 10 — 4
Compliance-Related Exam Issues ................................................................................................ 10 — 4
Practices Make Perfect ............................................................................................................ 10 — 4
Getting an “A” in Training ...................................................................................................... 10 — 5
The Regulators’ Approach to Risk Management............................................................................... 10 — 6
Means of Assessing Risk .............................................................................................................. 10 — 6
Assessing the Quantity and Quality of Risk ............................................................................ 10 — 6
A Shift in Paradigm ................................................................................................................. 10 — 7
Commitment to Risk Management.......................................................................................... 10 — 7
Managing the Examination Process................................................................................................... 10 — 8
Taking a Proactive Stance ............................................................................................................ 10 — 9
Setting the Tone..................................................................................................................... 10 — 10
Communicating with the Examiners........................................................................................... 10 — 10
The Exit Interview ...................................................................................................................... 10 — 11
The Regulators’ Assessments ..................................................................................................... 10 — 11
Response to the Report of Examination ................................................................................ 10 — 12
Monitoring Corrective Actions................................................................................................... 10 — 12
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Contents
Chapter 11
Compliance Issues and Trends
That Impact Commercial Lending
The Impact of Economic Factors and Industry Trends...................................................................... 11 — 1
Trends in Underwriting Practices ................................................................................................. 11 — 1
2001–2004 OCC Surveys ........................................................................................................ 11 — 2
2005 Survey of Credit Underwriting Practices........................................................................ 11 — 2
Interest Rate Risk and Profit Margins ..................................................................................... 11 — 3
The Impact of Interest Rates on Inflation ................................................................................ 11 — 4
Conclusions and Survey of Industry Trends................................................................................. 11 — 6
Economic Trends 2007-2008 and Their Impact on Commercial Lending......................................... 11 — 7
Overview on Where We Are ........................................................................................................ 11 — 7
How We Got Where We Are...................................................................................................... 11 — 10
How Loan Reviews Can Help .................................................................................................... 11 — 15
Commercial Loans in General............................................................................................... 11 — 15
Commercial Real Estate Loans.............................................................................................. 11 — 15
Key Elements Underlying Disruptions in Financial Markets ..................................................... 11 — 16
Real Estate Markets .................................................................................................................... 11 — 16
The Residential Market ......................................................................................................... 11 — 17
The Commercial Real Estate Market (CRE) ......................................................................... 11 — 20
Commercial Loans in General .................................................................................................... 11 — 22
Erosion of Market Liquidity .................................................................................................. 11 — 23
Shared National Credits (SNCs or Syndicated Loans) .......................................................... 11 — 23
Trends in Financial Markets ....................................................................................................... 11 — 23
Trends in the Federal Reserve's Beige Books ....................................................................... 11 — 23
Trends in the OTS Monthly Market Monitors....................................................................... 11 — 24
Trends in the FDIC Quarterly Banking Profiles.................................................................... 11 — 24
Trends in the OCC’s Surveys of Credit Underwriting Practices ........................................... 11 — 25
Gross Domestic Product (GDP).................................................................................................. 11 — 25
GDP Performance 2007......................................................................................................... 11 — 25
GDP So Far in 2008 .............................................................................................................. 11 — 26
Jobs and Wages................................................................................................................................ 11 — 27
The Big Picture ........................................................................................................................... 11 — 27
Layoffs in the Financial Sector.............................................................................................. 11 — 28
Gap between Wage and Price Increases ................................................................................ 11 — 28
Input Costs and Profit Margins.............................................................................................. 11 — 28
Consumer Confidence and Spending Trends................................................................................... 11 — 29
Consumer Confidence ................................................................................................................ 11 — 29
Spending Trends.................................................................................................................... 11 — 30
Bargain Shopping .................................................................................................................. 11 — 30
Less Bang for Your Buck ...................................................................................................... 11 — 30
Consumer Debt Delinquencies .............................................................................................. 11 — 31
Collapse of the Mighty Dollar .................................................................................................... 11 — 32
Fed Reductions Quicken Dollar Slide ................................................................................... 11 — 32
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Consumers Feel the Pinch ..................................................................................................... 11 — 32
The Dollar Economy ............................................................................................................. 11 — 33
How the Dollar Weakened .................................................................................................... 11 — 33
The Threat of Inflation................................................................................................................ 11 — 35
Inflated Energy Prices................................................................................................................. 11 — 36
Oil and the Commodities Market .......................................................................................... 11 — 36
The Soaring Price of Crude ................................................................................................... 11 — 36
Pressures on Transportation........................................................................................................ 11 — 37
Struggling Airlines ................................................................................................................ 11 — 38
Consumption and Price.......................................................................................................... 11 — 38
Coal and Natural Gas............................................................................................................. 11 — 39
A “Frantic Round of Finger-Pointing” .................................................................................. 11 — 39
Inflation and the U.S. Trade Deficit ........................................................................................... 11 — 40
Overview ............................................................................................................................... 11 — 40
Cheaper U.S. Products........................................................................................................... 11 — 40
Food Prices in Developing Countries.................................................................................... 11 — 40
Prices for Raw Materials ....................................................................................................... 11 — 41
The Consumer Price Index .................................................................................................... 11 — 41
The Fed’s Balancing Act ....................................................................................................... 11 — 41
The Trade Deficit .................................................................................................................. 11 — 41
The Stock Market ....................................................................................................................... 11 — 42
“Wild Ride into Uncertainty” ................................................................................................ 11 — 42
When Investors Play It Safe .................................................................................................. 11 — 42
It Wasn’t All Bad................................................................................................................... 11 — 43
The Bear Market.................................................................................................................... 11 — 43
New Stock Issues Boost Capital............................................................................................ 11 — 44
Trouble in the Financial Sector ............................................................................................. 11 — 45
Subprime and MBS Impact ................................................................................................... 11 — 45
Big Write-Downs and Loan Loss Provisions ........................................................................ 11 — 46
Limited Profitability .............................................................................................................. 11 — 46
Historic Losses by Major Lenders......................................................................................... 11 — 47
Liquidity Problems Plague Big Players................................................................................. 11 — 47
Loan Loss Provisions Up – Prices/Dividends Down............................................................. 11 — 48
Impact on Community Banks ................................................................................................ 11 — 48
Losses by Wall Street’s Investment Banks............................................................................ 11 — 49
Roles and Limits of GSEs ..................................................................................................... 11 — 50
What the Regulators Are Saying ................................................................................................ 11 — 50
Examiners Report Weak Underwriting....................................................................................... 11 — 51
Back to Basics............................................................................................................................. 11 — 51
Mortgage-Backed Securities (MBSs) ......................................................................................... 11 — 52
Corruption in the Financial Sector.............................................................................................. 11 — 52
Mortgage Fraud ..................................................................................................................... 11 — 52
Abusive Appraisal Practices.................................................................................................. 11 — 53
Federal Reserve Policy ............................................................................................................... 11 — 54
A Little History...................................................................................................................... 11 — 54
Fighting the Two-Headed Dragon: Recession and Inflation ................................................. 11 — 54
The Fed’s Monetary Policy ................................................................................................... 11 — 55
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Contents
Factors Influencing Fed Policy.............................................................................................. 11 — 55
Addressing the Credit Crunch ............................................................................................... 11 — 58
Money Where It Is Needed.................................................................................................... 11 — 60
Strategies to Help CRE/Business Borrowers......................................................................... 11 — 61
Recap ............................................................................................................................................... 11 — 62
On the Upside ............................................................................................................................. 11 — 62
Mitigation of Systemic Risk .................................................................................................. 11 — 62
On the Downside ........................................................................................................................ 11 — 63
References ............................................................................................................................. 11 — 64
Compliance Issues That Impact Commercial Lending .................................................................... 11 — 65
Equal Credit Opportunity Act (ECOA) ...................................................................................... 11 — 66
Joint Credit ............................................................................................................................ 11 — 67
Risk-Based Pricing ................................................................................................................ 11 — 67
The FTC Act: Unfair or Deceptive Acts or Practices ................................................................. 11 — 68
Lending Limits............................................................................................................................ 11 — 68
Servicemembers Civil Relief Act ............................................................................................... 11 — 70
Garn-St. Germain Depository Institutions Act of 1982 .............................................................. 11 — 70
Section 106 of the Bank Holding Act......................................................................................... 11 — 72
The Patriot Act............................................................................................................................ 11 — 73
Enhanced Due Diligence ....................................................................................................... 11 — 74
Bank Secrecy Act Reporting Requirements ............................................................................... 11 — 76
Laws That Impact Commercial Real Estate Transactions .......................................................... 11 — 76
Flood Insurance Requirements .............................................................................................. 11 — 76
CERCLA, as Amended ......................................................................................................... 11 — 77
Community Reinvestment Act and Commercial Lending..................................................... 11 — 83
Gramm-Leach-Bliley Act of 1999.............................................................................................. 11 — 84
Bankruptcy Abuse Prevention and Consumer Protection Act .................................................... 11 — 84
The Sarbanes-Oxley Act of 2002................................................................................................ 11 — 84
Electronic Communications........................................................................................................ 11 — 85
Compliance Management ........................................................................................................... 11 — 86
Checklist 11.1: Environmental Evaluation Checklist............................................................ 11 — 88
Exhibit 11.1: Summary of ECOA Rules Applicable to Denials of Business Loan
Applications, Adverse Action Notices, and Appraisals....................................................... 11 — 103
Exhibit 11.1(a): Fair Lending Examination Procedures Applicable
to Commercial Lenders ....................................................................................................... 11 — 106
Exhibit 11.1(b): Issues in BSA/AML Examination Manual Applicable
to Commercial Lenders ....................................................................................................... 11 — 110
Exhibit 11.2: Written Flood Procedures .............................................................................. 11 — 118
Exhibit 11.3: Environmental Risk Management Policy ...................................................... 11 — 120
Exhibit 11.4: CRA Reporting Rules and Pointers ............................................................... 11 — 122
Exhibit 11.5: Corporate Governance Regulations ............................................................... 11 — 128
Exhibit 11.6: Housings: Sales Volumes and Median Prices of New
and Existing Homes............................................................................................................. 11 — 134
Exhibit 11.7: Addressing the Subprime Crisis: Complexities of the Sub-Prime
Housing Market ................................................................................................................... 11 — 139
Exhibit 11.8: Beige Books Economic Trends ..................................................................... 11 — 147
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Exhibit 11.9: OTS Market Monitor: Summaries of the Monthly Market Monitor
Office of Thrift Supervision, October 29, 2007 – April 25, 2008 ...................................... 11 — 156
Exhibit 11.10: Foreign Economies Catch U.S. Flu ............................................................. 11 — 165
Chapter 12
Basel I, Basel IA, and Basel II
Overview............................................................................................................................................ 12 — 1
Benefits from Basel II Implementation ........................................................................................ 12 — 2
Reactions and Developments........................................................................................................ 12 — 3
Benefits from Basel IA Implementation ....................................................................................... 12 — 4
Trifurcation of Regulation of Financial Institutions .......................................................................... 12 — 4
Basel II ............................................................................................................................................... 12 — 5
Required Implementation ............................................................................................................. 12 — 6
U.S. Basel II Banks ................................................................................................................. 12 — 6
The Standardized Approach ......................................................................................................... 12 — 7
The Internal Ratings-Based (IRB) Approach — Portfolio Perspective ............................................. 12 — 7
Predictable and Unpredictable Losses .......................................................................................... 12 — 8
Probability Distribution of Losses ................................................................................................ 12 — 9
Simplifying Assumptions ........................................................................................................... 12 — 10
Portfolio Invariance ............................................................................................................... 12 — 10
Single Risk Factor ................................................................................................................. 12 — 11
Asset Correlation ........................................................................................................................ 12 — 11
The Internal Ratings-Based (IRB) Approach — Individual Loan Perspective................................ 12 — 13
Asset Classes .............................................................................................................................. 12 — 13
Risk Ratings................................................................................................................................ 12 — 13
Expected Loss on an Individual Loan......................................................................................... 12 — 14
Foundation Approach ............................................................................................................ 12 — 14
Advanced Approach .............................................................................................................. 12 — 14
Validation .............................................................................................................................. 12 — 15
Capital Formulae Under Basel II ..................................................................................................... 12 — 15
Risk-Weighting: the Solution to the Apples and Oranges Problem ........................................... 12 — 15
The Calculations ......................................................................................................................... 12 — 15
Results from QIS4 ...................................................................................................................... 12 — 16
Basel IA ........................................................................................................................................... 12 — 17
Changes from Basel I.................................................................................................................. 12 — 17
Risk Weight Categories ......................................................................................................... 12 — 17
External Credit Ratings ......................................................................................................... 12 — 17
Eligible Collateral and Guarantees ........................................................................................ 12 — 18
Risk Weights for Residential Mortgages............................................................................... 12 — 19
CCF: Credit Conversion Factors ........................................................................................... 12 — 19
Other Items ............................................................................................................................ 12 — 19
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Contents
Chapter 13
Special Issues Facing Foreign Banks
Ratings ............................................................................................................................................... 13 — 1
SOSA: Strength-of-Support Assessment ...................................................................................... 13 — 1
SOC: Summary of Condition........................................................................................................ 13 — 3
Consequences of Ratings .............................................................................................................. 13 — 3
Pitfalls ................................................................................................................................................ 13 — 4
Culture .......................................................................................................................................... 13 — 4
Scenario 1: Surprise Inspections.............................................................................................. 13 — 4
Scenario 2: The Consequences of Parking Illegally ................................................................ 13 — 5
Scenario 3: Marching to the Beat of a Different Drummer ..................................................... 13 — 6
Scenario 4: An Indecent Proposal ........................................................................................... 13 — 7
Crossing the Cultural Divide ........................................................................................................ 13 — 8
Compliance ................................................................................................................................... 13 — 8
Noncompliance...................................................................................................................... 13 — 10
Control ........................................................................................................................................ 13 — 11
Good News ............................................................................................................................ 13 — 12
Communication ..................................................................................................................... 13 — 13
Exhibit 13.1: International Banking Activities Capital Equivalency Deposits ..................... 13 — 14
Exhibit 13.2: ROCA Rating System...................................................................................... 13 — 20
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