The Importance of a Loan Policy “Tune-Up”

The prosperity of FDIC-insured institutions is strongly attached to the management of their credit risks. In today’s competitive society, a well-written and executed loan policy is key for financial institutions. These loan policies must be kept up-to-date and in accordance with the ability of the lending institution. There are benefits to an effective policy as well as warning signs and penalties of a bad policy. Loan policies should be continually reviewed and updated to maintain the effectiveness of the policy.

Elements of an Effective Loan Policy

Written loan policies are different from one institution to the next. Each institution has to create loan policies to fit the size, the complexity and the tolerance risk of the institution. The policy must also address the product mix offering and be related to the economic conditions that the individual institution faces. Effective loans should be tailored to the bank’s needs and characteristics with enough flexibility for changes in the activities. Although each lending department should include different and detailed guidelines, there are some basic areas that loan examiners look for in all policies: general fields of lending, collection procedures, normal trade area and credit and collateral documentation standards along with many others. A complete list can be found in the FDIC Manual of Examination Policies.

Benefits of an Effective and Up-to-Date Loan Policy

The board of directors should always approve all loan policies since these policies reflect back on the board and are essential to the institutions prosperity and growth. Once in writing, the management is better able to enforce the policy. When the policies are effective and stay up-to-date there is a better possibility that the board will be satisfied with the loan documentation and underwriting practices. Levels of control are created which help examiners identify high-risk areas and allot time correctly for the examination. Using the risk-focused examination process, started in 1997, the sections with the highest risks are focused on. An up-to-date and effective written policy is tangible evidence that proves there have been actions taken to identify, measure, monitor and control risks. A poorly maintained policy,makes it difficult to identify the high-risk areas.

Signs That a Loan Policy Needs a Tune-Up

Changing the dates in the policy does not mean that it has been properly updated. The policy must be carefully reviewed to determine if it needs to be updated. Some common red flags include, but are not limited to:

• New regulations are not addressed.
• Officers or directors who no longer serve are listed, or new ones are not listed.
• Multiple versions of the policy are in circulation.

In addition, there may be areas where management has departed from specifics of the loan policy, including:

• Actual lending practices vary significantly from the policy outline.
• Policy limits are ignored.
• Numerous policy exceptions have been approved.

Exceptions should be minimal and properly explained. If actual practices vary, the policy should be reviewed by the board and either actual practices or the policy changed.

Potential Consequences of an Inadequate Loan Policy

The bank’s current situation and lending environment may not match the policies if the policies are not updated so that guidelines are not too restrictive, too lenient, or inappropriate in other ways. Inadequate loans can lead to earnings not supporting operations making the institution vulnerable to a decline in the economy, change in interest rates, or other economic events.

The Loan Policy Updating Process

Changes occur in business, regulations or economic conditions which require the loan policy to be changed and updated to fit the needs of the institution. Economic conditions, staff expertise, and growth expectations are just some of the factors that will determine how often the loan policy should be reviewed. Planned changes to the business function or business plan should be amended immediately. Not only are new sections being added but obsolete sections should be removed. Periodic training should be enforced to keep employees aware and complying to loan policies. Noncompliance should not be tolerable

Conclusion

In order for management to maintain the prosperity and lower the risk of the institution, the loan policy should be periodically updated and continually enforced. Employees, borrowers, and examiners will benefit from the up-to-date, comprehensive, effective loan policy.

References:

The full article on the FDIC website

Other references include:

• The FDIC Manual of Examinations Policies, Section 3.1 – Loans
• The Interagency Guidelines for Real Estate Lending Policies
• The Interagency Guidelines Establishing Standards for Safety and Soundness
• The MERIT (Maximum Efficiency, Risk-Focused, Institution Targeted Examinations) program

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