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Loan Quality

Category: Corporate Governance

Normally, the most readily available information for members of Supervisory Council concerning loan quality comes from management ‘s internal risk rating reports, reports on past-due and nonaccrual loans, renegotiated and restructured loan reports, and policy exception reports. Reviewing these reports can help members of Supervisory Council identify negative trends early.

Members of Supervisory Council may review:

Risk rating reports —summarize the total amount of loans in each risk rating category, often by division or product. This report is especially useful to monitor risk rating trends. In addition to the problem loan categories, banks may develop its own internal multiple «pass» (non-problem) rating grades so that negative trends in overall loan quality can be identified quickly.

Problem loan reports —identify problem or watch credits and quantify the bank’s potential loss on each significant problem credit. The bank’s internal loan classifications should be updated and summarized periodically and should be easily translatable to the NBU classification system (pass, watch, substandard, doubtful, and loss). Effective members of Supervisory Council should understand why a loan is a problem and what action management is taking to strengthen it.

Past-due and nonaccrual reports —show seriously delinquent borrowers and tell the percent of loans past due by loan category (i.e., commercial, installment, real estate). Effective members of Supervisory Council should understand the reasons for delinquencies.

Renegotiated and restructured loan reports —identify loans whose original terms or structure has been modified. High levels of renegotiated or restructured loans can signal an attempt by a loan officer or management to mask the true number and amount of past-due loans. Effective members of Supervisory Council should understand why a loan was restructured or terms were renegotiated.

Reports on disposal of property — details efforts to dispose of each piece of other real estate owned (generally foreclosed properties) and show if appraisals are current for all parcels.

Exception reports —list exceptions to loan policies, procedures, and underwriting standards. The reports should include the trend in number and r amount of loans approved that are exceptions to policy as well as the percentage of loans that are exceptions to policy. Members of Supervisory Council require that management explain these exceptions and determine whether to re-enforce or revise loan policies.

Allowance for Loan and Lease Losses

The allowance for loan losses is a valuation reserve charged against the bank’s operating income. Members of Supervisory Council must ensure that the estimates are reasonable and the allowance covers all estimated inherent loan and losses. Members of Supervisory Council should review the following information to determine whether the loan loss provision is adequate:

Management’s quarterly evaluation of the adequacy of the loan loss provision

Management’s problem loan list.

Charge-off and recovery experience.

A reconcilement (or movement) of the loan loss provision for the current period and previous year-end.

Any independent analysis of the loan loss provision (e.g., external loan review).

Loan Summary

Members of Supervisory Council can find out what types of loans the bank is making and management’s lending practices by looking at lists of new credits approved, loans renewed, concentrations of credit. Management board and the Supervisory Council together should establish the limits for the loans detailed in those reports.

Loan Portfolio Red Flags:

Large or increasing volume of loans granted or renewed with policy exceptions.

Large or increasing volume of credit/collateral exceptions.

Loans remaining on the problem loan list for extended periods of time without improvement.

Loan review personnel reporting to a person(s) other than the Council or a Council committee.

Delinquent internal loan reviews or late identification of problem loans.

Large concentrations of credit to individuals or industries with or without prior Council approval.

Loans to members of Council, significant shareholders, management board, and other insiders (including third parties performing services for the bank, external accountants, auditors, and marketing firms).

Loans to affiliates.

Excessive out-of-territory lending.

Loans to borrowers who appear on the overdraft or uncollected funds reports.

Rapid growth in total loan volume or particular types of lending.

Growth in the loan loss provision that is significantly greater or less than the percentage growth in total loans over a given period.

Non-performing or problem loans as a percentage of total loans increasing at a greater rate than the loan loss provision.

Loan officer compensation that is tied to growth or volume targets.

High or increasing yield on the loan portfolio.

Significant shifts in the bank’s risk rating profile or increase in the number or amount of problem or watch loans as a percent of loans, in aggregate, or for loan types.

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