INTRODUCTION

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 functions.

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.

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.

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:

Delinquent loans

Nonaccruing loans

Loans adversely classified by regulatory agencies

Restructured loans

Loans featuring irregular payment histories

Out-of-area loans

Indirect loans purchased

Loans that pose exposure to environmental liability

Overdrafts

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

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 areas:

The institution's lending staff (officers review loans originated by others)

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 mix

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.