Utah Bankers Association
Credit & Risk Review
Executive Development Program 2016
Jeffery W. Johnson
Bankers Insight Group, LLC
770-846-4511
[email protected]
June 2016
TABLE OF CONTENTS
Credit and Risk Review entails management of the entire credit administration area of banks.
Management of credit risk is vitally important for banks because poor asset quality is the number
one reason why banks fail. As you recall, Asset Quality is the second factor in the CAMELS
rating system utilized by regulators to measure the health of financial institutions. Therefore,
understanding this aspect of banking is very important for bank management.
There are seven distinct characteristics well managed and successful banks have in their Credit
Administration area. This course will evaluate the reasoning and requirements for each of these
characteristics so that the participant can begin the process of developing such a culture within
their respective organization. The seven characteristics are as follows:
1. Well Defined Credit Culture Established and Supported by
a. An Effective Loan Policy
2. Highly Effective Risk Assessment and Credit Underwriting System by
a. Choosing the right personnel to be Credit Analysts, Lenders or Loan
Administrators
b. Knowing how to balance Risk and Rewards through proper credit, ratio and cash
flow analysis
c. Knowing how to report risk assessment by writing effective credit memoranda
3. Highly Effective Credit Committee that
a. Considers all pertinent information
b. Allows members to express their opinion “freely”
c. Records Minutes that matter
4. Utilize Credit Risk Rating to Identify Risk in the Loan Portfolio by:
a. Clearly defining credit grades and applying them to various types of borrowers
b. Utilizing a clear, objective and measurable loan grading system
5. Loan Documentation Procedures that will:
a. Identify the Borrower’s legal structure
b. Identify, value and properly classify the collateral (emphasizing appraisal
reviews)
c. Evidence the debt outstanding
d. Attach the bank’s security interest in the collateral
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e. Perfect the bank’s lien position in the collateral
6. Effective Loan Portfolio Management by:
a. Defining the expectations of loan officers in the management of their loan
portfolio
b. Using Loan Agreements, Covenant Compliance Reports and other monitoring
tools to manage the loan portfolio
7. Problem Loan Management and Accounting
a. Identifying problem loans, managing and accounting for them
b. Adopting prudent commercial real estate loan workout strategies for problem
loans
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BACKGROUND:
Credit Risk Administration Defined
Credit Administration is the oversight of all activities related to a bank’s credit process ensuring
the bank’s largest balance sheet asset – the loan portfolio – maintains its value.
It comprises the entire credit process
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policy/procedure, underwriting guidelines,
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application – underwriting-approval-documentation
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booking – servicing
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credit management
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portfolio management
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monitoring delinquencies (to include overdrafts)
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problem credit management
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regulatory reporting – regulatory compliance
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A/L Management
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financial reporting (ALLL)
Risk Management is:
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A continuous process (not a static exercise) of identifying risks that is sometimes
subject to quick and volatile changes. The identification of risks may result in
opportunities for portfolio growth or may aid in avoiding unacceptable exposures for
the institution.
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A subjective evaluation driven by the experience of the lending and credit policy
management team of your financial institution.
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Effective credit risk management is achieved through:
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A comprehensive credit policy; augmented by
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Supporting underwriting and portfolio management guidelines; implemented by
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Qualified staff; executing
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Efficient processes and procedures from application through payoff.
It should be pointed out that hope is not an effective risk management strategy!”
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Primary Causes of Loan Loss
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Poor Initial Selection of Risk
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Timidity
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Over lending
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Documentation Flaws
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Failure to Implement Approval Terms and Conditions
(Vaughn Pearson, Problem Loan Fundamentals, RMA Web seminar)
Key words: Discipline & Integrity
TECHNIQUES FOR MAINTAINING A HIGH QUALITY LOAN PORTFOLIO
No one thing assures a high quality loan portfolio…
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It is the aggregation of all people and processes from application through payoff
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But it is only as effective as one underlying fundamental – A well-defined Policy
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EFFECTIVE HABIT #1:
WELL DEFINED CREDIT CULTURE SUPPORTED BY A GOOD LOAN POLICY CULTURE
The above factors are items that can be established and measured. But what about those
intangibles? You know, those things that people do, think, say and behave without any formal
instructions from some type of a policy. I am talking about “Culture”. Culture is the key
attitudes and behaviors of members of a group. It is what people think and what people do. For
an example, a sales culture exists in a bank when these attitudes and behaviors are pro-selling
and selling is perceived as legitimate and important. It is part of the job.
A bank’s credit culture is the sum of its credit values, beliefs and behaviors. It is what is done
and how it is accomplished. It exerts a strong influence on a bank’s lending and credit risk
management. Values and behaviors that are rewarded become the standards and will take
precedence over written policies and procedures.
What is the dominate Culture within your bank? Let’s discuss this
RISK PROFILE
A bank’s risk profile is more measurable than its credit culture. A risk profile describes the
various levels and types of risk in the portfolio. The profile evolves from the credit culture,
strategic planning, and the day-to-day activities of making and collecting loans. Developing a
risk profile is no simple matter as it varies from bank to bank. Some banks approach credit very
conservatively, while growth –oriented banks may approach lending more aggressively
It is all about achieving a good CAMELS Rating!
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C
A
M
E
L
S
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The Importance of a Loan Policy "Tune-Up"
The fortunes of FDIC-insured institutions have been closely tied historically to how well they
managed credit risk. A written loan policy, approved by a bank's board of directors and adhered
to in practice, is of critical importance in ensuring that the bank operates within prescribed risk
tolerances. In today's fiercely competitive and challenging lending environment, an up-to-date
policy, appropriate to an institution's lending function and business plan, may be more important
than ever. This article summarizes features and benefits of an effective policy, details warning
signs and potential consequences of an outmoded policy, and offers practical advice about
reviewing and updating a loan policy.
Elements of an Effective Loan Policy
Written loan policies vary considerably in content, length, and specificity, as well as style and
quality. No two institutions share the same tolerance for risk, offer the same product mix, and
face the same economic conditions. An effective loan policy should reflect the size and
complexity of a bank and its lending operations and should be tailored to its particular needs and
characteristics. Revisions should occur as circumstances change, and the policy should be
flexible enough to accommodate a new lending activity without a major overhaul.
During risk management examinations, examiners make a determination about the adequacy of
an institution's loan policy. Bank examiners are guided in their review by regulations,
examination guidelines, and common sense: Is the policy up-to-date and are important areas
adequately addressed? The FDIC Manual of Examination Policies lists broad areas that should
be addressed in written loan policies, regardless of a bank's size or location (see box below).1
A Loan Policy Should Address...
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General fields of lending
Normal trade area
Lending authority of loan officers and committees
Responsibility of the board of directors in approving loans
Guidelines for portfolio mix, risk diversification, appraisals, unsecured loans, and rates of
interest
Limitations on loan-to-value, aggregate loans, and overdrafts
Credit and collateral documentation standards
Collection procedures
Guidelines addressing loan review/grading systems and the allowance for loan and lease
losses
Safeguards to minimize potential environmental liability
A loan policy should include more detailed guidelines for each lending department or function.
For example, the real estate lending department should comply with specific guidelines
appropriate to the size and scope of its operations. In fact, as part of the Interagency Guidelines
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for Real Estate Lending Policies, the federal banking agencies list 57 areas to be considered in
written policies on real estate lending, ranging from zoning requirements to escrow
administration.2
In addition, in 1995, the federal banking regulatory agencies established basic operational and
managerial standards for loan documentation and credit underwriting.3 These standards also
should be incorporated into a bank's written loan policy. For example, loan documentation
practices should take into account the size and complexity of a loan, the purpose and source of
repayment, and the borrower's ability to repay the indebtedness in a timely manner. And among
other things, underwriting practices should include a system of independent, ongoing credit
review and appropriate communication to management and the board of directors.
Benefits of an Effective and Up-to-Date Loan Policy
A sound loan policy, established and overseen by the board of directors, reflects favorably on the
board and management. When a board sets forth its expectations clearly in writing, management
is better positioned to control lending risks, ensure the institution's stability and soundness, and
fulfill oversight responsibilities. An effective and up-to-date loan policy increases the likelihood
that actual loan documentation and underwriting practices will satisfy the board's expectations.
Furthermore, a well-conceived policy clearly and comprehensively describes management's
system of controls and helps examiners identify high-risk areas and prioritize and allocate
examination time.
In 1997, the FDIC began implementing new, risk-focused examination processes.4 During a riskfocused examination, examiners focus on areas that represent the greatest risk to the insured
institution. A written policy is tangible evidence of the processes that have been established to
identify, measure, monitor, and control risks in the lending area. An incomplete or inadequate
policy makes it more difficult to identify potentially high-risk areas and may raise supervisory
concerns about an institution's risk management practices.
Signs That a Loan Policy Needs a Tune-Up
A recent cover date does not provide adequate assurance that a policy is current. Only a careful
review of the entire policy will reveal the extent of any shortcomings; however, even a cursory
review can provide clues that a policy needs an overhaul. Common red flags include:
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The policy has not been revised or reapproved in more than a year.
Multiple versions of the policy are in circulation.
The table of contents is not accurate.
The policy is disorganized or contains addendums from years past that have never been
incorporated into the body of the policy.
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The policy contains misspellings, typos, and grammatical errors.
Officers and directors who no longer serve are listed, or new ones are not listed.
The designated trade territory includes areas no longer served, or new areas are omitted.
Discontinued products are included, or new products are not addressed.
New regulations are not addressed.
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In addition, a review of lending decisions may identify areas where management is departing
from the specifics of the loan policy, such as:
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Actual lending practices vary significantly from those outlined in the policy.
Numerous exceptions to policy requirements have been approved.
Policy limits are being ignored.
Exceptions to policy should be few in number and properly justified, approved, and tracked. If
actual practices vary materially from the written guidelines and procedures, the source of this
discrepancy should be identified, and either actual practices or the written policy should be
changed. Management may conclude that specific sections of the written policy are no longer
relevant. A case is then made to the board of directors to amend the policy to reflect different,
but still prudent, procedures and objectives.
Potential Consequences of an Inadequate Loan Policy
Outdated and ineffective loan policies can contribute to a range of problems. Introducing a loan
product that is not adequately addressed in the written loan policy can create a variety of
challenges for the lending staff and involve risks that management did not anticipate.
If lending authorities, loan-to-value limits, and other lending limitations are not revised when
circumstances change, a bank could be operating within guidelines that are too restrictive, too
lenient, or otherwise inappropriate in light of the bank's current situation and lending
environment. If guidelines do not comply with current laws and regulations, lending decisions
may not reflect best practices or regulatory requirements. Imprudent lending decisions can have a
ripple effect. A loan policy that does not anticipate the risks inherent in an insured institution's
lending practices can lead to asset quality problems and poor earnings. In turn, earnings that do
not fully support operations increase an institution's vulnerability to adverse movements in
interest rates, a downturn in the local economy, or other negative economic events.
The Loan Policy Updating Process
A bank's loan policy is not a static document, but rather should be revised as the institution,
business conditions, or regulations change. A comprehensive annual review, in addition to more
limited reviews as needed, will help ensure that a loan policy does not become outdated and
ineffective. The frequency and depth of the reviews will depend on circumstances specific to
each institution, such as growth expectations, competitive factors, economic conditions, staff
expertise, and level of capital protection. Planned changes to an institution's lending function or
business plan should prompt a modification to the policy. Pertinent criticisms and
recommendations made during recent audits and regulatory examinations should be considered
during the updating process.
In certain situations, a loan policy can be updated effectively through addendums or
supplemental memorandums, but if carried too far, such "cobbling together" can result in a
cumbersome and disorganized document. It is best to merge supplementary materials
periodically into a logical place in the main document. The updating process also includes
identifying obsolete or irrelevant sections of the policy. For example, a bank might have entered
a new field of lending a few years ago and modified its loan policy at that time. However, when
it became obvious the bank could not compete successfully in this field, management wound
down the operations. The loan policy should reflect the decision to exit that lending niche.
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Compliance testing, conducted as part of the updating and audit processes, will help management
determine whether staff is aware of and adhering to the provisions of a loan policy. An
institution's board of directors should demonstrate their commitment by emphasizing that
noncompliance is unacceptable. Loan staff, executive officers, and directors should be able to
demonstrate some level of familiarity with all provisions—more so with the provisions that
affect their daily responsibilities. Awareness and knowledge of the policy's specific provisions
can be promoted through periodic training that stresses the need for the policy to keep pace with
current lending activities and clarifies any areas of ambiguity or uncertainty. Specific areas that
may benefit from review are
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ranges for key numerical targets, such as loan-to-value ratios or loan portfolio segment
allocations
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responsibility for monitoring and enforcing loan policy requirements
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documentation requirements for various classes of loans
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remedial measures or penalties for loan policy infractions
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preparation and content of loan officer memorandums
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individual and committee lending authorities
Conclusion
A current and effective loan policy is a tool to help management ensure that a bank's lending
function is operating within established risk tolerances. Such a policy is more likely to be
consulted and followed by staff and contributes to uniform and consistent board-approved
practices. Therefore, insured institution staff, borrowers, and regulators will be well served by
the implementation of a process that helps ensure that a bank's loan policy remains
comprehensive, effective, and up to date.
Footnotes
1
See FDIC Manual of Examination Policies, Section 3.1 - Loans (I. Loan Administration - Lending Policies).
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2
The Interagency Guidelines for Real Estate Lending Policies describes the criteria and factors that the bank regulatory agencies
expect insured institutions to consider when establishing real estate lending policies. These guidelines, which took effect March 19,
1993, address loan-to-value limits for various categories of real estate loans.
3
The Interagency Guidelines Establishing Standards for Safety and Soundness, which implements Section 39 of the Federal Deposit
Insurance Act, was adopted on July 10, 1995
4
On October 1, 1997, the FDIC, Federal Reserve, and state banking departments implemented a risk-focused examination process.
To allocate examination resources effectively, on-site procedures are customized on the basis of a bank's overall risk profile. In April
2002, the FDIC implemented a streamlined examination program called MERIT (Maximum Efficiency, Risk-Focused, Institution
Targeted Examinations). This program was applicable to banks that met basic eligibility criteria, such as total assets of $250 million
or less and satisfactory regulatory ratings. In February 2004, the FDIC expanded the use of MERIT to eligible, well-rated banks with
total assets of $1 billion or less (see FIL 13-2004).
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LOAN POLICY OUTLINE COMPARED WITH A CLIENT’s POLICY
I.
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II.
Addressed in Client Policy
NO
NO
YES
NO
NO
YES*
YES*
YES
YES
Loan Administration
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III
The Executive Loan Committee
The Officers Loan Committee
Loan Administration
Lending Officers
The Role of the Lending Officer
Authority to Make Loans
Approval of Loans
Current Loan Authorities
Individual Lending Authority
Expiration of Approvals
Loan Operations Department
YES
YES
YES*
NO
YES*
YES*
YES*
NO
NO
NO
NO
Lending Criteria
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VI
Desirable Loans
Undesirable and Problem Loans
Unacceptable Loans/Prohibited Loans
NO
YES*
YES
Definition of Loan Types
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V
Loan Policy
Table of Contents
Introduction
Lending Objectives
External Policy Goals
Internal Policy Goals
Lending Philosophy
Compliance Assessment Area
Out of Territory Lending
Legal Lending Limit
Consumer Loans
Real Estate Loans
Interim Construction Loans
Commercial Loans
Unsecured Loans
Secured Loans
Credit Guidelines
Bankers Insight Group
YES
YES*
NO
YES
YES
YES
Addressed in GCB’s Policy
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VI
Loan Applications
Financial Statements
Types of Financial Statements
Analysis of Financial Statements
Frequency of Financial Statements and Follow-up Procedures
Waiving Financial Statements
Confidentiality of Information
Deposit Relationships
Fee Reimbursement
Government Regulations
Guarantors
Credit Investigation
Credit Files
Renewals
Capitalization of Interest
NO
NO
NO
NO
NO
NO
NO
NO
NO
NO
YES
YES
YES
YES
NO
Loan Documentation
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Signatures on Loan Documents
Computer-generated and Standard Credit Memo Form
Responsibilities for Loan Documentation
Collateral Files
Insurance
NO
NO
YES*
YES*
YES
VII
Loan Pricing
YES*
VIII
Commercial Lending
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XI
Commercial Loans-General
Unsecured Loans
Lines of Credit
Secured Credit
Loans Secured by Marketable Securities
Accounts Receivable and Inventory Collateral Monitoring
Loans Secured by Equipment
Term Loans
Letters of Credit
Loans to US Agencies or Other Government Bodies
Real Estate Lending
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General Requirements
Interest Reserves
Loan to Value Limits for Real Estate Loans
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YES
YES
YES
YES
YES*
YES*
YES*
YES*
NO
YES
Addressed in GCB’s Policy
YES
NO
YES
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XI
Specific Requirements for Single-Family Owner-Occupied Dwelling
Construction Loans
Land and Development Loans
Commercial Mortgage Loans
Loans to Churches and Other Non-Profit Organizations
Home Improvement Loans
Home Equity Loans
Second Lien Real Estate Loans
NO
NO
NO
NO
NO
NO
NO
NO
Real Estate Appraisal Procedures
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XII
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XIII
Selecting the Appraisal
Ordering Appraisals
Regulatory Requirements for Certified and Licensed Appraisers
Minimum Appraisal Standards
Appraisal Foundation Standards
Written Appraisals Requirements
Analysis of Deductions and Discounts
Market Value Prospective Values
When Federal Regulatory Standards are not Firm Requirements
Unsafe and Unsound Appraisal Practices and Policies
Real Estate Appraisal Reviews
Problem Loans and OREO Appraisal Policies
Environmental Requirements on Potential Borrowers
Environmental Audits
Phase 1 Environmental Audits
Historical Use Record Review
Regulatory Agency Review
Site Inspection
Phase 2 & 3 Audits
When an Audit is Needed
When to Use Bank Personnel to Perform Limited Audits
Loans to Directors, Officers and Employees
Directors and Executive Officers
Other Officers
Reports of Officer Borrowings
Loans to Employees
NO
NO
NO
NO
NO
NO
NO
NO
NO
NO
NO
YES
YES
YES
NO
NO
NO
NO
NO
NO
NO
Addressed in GCB’s Policy
YES
YES*
YES
YES
Overdrafts
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Customers
Employees Who Are Not Directors or Executive Officers
Reports to the Board of Directors Regarding Overdrafts
YES
YES
YES
XIV
Loan Participations
YES
XV
Collection Procedures
YES
XVI
Charge Off Policy
YES
XVII Extensions / Modifications / Repossessions
YES*
XVIII ACH Origination
NO
XIX
Predatory Lending
NO
XX
Other Real Estate Owned
YES
XXI
Credit Grades
YES
XXII Concentration of Credit
YES*
XXIII Allowance For Loan and Lease Losses
YES
Addressed in GCB’s Policy
XXIV Loan Review
NO
XXV Conflict of Interest
NO
XXVI Policy Exceptions and Review
YES*
XXVII Distribution of the Loan Policy
NO
*Requires expansion, clarification or improvement
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EFFECTIVE HABIT #2
HIGH EFFECTIVE RISK ASSESSMENT AND CREDIT UNDERWRITING
Credit (Risk) Analysis is one of the most important functions performed by banks.
Since interest and fee income from loans represent the largest source of revenue for
banks, it is vital that thorough credit analysis be performed before loans are
approved and funded. Credit Analysis not only considers the financial condition of
prospective borrowers, but also considers non-financial factors which may impact
the ability to repay loans.
Proper Credit Analysis starts with analyzing the financial statements followed by
reporting the findings in a Credit Memorandum, then recommending a loan
structure that provides the borrower what they need while providing the bank with
the highest possible chance of being repaid. There is a very thin line between
Financial Analysis and Credit Analysis because many of the techniques utilized to
make an assessment overlap. However, the biggest difference is that Credit
Analysis is appropriate when money is on the line. It focuses on analyzing
financial and non-financial factors with the primary objective of determining the
ability of a borrower.
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TYPES OF ANALYSIS
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Common Sizing:
Balance Sheet items as a % of Total Assets
Income Statement items as a % of Net Sales
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Percent Change:
Amount change shown as a percentage
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Ratios:
Mathematical relationship among logically related factors
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Cash Flow:
Determination of cash generation or usage from items on
the Income Statement and from the changes in the Balance
Sheet items from one period to another period
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Comparative:
Matching or contrasting to similar peer or industry data
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Trend:
Analysis of changes over at least a 3 year period
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Indexing:
Changes related to a designated base year
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Forecasting:
Forecasting financial statements to observe the likely
results based upon management’s assumptions
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Breakeven:
Determination of the level of Sales required to cover Fixed
Costs
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Working Capital:
Determine ability to meet current debt payments and to
measure working assets efficiency

Sustainable
Growth:
Bankers Insight Group
Rate at which a company can grow and maintain a certain
level of leverage (Debt to Worth position)
Page 17
RATIO ANALYSIS
I believe all borrowers being analyzed for financial soundness should be scrutinized to determine
five vital signs that are critical for an entities financial success. The method I recommend to
check these vital signs is referred to as:
LLAMOPCAFLO
(Pronounced: la-mop-ca-flo)
LLAMOPCAFLO measures an entity’s five vital financial factors that would indicate their
ability to thrive and be able to service short term and long term debt. LLAMOPCAFLO is an
acronym for the following:
LIQUIDITY
LEVERAGE
ASSET MANAGEMENT
OPERATIONS
CASH FLOW
If you stop and think about it, an entity’s financial woes occur in its inability to pay current debts
as they come due (Liquidity); or debt on their balance sheet is more than the owners’ equity
(Leverage); or management is not utilizing their assets (or may have the wrong assets) to
generate sufficient sales or to create profits (Asset Management); or the company may lose
money as a result of their operations (Operations); or the company may not be able to generate
sufficient cash flow to sustain the company or to pay down long-term debt (Cash Flow). If
LLAMOPCAFLO is utilized, these issues will easily be uncovered.
Non-Financial factors such as the character of management or the condition of the economy are
not measured through LLAMOPCAFLO. Since LLAMOPCAFLO focuses only upon the
financial factors, it is recommended that character of management and conditions of the
economy o be added in order to gain a full understanding of an economic entity’s financial
condition. As a result, LLAMOPCAFLO has now been revised into LLAMOPCAFLOCC , with
the last two C’s representing Character of Management and Conditions of the Economic
Environment.
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Underwriting Commercial Loans
For the Commercial Borrower (manufacturers, wholesalers, retailers and service companies, a
review of the financial statements to determine the following factors should be conducted.
(“LLAMOPCAFLO”)
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LIQUIDITY
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LEVERAGE
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ASSET MANAGEMENT
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OPERATIONS
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CASH FLOW
LIQUIDITY
Liquidity is a measure of the quality and adequacy of current (short-term) assets to meet current
(short-term) obligations as they come due.
Current Ratio
Calculation:
Current Assets
Current Liabilities
This ratio gives a general indication of a firm’s ability to pay its current obligations. Generally,
the higher the Current Ratio, the greater the cushion between current obligations and a firm’s
ability to pay. A benchmark for this ratio has been 2 to 1. The higher the ratio reflects more
current assets available to cover Current Liabilities. However, the composition and quality of
Current Assets is a critical factor in the analysis of an individual firm’s liquidity.
Quick Ratio
Calculation:
Cash + Marketable Securities + Accounts Receivable
Current Liabilities
Also known as the “Acid Test Ratio”, it is a refinement of the Current Ratio and is a more
conservative measure of liquidity. The numerator from the Current Ratio is adjusted by omitting
inventory (because of obsolesce, slow moving items and encumbered items). The ratio expresses
the degree to which a company’s Current Liabilities are covered by the most liquid Current
Assets. Generally, any value of less than 1 to 1 implies a dependency on inventory or other
Current Assets to liquidate short-term debt
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Accounts Receivable Turnover in Days
Calculation:
Accounts Receivable
Net Sales
X
365 Days
This figure expresses the average number of days that Accounts Receivable are outstanding.
Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the
probability of delinquencies in Accounts Receivable.
Inventory Turnover in Days
Calculation:
Inventory
Cost of Goods Sold
X
365 Days
This figure expresses the average number of days it takes for cash used to purchase raw material
or finished goods inventory to be sold to the end user. Generally, the higher the number of
Inventory days outstanding, the more the need for cash to carry this inventory.
Accounts Payable Turnover in Days
Calculation:
Accounts Payable
Cost of Goods Sold
X
365 Days
This figure expresses the average number of days that Accounts Payable are outstanding.
Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the
probability of the company being delinquent with its suppliers and other creditors.
Working Capital
Calculation:
Current Assets minus Current Liabilities
Working Capital is the amount of Current Assets remaining after the Current Liabilities are paid.
This excess cash can be used to repay long term debt, invest in long term assets or pay a
dividend. The higher the working capital the stronger the entity.
2013
2014
2015
Current Ratio
1.98
2.41
2.94
Quick Ratio
0.67
0.71
1.10
Working Capital
1,878,000
2,005,000
2,352,000
Bankers Insight Group
Page 20
A/R Turnover Rate
7.0
8.1
7.4
A/R Turnover Days
52
45
49
Inventory Turnover Rate
2.9
2.7
3.1
Inventory Turnover Days
128
135
116
Accounts Payable Turnover Rate
6.9
13.0
13.5
Accounts Payable Turnover Days
53
28
27
Net Working Investment Analysis
When the Accounts Receivable, Inventory and Accounts Payable turnover ratios are calculated,
the results can be used to calculate the Net Working Investment (“NWI”) for the entity. Before
the NWI can be defined, a definition of the Operating Cycle must be established.
The Operating Cycle is defined as the time it takes for an entity to utilize its available cash to
purchase raw material; convert it to finish goods inventory and eventually sell it (for a
manufacturer): or purchase finished goods inventory and sell it to the end user (for a wholesaler
and retailer): or fund upfront expenses in order to provide a service (for service companies).
Another source of funding is derived from suppliers which often provide interest-free financing
for inventory, and this is the most common form of short-term financing for businesses. These
terms may be up to 60 days or longer. For our company, the suppliers are being paid every 27
days. This means the suppliers are essentially providing 27 days of financing or carrying a
portion of the amount needed over the 138 days of Operating Cycle
Our sample company is producing excess cash flow after existing debt service that could be used
to cover the financing gap shown. If the cash flow is presented on an annual basis, it will be
necessary to convert the amount of available cash flow after debt service based on the length of
the Operating Cycle ($835,332 - $132,643 X 138/365)
The final adjustment considers the existing equity in the Trading Assets (A/R + Inv) – (AP +
AE). While in theory the cash from existing equity in working capital assets and liabilities is not
available until the end of the Operating Cycle, for most businesses, new and old Operating
Cycles are started and completed nearly every day. Thus there is some ongoing daily “return of
equity” embedded in the trading assets.
If we consider all of the above factors, the end result will be the amount required under a Line of
Credit.
Accounts Receivable Turnover (days)
+ Inventory Turnover (days)
49
116
$1,280,430
$2,205,935
= Operating Cycle
165
$3,486,365
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Page 21
- Accounts Payable (days)
(27)
( 506,961)
Financing Need After Accounts Payable
Less: Amount Covered by Excess Cash Flow
138
$2,979,404
( 265,674)
Remaining Financing Needs
$2,713,830
Less Amount Covered by Equity in Trading Assets
(2,554,929)
Amount to be Financed by a Working Capital Line of Credit
$ 158,901
 We now see that the required amount of the Line of Credit is in the neighborhood of
$160,000.
 With this information, we are able to finally compare what our customers’ requests in a Line
of Credit with what we determine to be the true need.
 Having this knowledge should accomplish the following goals:
Prevents loan officer from going to loan committed repeatedly to obtain the right amount
needed.
The risks of the Line becoming an “Evergreen Line” is substantially reduce if the
customer managers the credit facility properly.
 Don’t Leave Your Customer’s Request for a Line of Credit Up for Chance
 Educate Your Borrower on the Proper Use of Their Line
 Monitor the Activity of Your Borrower’s Line of Credit Quarterly (for strong companies)
and Monthly (for weaker companies); then, make necessary adjustments according to
changes in the Operating Cycle
 Require a Monthly Borrower’s Certificate to Track Levels of A/R, Inventory and Cash
Collections
FINANCIAL IMPACT ANALYSIS
What is the financial impact on the cash flow of a company if Accounts Receivable, Inventory
and Accounts Payable turnover measured in days speed up or slow down. There is a definite
positive or negative impact that can be measured and will serve as justification for a need for
additional cash or an explanation for an excess of cash being generated. The methods to
determine the financial impact on these asset and liability accounts can be calculated as follows:
Accounts Receivable Turnover Financial Impact
Sales
Bankers Insight Group
9,545,000
= 1,178,395
Page 22
Target Turnover Rate
8.1
Minus: Actual Accounts Receivable Balance
- 1,280,430
= Positive or Negative Financial Impact
(102,035)
Inventory Turnover Financial Impact
Cost of Sales
Target Turnover Rate
6,806,593
2.7
Minus: Actual Inventory Balance
= 2,520,960
- 2,205,936
= Positive or Negative Financial Impact
315,024
Accounts Payable Turnover Financial Impact
Cost of Sales
Target Turnover Rate
6,806,593
6.9
= 986,463
Minus: Actual Accounts Payable Balance
- 506,961
= Positive or Negative Financial Impact
=(479,502)
Bankers Insight Group
Page 23
LEVERAGE
Leverage refers to the proportion of funds invested in an entity by the creditors in the form of
loans and the owners in the form of equity. Highly leverage firms (those with heavy debt in
relation to net worth) are more vulnerable to business downturn than those with lower debt to
worth positions. While leverage ratios help measure this vulnerability, it does greatly depend on
the requirements of particular industry groups.
Debt to Net Worth
Calculation:
Total Debt divided by Tangible Net Worth
This ratio indicates the extent to which the company’s funds are contributed by creditors
compared to the owners. It expresses the degree of protection provided by the owners for the
creditors. A low ratio generally indicates greater long-term debt paying ability. A firm with a
low debt/worth ratio usually has greater flexibility to borrow in the future. A highly leveraged
company has a limited ability to absorb more debt.
Debt to Tangible Net Worth
2013
2014
2015
1.33
1.09
0.93
ASSET MANAGEMENT (EFFICIENCY) RATIOS
Asset Management or Efficiency Ratios measures management’s ability to utilize assets to
generate revenue or create value (i.e. generate a profit).
Asset Efficiency or Asset Turnover Ratio
Calculation:
Total Sales
Total Assets
This ratio measures management’s ability to use its Total Assets to its best advantage. Since
sales are the numerator, it measures the ability of Total Assets to generate sales. A lower ratio
from earlier periods indicates that the existing assets owed at the time the ratio was calculated
were not as efficient in generating sales as in the past. This ratio is useful when considering a
loan request to increase operating and non operating assets.
Net Fixed Assets Efficiency or Turnover Ratio
Calculation:
Total Sales
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Page 24
Net Fixed Assets
This ratio is most useful for companies in which Fixed Assets represent a major portion of Total
Assets. It measures the extent to which Fixed Assets can generate revenue or sales. A falling
ratio indicates the existing Net Fixed Assets are not as efficient in generating sales as they were
in previous periods. It is most useful when considering a term loan request to acquire equipment
or other Fixed Assets.
Fixed Asset Usage Ratio
Calculation:
Accumulated Depreciation
Gross Fixed Assets
This ratio is useful in determining how much usage the Fixed Assets has experienced. It is most
useful to lenders considering a request to finance new equipment. If the usage is less than 50%,
further justification should be required for new or replacement Fixed Assets.
Fixed Asset Life Ratio
Calculation:
Net Fixed Assets
Depreciation Expense
Similar to the ratio above, this ratio indicates how much life is left in the Fixed Assets by taking
the Net Fixed Assets and dividing it by the current year’s depreciation expense. This ratio
should complement the above ratio. For example, if the Fixed Assets Usage Ratio indicates
usage of 90%, you would not expect the Fixed Assets Life Ratio to show 8 years of life left.
2013
2014
2015
Asset Turnover Ratio
1.86
1.81
2.02
Net Fixed Asset Efficiency Ratio
11.4
9.2
10.1
Fixed Asset Usage Ratio
0.67
0.65
0.66
Net Fixed Asset Life Ratio
5.2 years
6.4 years
Bankers Insight Group
4.8 years
Page 25
OPERATIONS (PERFORMANCE OR PROFITIBILITY RATIOS)
Gross Profit Margin
Calculation:
Gross Profit
Net Sales
This ratio expresses Gross Profit as a percentage of Net Sales. It measures how many dollars out
of each dollar of sales remains to cover all operating expenses (those that are not directly related
to the costs required to produce the good or service). The higher the margin, the more funds
available to cover operating expenses.
Operating Profit Margin
Calculation:
Operating Profit
Net Sales
This ratio expresses Operating Profit as a percentage of Net Sales. It measures how many dollars
or cents out of each dollar of sales remains to cover other non-operating expenses including:
Interest, Extra-Ordinary Expenses, Taxes, etc. The higher the margin, the more funds available
to cover these items.
Net Profit Margin
Calculation:
Net Profit
Net Sales
This ratio expresses Net Profit as a percentage of Net Sales. It measures how many dollars or
cents out of each dollar of sales remains as profit. The higher the margin, the more profitable the
company.
2013
2014
2015
Gross Profit Margin
22.8%
25.8%
28.7%
Operating Profit Margin
6.1%
6.0%
9.4%
Net Profit Margin
1.9%
2.6%
5.2%
Return on Stockholders Equity
Calculation:
Net Income divided by Stockholder’s Equity
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Page 26
This ratio expresses the profitability of the company’s operations to owner after income taxes. It
can be compared to alternative investments available to the owners.
Return on Investment (Assets)
Calculation:
Net Income divided by Total Assets
This ratio measures the effective utilization of the assets of the company in generating profits or
creating value.
2013
2014
2015
Return on Equity
8.3%
9.8%
20.5%
Return on Assets
3.4%
4.7%
10.6%
Bankers Insight Group
Page 27
COVERAGE RATIOS
Financial Ratios measure the ability of a borrower to meet its financing obligations including
Interest Expense, Principal Payments on Long-Term Debt and other fixed charges such as Lease
Payments.
Interest Coverage Ratio
Calculation:
Earning (profit) before Interest, Taxes, Depreciation & Amortization
Annual Interest Expense
This ratio is a measure of a firm’s ability to meet interest payments. It measures the number of
times all interest paid by the company is covered by earnings before interest charges and taxes. A
high ratio may indicate that a borrower would have little difficulty in meeting the interest
obligations of a loan. This ratio also serves as an indicator of a firm’s capacity to take on
additional debt.
500 + 97 + 0 + 196
97
=
8.3 Times
Cash Flow / Debt Coverage Ratio
UCA
Calculation:
Net Profit
Plus: Non-Cash Charges
+ Change in Accounts Receivable
+ Change in Inventory
+ Change in Accounts Payable
+ Change in Accrued Expenses
= Cash After Operating Cycle
Minus: Dividends Declared
+ Change in Net Worth
= Cash After Financing Cost
Less: Current Portion of Long-Term Debt
= Cash Available for Other Debt
+ Change in Gross Fixed Assets
= Financing Surplus (Requirement)
500
196
282
187
(532)
( 49)
584
(243)
0
341
(134)
207
(219)
( 12)
Tradition
500
196
696
(134)
562
(219)
343
The Cash Flow calculation shown above is more comprehensive than the traditional formula of
Net Profit plus Depreciation because it considers changes in working capital requirements of
companies which either generate or use cash. By using the above calculation, the analyst can see
the impact upon cash at various target points as shown by the bold lines in the formula. The
definitions of cash at each target point are as follows:
Cash After Operating Cycle: This is the Cash remaining after considering the operating
performance of the entity plus or minus the impact of the change in
Net Working Investment (Accounts Receivable plus Inventory
minus Accounts Payable plus Accrued Expenses.
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Page 28
Cash After Financing Cost:
Cash Available
For Other Debt:
Financing Surplus
(Requirement):
Bankers Insight Group
This is the Cash remaining after considering the impact of any
dividends paid and/or owners’ withdrawals from the company.
This is the Cash available to
measures the company’s ability
measured before Fixed Assets
changes in Fixed Assets are
management.
meet future debt payments. It
to take on additional debt. It is
increases or decreases because
generally at the discretion of
This is the Cash Surplus or Requirement the company experienced
after considering the major items that impact cash. If a Financing
Surplus resulted, the cash was used to pay down existing debt, pay
dividends or reinvested in the form of Fixed Assets or Equity. If a
Financing Requirement resulted, the company was required to
utilized its own cash, borrow, or raise equity to meet all their
obligations incurred during the previous year.
Page 29
DETERMINING CREDITWORTHINESS FOR REAL ESTATE LOANS
Real Estate Loans are those in which the primary sources of repayment are from the sale, leasing
or renting of the property to cover expenses and to service debt. If this fact does not exist, then
loans that are secured by real estate as “back-up” collateral are loans where the primary sources
of repayment are conversion of assets, cash flow or cash infusions from the personal assets of the
principles and not the underlying real estate. The latter scenario are considered normal
commercial loans and not real estate loans
Underwriting real estate loans requires a different approach. The basic requirements are to
determine the following:
•
Capacity of Borrower
•
Net Operating Income
•
Debt Coverage Ratio (NOI / ADS) > 1.15
•
Value of Mortgage Property
•
Overall Financial Strength of Borrower
•
Hard Equity Invested into Property (Including unencumbered equity in properties)
•
Secondary Sources of Repayment
•
Additional Collateral or Credit Enhancements
Bankers Insight Group
Page 30
CALCULATING NET OPERATING INCOME AND DSCR
Potential Gross Income (PGI)
Less: Physical Vacancy
Economic (Credit) Loss
Effective Gross Income (EGI)
Less: Operating Expenses
Real Estate Taxes
Hazard Insurance
Repair/Maintenance (Buildings)
Maintenance (Grounds)
Depreciation
Water/Sewer/Trash
Electric (Common)
Interest Expense
Management Fees
Leasing Commissions
Reserves for Replacement
_______________________________
_______________________________
Total Operating Expenses
Net Operating Income (NOI)
NOI
ADS
= > 1.25 times
Bankers Insight Group
Page 31
EFFECTIVE HABIT # 3
HIGHLY EFFECTIVE CREDIT COMMITTEE
So What Are the Seven Effective Habits of the Loan Committee?
1.
Understand the Objectives of the Loan Committee
2.
Led by Chairperson with the Right Temperament
3.
Create and Maintain the Proper Loan Committee Member Mix
4.
Set Standards on What Is Expected From Loan Officers Presenting Credit Requests
5.
Timely Access to Relevant and Current Information
6.
Maintain Open Lines of Communication that Encourage Questions and Expression of
Thoughts at all Times
7.
Take Copious Minutes that Matters
Bankers Insight Group
Page 32
1. Understand Objectives of Committee
 To grow the loan portfolio in a safe and sound manner
 Place Safety and Soundness objective over Growth and Profitability objectives
 Understand they are not the ruler of the bank but play a vital role in its success
 Nurture and Develop Loan Officers into competent and responsible Relationship
Managers
 Establish portfolio limits
2. Chairperson With Right Temperament
 Usually the Chief Credit Officer of the Bank
 Must have a keen awareness of the credit policy to enforce it without stifling growth
of the loan portfolio
 Understand the strengths and weaknesses of loan officers and avoid situations that
may embarrass a sponsoring loan officer during a loan presentation
 Fair in all dealings
 Keenly aware of “Hidden Agenda” that may exist among the Loan Committee
members, Loan Officers and others connected to the credit approval process
LOAN DISCUSSION / PRESENTATION
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Bankers Insight Group
Page 34
3. Loan Committee Mix
 Avoid “Stacking the Deck” with single minded individuals
 Avoid creating a “Group Think” environment
 Seek diversification by having members from or a background in:

◦
Lending (Commercial, Consumer & Real Estate);
◦
Credit Administration;
◦
Financial Management (Accounting or Investment);
◦
Auditing;
◦
Marketing;
◦
Operations
Individuals with different skills and approaches to solving problems
4. Set Expectations of Loan Officers
 Committee should provide clear expectations for Loan Officers to follow such as:
◦
Underwriting Standards (Knowing the Committee’s and Individual’s “Hot
Buttons”)
◦
Loan Presentation Packages
◦
Loan Presentation Style
◦
Common Questions and Factors that should always be addressed
◦
Presentation of Exception Loan approval to require written justification with
demonstrated ability to track progress
5. Timely Access to Relevant Information
 Loan Processing System should allow Loan Officers sufficient time to adequately
prepare the loan package for presentation
 In cases where an immediate decision must be made, a system should be in place to
accommodate such requests
 Loan Committee Packages should be submitted to all Loan Committee Members in
enough time for them to read and reasonably understand the loan requests
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 Each package should contain a Strength and Weakness matrix to show what’s good
and bad about each credit and a well written analysis of the credit
 For each weakness, a mitigating factor should be provided, if any.
6. Communications, Questions & Expression
 Members should be encouraged to raise questions, issues and openly discuss their
feelings without fear of reprisal. In lending, “Silence is not Golden”.
 Members should avoid having “hidden agenda” or favorite lending personnel
 Loan Committee is not “Congress”. Trading votes should never be a common
practice in the Loan Committee
 Patience should be a common virtue, which allows Loan Committee members
sufficient time to gain a full understanding of the request
 As a Loan Committee Member, you should have a firm understanding of three areas after
each loan presentation:
◦
Who are we doing business with?

◦
How will the loan proceeds be used?

◦
Character, Capacity, Capital, Collateral, Conditions & Can We?
Insure proper structure for best chance of being repaid
How will they repay us?

Always have a Primary and Secondary Source of Repayment
7. MINUTES THAT MATTER
 Detailed notes should be taken by the Loan Secretary to indicate the depth of
discussion held over the loan approval and reflect questions and concerns of the loan
committee members
 Secretary to the Loan Committee should not be a Loan Officer or anyone that is
influenced by the Chairperson
 Votes should be recorded with any dissenting votes duly noted and explained
BOTTOM LINE
•
Attend Loan Committee Meetings
•
Pay Close Attention in Loan Committee
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Page 36
•
Question Things You Don’t Understand
•
Get Training In The Areas of Weakness
•
Use Influence to Develop Business
•
Help Shape The Loan Portfolio
•
Hire Right People and Support Them
Seven Bad Habits
• “What time is Lunch?
• “What’s for Lunch?
• “Side bet among the participants on who will fall asleep
first during loan presentations”
• “Another side bet on how long it will be for the member
who fell asleep to “snore”
• “A key consideration among the committee members is the
borrower’s Character & Social Network
Bankers Insight Group, LLC
Bankers Insight Group
38
Page 37
HIGHLY EFFECTIVE HABIT #4
UTILIZE CREDIT RISK RATING TO IDENTIFY RISK IN THE LOAN PORTFOLIO
Regulators expect community banks to have credit risk management systems that produce
accurate and timely risk ratings. They consider accurate classification of credit among its top
supervisory priorities
Credit ratings are an approximation of the quality of the loan and the potential for complete
repayment. They are based on the financial institution’s underwriting standards. If a financial
institution's underwriting standards are weak, then the Credit Ratings will not properly the risk in
the loan portfolio. The standards act as signals that indicate the general quality of the individual
loans and the loan portfolio.
Before individual credit reviews can be performed, criteria for determining the quality of a loan
must be established. The standards require that financial institutions:
(1) Establish prudent underwriting standards that are clear and measurable
(2) Establish loan documentation procedures
(3) Establish review procedures for monitoring compliance with internal policies and
regulations.
There are five key control attributes that should be present for the grading system to be effective.
They are as follows:
1. Definitions or attributes of each loan grade are stated clearly.
2. Loan officers and credit reviewers understand the definitions of the grades.
3. Loan grades are updated periodically.
4. Senior management reviews and approves loan grades and specific problem credits.
5. “Loss” credits deteriorate steadily through the grades and do not deteriorate suddenly
from grade 2 to grade 9.
Credit ratings are essential to other functions including:
1.
2.
3.
4.
Credit approval (who can approve)
Loan pricing
Credit administration
Allowance for loan & lease losses calculations
EXPECTATIONS OF CREDIT RISK RATINGS
System should be integrated into the bank’s overall portfolio risk management
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Page 38
Board should approve the credit risk rating system and assign accountability for the risk
rating process
All credit exposures should be rated
Risk rating system should assign an adequate number of ratings
Risk ratings must be accurate and timely
Criteria for assigning each rating should be clear
Rating should reflect the risks posed by borrower’s expected performance and the
transaction’s structure
The risk rating system should be dynamic and change when the risk changes
The risk rating process should by independently validated in addition to regulatory
examinations
Banks should determine through back-testing whether the assumptions implicit in the
rating definitions are valid, i.e. whether they accurately anticipate outcomes. If
assumptions are not valid, rating definitions should be modified.
The rating assigned should be well supported and documented in the credit file
Examiners rate credit risk based on the borrower’s expected performance, i.e., the
likelihood that the borrower will be able to service its obligations in accordance with the
terms. Remember, Payment performance is a future event
Credit risk ratings are meant to measure risk rather than record history
DEVELOPMENTS IN RISK RATING SYSTEMS
Banks are developing more robust internal risk rating processes in order to increase the precision
and effectiveness of credit risk measurement and management
More and more banks are:
1. Expanding the number of rating they use, particularly for pass credits
2.
Using two rating systems, one for risk of default and the other for expected loss
3.
Linking risk rating systems to measurable outcomes for default and loss probabilities
4.
Using credit rating models and other expert systems to assign rating and support internal
analysis
Bankers Insight Group
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Most significant change has been the increase in the number of rating categories (grades)
especially in the pass category
The number of pass ratings a bank will find useful depends on the complexity of the portfolio
and the objectives of the risk rating system
Less complex community banks may find that a few pass ratings are sufficient to differentiate
the risk among their pass rated credits:
Rating for loans secured by liquid collateral
A Watch category
One or two other pass categories
In addition to increasing the number of rating definitions, some banks have initiated Dual
Rating Systems (DRS)
DRS have emerged because a single rating may not support all of the functions that require credit
risk ratings
DRS typically assign a rating to the general creditworthiness of the obligor and a rating to each
facility outstanding
Facility rating considers the loss protection afforded by assigned collateral and other elements of
the loan structure in addition to the obligor’s creditworthiness
Obligor ratings support deal structuring and administration, while facility ratings support ALLL
and capital estimates
Below is an example of a Dual Rating System proposed in the past (by the accounting industry).
This system was not widely accepted by bankers but the concept has some validity
Risk of Default
Probability of Loss
Marginal
Weak
Default
No Risk of Loss
Low Risk of Loss
Moderate Risk of Loss
High Risk of Loss
The OCC and other regulatory authorities do not advocate any particular rating system rather; it
expects all rating systems to address both the ability and willingness of the obligor to repay and
support provided by structure and collateral. Such systems can assign a single or dual rating.
RISK RATING AND THE MANAGAMENT INFORMATION SYSTEM
A good MIS should enable the calculation of
–
Volume of credits whose ratings changed more than one grade (double
downgrades)
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Page 40
–
Seasoning of ratings (time a credit holds grade)
–
Velocity of rating changes
–
Default and loss history by rating category
–
Ratio of rating upgrades to rating downgrades
–
Rating changes by line of business, officers & location
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Special Mention (OAEM)
Included in this category are loans that do not presently expose the bank to a sufficient degree of
risk to warrant adverse classification but do possess credit deficiencies deserving the bank’s
close attention. Failure to correct deficiencies could result in greater credit risk in the future.
Ordinarily, such borderline credits have characteristics which corrective action by the bank
would remedy. Often in credit lines warranting Special Mention, it is the bank’s weak origination
and/or servicing policies that constitute the cause for criticism. The nature of this category of
loan criticism precludes inclusion of smaller lines of credit unless those loans were part of a large
grouping listed for related reasons.
Substandard Assets
A substandard asset is inadequately protected by the current sound worth and paying capacity of
the debtor or of the collateral pledged, if any. Assets classified Substandard must have a welldefined weakness or weaknesses that jeopardize the liquidation of the debt. They are
characterized by the distinct possibility that the institution will sustain some loss if the
deficiencies are not corrected.
Doubtful Assets
An asset classified Doubtful has all the weaknesses inherent in one classified Substandard with
the added characteristic that the weaknesses make collection or liquidation in full, on the basis of
currently existing facts, conditions, and values, highly questionable and improbable.
Loss Assets
Assets classified Loss are considered un-collectible and of such little value that their continuance
as bankable assets is not warranted. This classification does not mean that the asset has
absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer
writing off this basically worthless asset, even though partial recovery may be affected in the
future.
Technical Exceptions
Technical deficiencies in documentation of loans will be brought to the attention of the bank for
remedial action. Failure of the bank to effect corrections may lead to the development of greater
credit risk in the future. Moreover, the presence of an excessive number of technical exceptions
is a reflection on the bank’s quality and ability. During the course of the examination, the bank
will be given a listing of loans that possess technical deficiencies. Such a procedure is intended
to expedite early correction, of the deficiencies and, in normal circumstances, inclusion of such
exceptions in the report will be unnecessary. However, when spot checks reveal an excessive
volume of deficiencies in loans under the cut-off point, regulatory agencies will insert the
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Page 43
applicable technical exceptions page in the report of examination. Such a procedure adds
emphasis to the importance of the documentation and provides support for the regulatory
agencies’ Comments and Conclusions schedule. Regardless of the size of the loan, existence of
an inordinate number of technical defects will be emphasized.
Troubled Commercial Real Estate Loan Classification Guidelines
Additional classification guidelines have been developed to aid the examiner in classifying
troubled commercial real estate loans. These guidelines are intended to supplement the uniform
guidelines discussed above. After performing an analysis of the project and its appraisal, the
examiner must determine the classification of any exposure.
The following guidelines are to be applied in instances where the obligor is devoid of other
reliable means of repayment, with support of the debt provided solely by the project. If other
types of collateral or other sources of repayment exist, the project should be evaluated in light of
these mitigating factors.

Substandard - Any such troubled real estate loan or portion thereof should be classified
Substandard when well defined weaknesses are present which jeopardize the orderly
liquidation of the debt. Well defined weaknesses include a project's lack of marketability,
inadequate cash flow or collateral support, failure to complete construction on time or the
project's failure to fulfill economic expectations. They are characterized by the distinct
possibility that the bank will sustain some loss if the deficiencies are not corrected.

Doubtful - Doubtful classifications have all the weaknesses inherent in those classified
Substandard with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently known facts, conditions and values, highly
questionable and improbable. A Doubtful classification may be appropriate in cases
where significant risk exposures are perceived, but Loss cannot be determined because of
specific reasonable pending factors which may strengthen the credit in the near term.
Examiners should attempt to identify Loss in the credit where possible thereby limiting
the excessive use of the Doubtful classification.

Loss - Advances in excess of calculated current fair value which are considered
uncollectible and do not warrant continuance as bankable assets. There is little or no
prospect for near term improvement and no realistic strengthening action of significance
pending.
Bankers Insight Group
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WHO SHOULD ASSIGN THE RISK RATING?
Loan risk classifications should accurately reflect the risk of non-repayment. An institution’s
classification system should closely parallel those contained in the regulation (Special
Mentioned, Substandard, Doubtful, and Loss) both to promote accuracy in filing quarterly
reports and to enable examiners to test the accuracy of the classification ratings efficiently.
Typically, the loan officer will rate loans at the time a credit is booked. The loan officer will
revise the rating as a borrower’s financial condition changes or circumstances require. During the
loan review process, the loan review officer will independently rate each credit reviewed. This
becomes a verification of the loan’s rating.
The regulatory agencies pay considerable attention to loan grading. Typically, the examiner will
select credits and review documentation in order to determine whether or not the grading system
is reliable based on the examiner’s classification of assets.
When assigning a risk rating, it should reflect the following factors:
1.
Financial and Credit Quality of the relationship
2.
Credit File Documentation and Completeness
3.
Regulatory and Policy Compliance
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HIGHLY EFFECTIVE HABIT #5
PROPER LOAN DOCUMENTATION TO PROTECT THE BANK
The heart of any loan transaction is the loan itself and the documentation setting forth the terms and
conditions under which the loan is to be repaid by the borrower. Even the most marketable
collateral and the best drafted collateral and guaranty agreements may be of little assistance to a
lender if there is some flaw in the terms of or the documents evidencing the underlying loan
transaction. Loan documentation is simply the commitment of the negotiated loan transaction to
paper. This commitment serves two purposes:

It clarifies the deal so that each party understands the details of the deal
It transforms the deal to a legally enforceable form

There are five basic steps to be taken in the documentation of any secured transaction.
Each should be reviewed by the lender for every loan. They are as follows:
1. IDENTIFY THE BORROWER
Use the correct name
Type of legal entity
Who is authorized to represent the entity?
How do we know?
Is the borrower authorized to conduct its business under federal legal requirements?
2. IDENTIFY THE COLLATERAL
Who owns it?
Where is it located?
Does the borrower have the authority to pledge it?
3. EVIDENCE THE DEBT
What is the mutual understanding of the loan arrangement?
How much money will be borrowed?
How and when will it be repaid?
What happens if I default?
4. ATTACH THE COLLATERAL
How can a security interest be granted?
5. PERFECT THE SECURITY INTEREST
Public notification of the security interest
All secured transactions will have these basic components, in some form.
Remember, the documentation becomes important if the deal goes sour
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It is important for the most fundamental aspect of any loan transaction be properly structured and
evidenced. The documents traditionally used to evidence debts arising from loan transactions,
namely the loan agreement and promissory note, are often used as companion documents to set
forth the parameters of the relationship between lender and borrower.
The promissory note is the central document to all loan transactions, as it evidences the debt. It
also outlines the terms of the loan. All notes must contain the following information:

The name of the lending institution

The date of the loan

The interest rate to be charged

Maturity date

Payment schedule

Any charges beyond the interest

Signature of borrower(s)
Promissory Notes
The promissory note is the basic instrument of lending as it evidences the indebtedness of the
borrower to the bank. The note serves to evidence the debt and the collateral that secures the
note. In addition, all collateral that the lender may take as security, is dependent upon the
enforceability of the note. Although the note identifies the collateral, the granting of a security
interest in the collateral must be accomplished by a security agreement. The Loan Agreement
provides more protection than the Promissory Note because it sets several parameters and
expectations for the borrower to follow
Definition
The Uniform Commercial Code (UCC) defines a note as a type of commercial paper.
Commercial paper is defined as any written promise or order to pay a sum of money. According
to this definition, commercial paper has two basic functions; it is a substitute for money, and it is
a credit device. Since this study guide deals with loan documentation, we will look at
commercial paper in its second function, a credit device.
The note is the simplest form of commercial paper. It is a written contract between two parties
in which one party, the maker, unconditionally promises to pay a specified sum of money to the
order of another party, the payee. If the note meets all of the following criteria, then it is also a
negotiable instrument and may be transferred to a third party as a holder in due course. The
formal requirements for negotiability may be briefly stated as follows:

The note must be dated

The instrument must be in writing and signed by the maker

It must contain an unconditional promise to pay a certain sum of money

It must be payable on demand or at a definite time (example: on 1/31/xx, or within 90 days)

It must be payable to order or bearer
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Types of Promissory Notes

Single Advance Note

Multiple Advance Note

Revolving Lines of Credit

Demand Notes

Specific Maturity Notes

Fully Amortizing

Balloon Note
Loan Agreements
A promissory note generally serves as primary evidence of a borrower's indebtedness to its lender;
however, it is becoming more common to supplement (and in some cases entirely replace) a
promissory note with a loan agreement. Separate loan agreements are usually not warranted in
simpler, single advance loan transactions, and in such transactions you should expect to continue to
see the promissory note as the primary evidence of the borrower's obligation regarding such a loan.
However, in more complicated transactions, such as those involving construction loans, revolving
lines of credit or other multiple advance transactions, the use of a separate loan agreement may be
necessary or appropriate for the following reasons:
All loans have loan agreements. However, some loan agreements are more tangible than others.
At one end of the spectrum are lengthy agreements that have been formally drafted by legal
counsel. In the middle are pre-printed loan agreements, usually containing a security agreement
that banks may use for nearly any type of credit extended. At the other extreme are completely
informal oral agreements, which have little significance.
Many banks take the position that loan agreements are simply too complicated and often attempt
to avoid using them in loan transactions. However, loan agreements can benefit both the lender
and the borrower. While the borrower must have sufficient latitude to operate the company,
certain limitations must be placed on the business due to the bank’s credit exposure. Provisions
in the loan agreement must be drafted to guarantee adequate cash is conserved by the borrower to
ensure continued financial viability and to repay the bank’s loan.
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In this section, we will discuss formal loan agreements that are generally used in large or
workout loans. By reviewing the components of this very formal and specific type of loan
agreement, we can examine in detail how a loan agreement works.
Definition
To begin, we need to define what a loan agreement is and what purposes it will serve. A loan
agreement is a legally binding document executed by the borrower and the bank with the
following objectives in mind:

Set forth the agreement between the bank and the borrower by clearly and concisely
defining the duties and responsibilities of both parties during the term of the loan

Establish restrictions and qualifications on the borrower’s activities and financial
condition, which are set out by affirmative and negative covenants

Cause the borrower and lender to work through various contingencies thus preparing an
alternative plan of action that both parties can agree to abide by should the original plan
become inoperable

Serve as a communication tool and monitoring device by requiring the borrower to
submit certain documents at specified times and to require notification of the lender about
certain plans of the borrower (Example: periodic financial statements and financial
projections).
In order to accomplish all of the objectives outlined above, most loan agreements contain certain
common articles, provisions or paragraphs. These articles are discussed below in the order that
they generally appear in a loan agreement.
Recitals
This is the first paragraph of the agreement and will set out the parties of the loan, i.e. identifies
the borrower, the lender and the guarantors. It states the date the agreement becomes effective,
and declares that all parties agree to be legally bound by the terms of the agreement.
Loan Transaction
This paragraph identifies the loan including its amount; purpose; the promissory note(s) involved
in the transaction; interest rate; fees (facility, commitment or compensating balance fees, if any);
costs and expenses attributable to the loan (who will pay them); limitations on advances and
prepayment penalties; and re-borrowing privilege (in the case of a revolving loan).
Collateral and Security
In this section, the debtor agrees to grant a security interest in collateral; procure guaranties from
specified third parties (these guaranties may be secured or unsecured); pledge life insurance and
procure subordination of certain other indebtedness. A cross-collateral clause may also be
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employed, which gives the lender the right to apply the existing collateral to any future
indebtedness.
Representations and Warranties
The borrower warranties and represents the following to the bank:

The borrower is qualified to do business in all jurisdictions in which he/she conducts
business

The loan agreement does not violate or cause the borrower to violate any law

The agreement has been daily authorized, executed, delivered and is binding on its behalf

The borrower is not involved in litigation, either actual or threatened, that would affect
his/her financial condition

Information prepared and supplied is true and correct

No subordination of this debt will be granted

The borrower possesses all permits and licenses necessary to conduct business

The legal title is held to all assets, which secure this obligation

The borrower is in compliance with all laws and regulations that control his/her business

All taxes have been paid

No other outstanding bank debt exists unless disclosed
Conditions Present
This section requires the borrower to fulfill certain conditions before the bank will advance on or
renew the credit facility. Examples of some of these conditions are: all legal matters related to
advances and renewals of the facility must be acceptable to banks’ counsel; all articles of the
agreement must be complied with; all security interests must have been granted; and finally, all
documents have been delivered.
Affirmative Covenants
In an affirmative covenant, the borrower pledges to perform some action or provide some
information specified in the loan agreement. Some common affirmative covenants you may see
in loan agreements include:

Punctual payment (usually within five days of the due date)

Accounting records that are kept in accordance with GAAP and open to inspection by
bank personnel at any time
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
Timely submission of the borrower’s and guarantor’s financial statements, accounts
receivable aging, annual audits, and tax returns

Maintenance of adequate insurance

Plant and equipment will be kept in good repair

All indebtedness will be discharged when due (including taxes)

Prompt notice will be given to the bank upon occurrence of default, change of name,
uninsured loss or movement of collateral that would require filing of new collateral
documents
Negative Covenants
Negative covenants are the exact opposite of affirmative covenants. Instead of the borrower
pledging to do something, he is now promising not to do something. Following are examples of
some negative covenants found in a loan agreement.
The borrower pledges not to:

Use the proceeds for the loan except for purposes set forth in the agreement

Make additions to fixed assets in excess of a certain dollar amount annually

Incur additional debt

Grant security interests without prior consent of the bank

Merge, consolidate or sell assets

Become guarantor or endorser of obligations of any person

Make loans in excess of a certain dollar amount or make investments that would impair
its liquidity

Declare or pay dividends without the bank’s prior approval

Allow certain financial rations (e.g. working capital, debt-to-worth, debt service) to fall
below specified levels

Permit the loan’s principal balance to exceed predetermined levels
Events of Default
This section of the loan agreement will spell out the specific events of default. Listed below are
a few of the common events of default:

Nonpayment of principal and interest

Materially false or incorrect representations or warranties

Failure to perform according to the terms or covenants of the agreement
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
Sale or transfer of ownership in the borrowing entity without lender approval

Governmental control of a substantial amount of assets

Suspension or revocation of material franchises, licenses or permits

Failure of borrower to pay any levy or judgment

Borrower or guarantor becoming insolvent or filing bankruptcy, voluntarily or
involuntarily
The section that spells out the events of default will also generally contain an acceleration clause.
The acceleration clause will tell the borrower that in any event of default, at the lender’s option,
all debt owed to the lender, including other notes, become due and payable immediately, without
presentment (demand of payment).
Miscellaneous
The final section of a loan agreement is the miscellaneous clause. This clause, just as the name
implies, takes care of anything the other clauses don’t cover. Generally, you will find that the
miscellaneous clause may contain any or all of the following:

The bank’s right to set off (a lending bank’s right to use funds of the borrower on deposit
to reduce the borrower’s indebtedness upon default)

The assignability of the agreement

The terms under which the agreement may be terminated

Which party shall be responsible for collection expenses in connection with the debt
So far, we have determined the legal entity and identity of the borrower in order to establish the
capacity to borrow; discussed the characteristics of the promissory notes evidencing the debt;
and learned how the loan agreement acts as a means to formalize the intentions of both parties
relating to the loan transaction.
Up to this point, any of the documents we have analyzed could be used in either secured or
unsecured lending transactions. However, since today, most lending is done on a secured basis;
we need to look at the documentation necessary to secure a loan. However, in order to
understand how documents secure a loan, we first need a lesson in secured transactions.
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FFECTIVE HABIT #6
EFFECTIVE LOAN PORTFOLIO MANAGEMENT
No matter how good the initial decisions, if the credit is not professionally followed, the
bank is asking for trouble. Portfolio management should be performed from two levels,
Senior Management and the Loan Officer.
The ultimate responsibility of a bank’s safety and soundness is the Board of Directors
however, since it is not expected for Board members to actively participate in
management on a day to day basis, this responsibility is delegated to executive
management of the bank.
When a bank’s total assets reach $300 million, it is usually recommended by regulators
for the bank to have a Senior Credit Officer and a Senior Loan Officer. Although their
responsibilities may have areas of overlap, there are some sharp differences. For
example, the Senior Credit Officer is primarily responsible for the overall credit quality
of the bank by enforcing credit policies, monitoring the types of loans being approved
and managing the approval process while the Senior Loan Officer is primarily
responsible for good loan business development, management of the lending staff and
directly managing the loan portfolio.
The SCO, SLO and the loan officers, for that matter must rely upon several management
reports to properly manage the loan portfolio. In other words, a bank’s Management
Information System (MIS) is critical to the lending process and management of the loan
portfolio. The following is a list of reports management should have on a frequent basis:

New Loans Report (Useful for loans made outside of loan committee)

Loan Renewed Report

Documentation Exception Report

Loan Grading Report
o Loan experiencing more than one grade change within one year
o Loans with the same grade for two years or more
o Number of loan upgrades and downgrades within one year
o Velocity of grade changes by officer, location, branch, etc.

Past Due Loan Report

Loans on Non-Accrual

Loans considered to be Trouble Debt Restructurings

Classified Loan Management Reports
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
Loan to Value Exception Report

Allowance for Loans and Lease Losses Report
The responsibility of a lender is to monitor the quality and profitability of the borrower’s
total relationship on an ongoing basis. The lender’s responsibility doesn’t end once the
loan is made and documented. Because circumstances change, both within the borrower’s
business and in its external environments, the lender must monitor the fluctuating quality
of a given credit as a result of those changes. This imposes on the lender the
responsibility of staying abreast of changes – economic, legislative, technological,
competitive, and demographic – and their implications on the borrower.”
Relationship Manager's Monitoring Responsibilities:
The key to success in relationship monitoring: quality communication between the client and
the bank.
Relationship manager is primarily responsible for:

Maintaining regular communication with the client

Anticipating problems

Working effectively in problem resolution

Maintaining accurate and current credit files

Understanding the effects of economic and regulatory changes on the client’s risk
profile
Forms of Communication:

Visits

Phone calls

Letters

Social Events
Objectives of these contacts:

Monitor the success of the business.

Maintain open lines of communication.

Strengthen and extend the relationship.
Company visits:



The key to good customer relations.
One of the ways to uncover organizational or operational changes.
On-site inspections can reveal changes in the company’s physical assets well before
they are disclosed in financial statements.
Other sources of Information
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Borrower’s:
 attorney, accountant or other consultants providing services.

competitors,

suppliers,

customers and

regulators.
Information from all possible sources can help you to put together a viable evaluation of
the company’s current position and future opportunities.
Inspections of public records including newspapers, magazines, and trade publications
can provide information on:

Filed liens on the company’s assets.

Plant closings.

Contracts received or terminated.
Maintenance of Credit Files:
Credit files:

are the written record of the relationship between the bank and the borrower;

are critical in effectively monitoring credit relationships.

outline the history of the relationship.

provide a snapshot of the entire client relationship, including all products and
services.

provide financial data for an evaluation of the entire portfolio.
Properly maintained files can help improve credit quality and minimize losses, they must be:

Complete

Accurate

Well organized
Suggested content of Credit Files:

Financial information

Credit write-ups and financial analysis

Credit inquiries and reports

Correspondence and memos

Miscellaneous materials

Copies of loan documents
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In all bank-generated information - It is important for the writer to be clear, concise, simple,
objective, factual, truthful and well organized. Any written information should:

Supply adequate information for decision-making.

Interpret facts for the reader.

Indicate all sides of an issue.

Differentiate between fact and opinion.

State where the information came from, and evaluate the reliability of the source.

Admit errors of judgment and action on the part of the client, and explain why they
occurred and what needs to be done.
Word of Caution - Be careful in what is written and contained in the file, ask this question:
Is there information that might expose the bank to lender liability? (Keep the judge in
mind!)
Covenants
Loan covenants are:

a key element for monitoring loans;

designed to protect the bank’s interest;

a part of the formal loan agreement;

an outline for certain acts that the borrower must

perform (affirmative covenants)

must refrain from doing (negative covenants).
Creating loan covenants is a key to achieving the bank’s objectives.

Full Disclosure of Information

Protection of Net Worth

Protection of Cash Flow

Protection of Asset Quality

Control Growth

Maintenance of Key Management

Assurance of Legitimacy and the Company as a Going Concern

Profitability for the Bank

Bring the borrower back to the table
Covenants must:
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
Be those that the bank expects to enforce.

Be set to provide timely warning signs.
Covenants do not:

Repay loans.
In crafting a covenant package, it is important to determine your key objectives to ensure
effective monitoring and management of the exposure and to assure the bank of the optimal
chance of repayment.
Monitoring covenants is an important function for the following reasons:

Provides a current set of financial statements

Facilitates awareness of the financial condition of the borrower(s) and guarantor(s)

Allows for periodic contact with the borrower

Minimizes risk through regular monitoring
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Ensure Continued Existence
Maintain Management Quality
Full Disclosure
Maintain Net Worth
Control Growth
Maintain Cash Flow
Preserve Asset Quality
Affirmative Covenants
(Financial)
Financial ratios: You should require the company to maintain certain minimum or
maximum levels for various ratios. These are triggers; if the borrower fails to comply,
company performance is outside the expected range. Frequently used ratios are:
Current ratio – minimum
X
Quick ratio – minimum
X
Sales / assets – minimum
X
Profits / assets – minimum
X
X
X
X
Return on equity or profits / tangible net worth – minimum
X
Debt / equity – maximum
X
ARDOH – maximum
X
X
Inventory DOH – maximum
X
X
APDOH – maximum
X
X
X
Times interest earned – minimum
X
X
Fixed charges coverage – minimum
X
X
Working capital: You should require a minimum dollar amount of working capital to be
maintained during the course of the loan based on the projections of future
performance
X
X
X
Net worth: You should require the company to maintain a certain minimum level of net
worth. This amount may increase for each year of the loan to correspond to the
projected net worth levels
X
X
X
X
X
X
X
Negative Covenants
Additional loans: You should place an upper limit on additional borrowing in terms of a
dollar amount or a ratio. Limit should permit normal operations and other expected
and acceptable needs.
Sale of assets: Limit the borrower’s ability to sell assets to a maximum dollar amount.
(The exception to this is assets sold in the normal course of the company’s business –
inventory, for example.)
X
X
X
X
HIGHLY EFFECTIVE HABIT #7
PROBLEM LOAN MANAGEMENT AND ACCOUNTING
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Good Credit Administration requires effective management and oversight of problem loans. In
doing so, quick and accurate identification of problem loans are required. Routine and
meaningful problem loan reporting must be:

Frequent

Meaningful

Action plans

Specific

Actionable

Date-certain
The financial regulators recognize that financial institutions face significant challenges
with borrowers secured by commercial real estate (CRE) caused by:
◦
Diminishing operating cash flow
◦
Depreciated collateral values
◦
Prolonged sales and rental absorption periods
On October 30, 2009, the financial regulators issue a Policy Statement on Prudent Commercial
Real Estate Loan Workouts
Replaces the Interagency Policy Statements on
◦
“Review and Classification of Commercial Real Estate Loans” (November 1991)
◦
“Review and Classification of Commercial Real Estate Loans” (June 1993)
Prudent CRE loan workouts are often in the best interest of Bank and Borrower
Examiners are expected to take a balanced approach in assessing an institution’s risk
management practices for loan workouts
Examiners will not criticize banks implementing prudent CRE loan workout arrangements
after
a comprehensive review of a borrower’s financial condition
Renewed or Restructured loans to paying borrowers will not be subject to adverse
classification solely because the value of the underlying collateral has declined to an amount
that is less than the loan balance
Purpose of Guidance
 Addresses supervisory expectations for an institution’s risk management elements
for
loan workout programs including:
◦
Loan workout arrangements
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◦
◦
Classification of
loans
Regulatory reporting and accounting considerations
Risk Management Elements
•
Should be appropriate for the complexity and nature of lending activity
 Should be consistent with safe and sound lending practices
•
Should be consistent with regulatory reporting requirements and should address:
◦
Management infrastructure to identify, control and manage the volume
and complexity of the workout activity
◦
Documentation standards to verify the borrower’s financial condition and collateral
values
◦
Adequacy of MIS and internal controls to identify and track loan performance
and risk, including concentration risk
◦
Management’s responsibility to ensure that the regulatory reports of the institution
are consistent with regulatory reporting requirements (including GAAP) and
supervisory guidance
◦
Effectiveness of loan collections procedures
◦
Adherence to statutory, regulatory and internal lending limits
◦ Collateral administration to ensure proper lien perfection of the institution’s
collateral
interests for both real and personal property
◦
An ongoing credit review function
Loan Workout Arrangements
•
Banks should consider loan workouts after:
1. Analyzing a borrower’s repayment capacity
2. Evaluating support provided by guarantors
3. Assessing the value of the collateral pledged
•
If institutions enter into restructuring with borrowers that result in an adverse
classification, those institutions will not be criticized for engaging in loan
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workout arrangements so long as management has:
1. Prudent workout policy establishing loan terms and amortization schedules
2. A well-conceived and prudent workout plan for an individual credit that
analyzes the financial information of borrower or guarantor. Key elements of
a workout plan include:
•
Updated and comprehensive financial information on the borrower,
real estate project and any guarantor
•
Current valuations of the collateral supporting the loan and the
workout plan
•
Analysis and determination of appropriate loan structure (e.g. term
and amortization schedule) curtailment, covenants or re-margining
requirements
•
Appropriate legal documentation for any changes to loan
terms
3. An analysis of the borrower’s global debt service that reflects a
realistic projection of the borrower’s and guarantor’s expenses
4. The ability to monitor the ongoing performance of the borrower and
guarantor under the terms of the workout
5. An internal loan grading system that accurately and consistently reflects the
risk in the workout arrangement
6. An ALLL methodology that covers estimated credit losses in the
restructured
loan, measured in accordance with GAAP, and recognizes credit losses in a
timely manner through provisions and charge-offs, as appropriate
How to Analyze Repayment Capacity
•
Character, overall financial condition, resources, and payment record of
the borrower
•
•
Degree of protection provided by cash flow or collateral on a global basis
that
considers the borrower’s total debt obligations
Market conditions that may influence repayment prospects and the cash
flow potential of the business operations or underlying collateral
•
Prospects for repayment support from any financially responsible
guarantors
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How to Evaluate Guarantees
 Existence of a guarantee from a financially responsible guarantor may improve
the prospects for repayment and may be sufficient to preclude classification or
reduce the severity of classification
 Be sure to determine number and amount of guarantees currently extended by
guarantor
 Consider if guarantor has significant investment in project
 Consider whether past call on guarantee have been honored voluntary or as a the
result of legal actions
Attributes of a Sound Guarantor
o Financial capacity and willingness to support the credit through
payments, curtailments or re-margining
o Adequate to provide support for repayment of the indebtedness in whole
or in part, during the remaining loan term
o Guarantee is written and legally enforceable
Assessing Collateral Values
 A new or updated appraisal or evaluation, as appropriate, should address current
project plans and market conditions
 Consideration should include:
◦
Performance of project
◦
Conditions for geographic market and property type
◦
Variances between actual conditions and original appraisal assumptions
◦
Changes in project specifications
◦
Loss of a significant lease or a take-out commitment
◦
Increase in pre-sales fallout
 A new appraisal may not be necessary in instances where an internal evaluation
updates the original assumptions to reflect current market conditions and provides an
estimate of the collateral’s fair value for impairment analysis
 A new appraisal may not be necessary in instances where an internal evaluation
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updates the original assumptions to reflect current market conditions and provides an
estimate of the collateral’s fair value for impairment analysis
 If weaknesses are found in assessing proper collateral value, examiners will direct
banks to address the weaknesses
 It may require the bank to obtain a new collateral valuation
 If a bank refuses, examiners will assess the degree of protection that the collateral
affords in analyzing an classifying a credit
Classification of Loans Based Upon:
 Loan Performance Assessment for Classification Purposes
o Examiners should not adversely classify or require the recognition of a
partial charge-off on a performing commercial loan solely because the
value of the underlying collateral has declined to an amount that is less than
the loan balance
o It is appropriate to classify a performing loan when well-defined
weaknesses exist that will jeopardize repayment
 Classification of Renewals or Restructurings of Maturing Loans
o
Renewals or restructuring of maturing loans to commercial borrowers
who have the ability to repay on reasonable terms will not be subject to
adverse classification, but should be identified in the internal credit
grading system requiring close monitoring
o Adverse classification or a restructured loan would be appropriate if
after restructuring, well defined weaknesses exist that jeopardize the
orderly repayment of the loan in accordance with reasonable modified
terms
 Classification of Troubled CRE Loans Dependent on the Sale of Collateral for
Repayment
o Amount of Loan in excess of Fair Value of Collateral (minus cost to sell)
should be classified as “Loss”
o Portion of loan balance that is adequately secured by the fair value of
real estate (less selling cost) should be classified no worse that
“substandard”
o Portion of loan balance in excess of the fair value of real estate (less
selling cost) should be classified as “Doubtful” when the potential for full
loss may be mitigated by the outcomes of pending events or when loss is
expected but the amount cannot be reasonable determined
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Effective problem loan management requires a full understanding of terms such as:

Impaired Loans as defined by ASC 310-10-35-2 through 30(fka FAS 114)

Impairment Analysis
o Present Value of Future Cash Payments
o
Observable Market Price
o
Fair Value of Collateral

Trouble Debt Restructure

Non-Accrual Loans

Recorded Amount of the Loan

Effective Interest Rate
Calculating the Allowance for Loans and Lease Losses and Defining Impaired
ASC 450 (Formerly FAS 5)
ASC 450 is an accounting requirement required to estimate the potential loan losses on large
individually reviewed loans that are not impaired and smaller balance homogeneous loans with
similar characteristics.
An estimated loss contingency shall be accrued by a charge to income if both of the following
conditions are met:
◦
Information available prior to issuance of the financial statements indicates that is
probable that an asset had been impaired or a liability had been incurred at the
date of the financial statement. It is implicit in this condition that it must be
probable that one or more future events will occur confirming the fact of the loss
◦
“The amount of loss can be reasonably estimated”
ASC 310 (formerly FAS No. 114)
ASC 310 considers a loan to be impaired when, based on current information and events, it is
probable that a creditor will be unable to collect all amount due (that is, both the contractual
interest payments and the contractual interest payment and the contractual principal payments of
the loan) according to the contractual terms of the loan agreement. In short all loans classified
Doubtful and certain loans classified Substandard, as currently defined for supervisory purposes,
will meet this impairment criterion. A loan whose terms are modified in a troubled debt
restructuring would be identified as an impaired loan.
ASC 310 clarifies that an insignificant delay in collection of an insignificant shortfall in the
amount does not constitute impairment. It states that a loan is not impaired during a period of
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delay in payment if the creditor expects to collect all of the amount due including interest
accrued at the contractual interest rate during the period the loan is outstanding.
Measuring Impairment
Once impairment is determined, ASC 310 requires that the impairment be measured in one of
three ways:
1.
The “present value” of expected future cash flows, discounted at the loan’s effective
interest rate
2.
3.
The “market value” for the loan where an observable market price exists
The “fair value of the collateral” where the loan is collateral dependent
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