||Loan Review Program and Loan Grading System
Loan review is defined as that function which assesses the overall quality
of the bank's loan portfolio, measures the degree of compliance with the
lending policies and procedures and determines the relative collectibility
of loans. A loan grading system rates individual loans with respect to
the likelihood of loss or unlikely full collection.
This bulletin discusses common objectives and major characteristics
of an effective loan review and grading program, and provides guidance
to assist institutions in evaluating or establishing their own review
Many Bureau-supervised institutions have loan review programs and loan
grading systems. The Bureau strongly endorses those effective programs
already in place, and now encourages all institutions to establish and
maintain a loan review and grading program. The Bureau is concerned about
the rapidity with which loan portfolios can deteriorate when close ongoing
scrutiny of the lending function is not maintained. This concern is manifested
in the fact that lending difficulties represent a major contributing factor
in over 85% of recent bank failures. While the nature, scope, and structure
of a loan review and grading program will vary with the size and complexity
of each institution, the Bureau believes every bank should have an effective
program. The following discussion of a loan review program is provided
for your consideration.
OBJECTIVES OF AN EFFECTIVE LOAN REVIEW PROGRAM AND GRADING SYSTEM
Effective loan review is both necessary and beneficial because it promotes:
Timely identification and subsequent monitoring of risk in problem
loans, which could minimize losses.
Ongoing evaluation of the effectiveness of management-generated loan
"watch lists" which are an integral part of the review process.
Objective evaluation of the overall quality of the loan portfolio
on a regular basis.
Regular monitoring of compliance with applicable laws and regulations.
Systematic evaluation of the adequacy of and compliance with established
lending policies and related operating procedures.
Identification of concentrations of credit and other significant trends
which warrant attention.
Scrutiny of insider loans.
Positive identification of all restructured loans.
Use of a loan grading/rating/classification system to ensure monitoring
of problem loans and permit more accurate quarterly assessments of the
adequacy of the loan valuation reserve and provision for loan losses.
Detection of shortcomings in the training afforded lending personnel.
Identification of deficiencies in loan file documentation, the perfection
of security interests, and valuation of collateral.
Assurance of the integrity of bank records relative to loans.
Accountability of the lending staff for effecting corrective actions,
by the timely reporting of deviations from promised corrective actions.
CHARACTERISTICS OF AN EFFECTIVE LOAN REVIEW PROGRAM AND GRADING SYSTEM
In order for a loan review program and grading system to be fully effective
and, therefore, truly informative, it must be:
Independent by requiring the timely submission of written reports
directly to the Board or a Board committee.
Supported by the Board and the institution's chief executive officer
by being allocated adequate resources and unquestioned authority to
exercise operational freedom to review all facets of the lending area.
Governed by a written policy which is reviewed annually by the Board
and revised when circumstances warrant.
Staffed by technically competent personnel either from within or from
outside the bank or holding company.
Guided by a definitive written procedures manual or set of review
instructions which outline minimum standards for setting scopes, reporting,
workpaper documentation and loan grading criteria.
Characterized by CONTINUITY and INTENSITY of effort in order to create
the expectation among the the institution's lending staff, of CERTAIN
and ONGOING scrutiny by review personnel.
Based on a strong loan rating/grading system to enhance the credibility
and accuracy of loan and Other Real Estate carrying values.
Flexible in the scope of functions performed, tailoring the scope
of activities to match the unique characteristics of the institution's
trade area, experience of the lending staff, composition of the loan
portfolio and reflective of the historical trend of disclosed weaknesses
in credit administration.
SCOPE OF REVIEWS
Loan review scopes should be flexible, reflecting the unique loan portfolio
mix and problem loan experience of each institution. The array of review
functions should be planned annually by the bank's loan review personnel,
in concert with the Board or the Loan Review Committee. At a minimum,
the loan review function should include periodic reviews, during the course
of each calendar year, of:
Loans adversely classified by regulatory agencies
Loans featuring irregular payment histories
Indirect loans purchased
Loans that pose exposure to environmental liability
Insiders' loans and those to their related interests
Adequacy of loan file documentation
Consistency of collateral valuations
Concentrations of credit
Letters of credit and unfunded loan commitments
Significant lines of credit, stressing assessment of repayment abilities
of the borrowers (conducted at least quarterly)
Random reviews of smaller loans for a determination of asset quality
and the adequacy of loan file documentation
Other Real Estate and repossessions
Compliance with applicable laws and regulations
Compliance with established lending policies and procedures
Lending department responsiveness to prior recommendations of auditors,
regulatory agencies or loan reviewers
Effectiveness of the management-generated loan watch list and/or the
related loan grading/rating/classification system
Verification of loan proceeds
Adequacy of the provision for loan losses
LOAN REVIEW ALTERNATIVES
There are five basic methods of providing staff for a loan review system,
each offering different advantages and posing various disadvantages. A
loan review staff may use personnel from one or more of the following
The institution's lending staff (officers review loans originated
In selecting one or a combination of these alternate methods of staffing
an effective loan review and grading program, the Board should be guided
by such factors as:
The auditing department
An outside firm
An independent loan reviewer or loan review department
Bank holding company staff
The size and complexity of the loan portfolio
The technical competence of the present lending, review or audit staff
The effectiveness of existing internal controls
The degree of portfolio risk present
The current volume of recession-sensitive loans held in the portfolio
Strategic plans for growth of the loan portfolio or changes in its
The adequacy of the institution's current loan review program and grading
system, policy, staff, and procedures should be reviewed in light of this
Bulletin. If no formal loan review program and grading system, or policy
and procedures are in effect, they should be developed and implemented.
Bureau personnel have been instructed to examine loan review programs
and to consider the adequacy of such programs when determining the scope
of an examination and when assigning CAMEL ratings.
||Eugene W. Kuthy, Commissioner
||Donald P. Mann, Director, Bank & Trust Division
||September 8, 1990