Loan Review: Scoping It Out

Introduction:?The Scope of Things to Come

“I knew who I was this morning, but I’ve changed a few times since then,” Alice lamented in Lewis Carroll’s Alice in Wonderland.?Loan reviewers probably feel that way when they commence a loan review only to find the review branches out from its original purpose as they discover new issues that lead them down new paths of inquiry.?Alice’s conversation with the Cheshire cat captures this frustration:

Alice:?“Would you tell me, please, which I ought to go from here?”

The Cheshire Cat:?That depends a good deal on where you want to get to.”

Alice:?“I don’t much care where.”

The Cheshire Cat:?“Then it doesn’t matter which way you go.”

Alice:?“So long as I get there.”

The Cheshire Cat:?“Oh, you’re sure to do that, if only you walk long enough.”

How far must a loan reviewer walk to look around an organization’s portfolio? How broad a field does loan review need to plow in order to unearth potential credit risks and to assess overall credit quality. How can loan review units shorten its journey to minimize scope creep??It is said that every journey begins with a single step, so let’s start walking.

Scope:?Hope We Get There Soon[i]

The Interagency guidance on credit review systems casts a wide net of expectations for loan reviewers that is bound to catch a lot of fish to fry.?It starts by stating that comprehensive and effective loan reviews cover all segments of the loan portfolio that pose significant credit risk or concentrations, and other loans that meet certain institution-specific criteria. Without defining what a properly designed scope should look like, the guidance expects the properly designed scope to take into account current market conditions, say, soaring lumber and construction materials prices, or other external factors—the pandemic or cyber criminals shutting down oil pipelines--that may impact a borrower’s current or future ability to repay the loan. Without offering any examples of and appropriate review scope, the guidance calls for the establishment of an appropriate review scope to ensure that the sample of loans selected for review, or portfolio segments selected for review, is representative of the portfolio as a whole and provides reasonable assurance that any credit quality deterioration or unfavorable trends are identified.

If that isn’t enough, the guidance also expects the credit risk review function to consider industry standards for credit risk review coverage consistent with the institution’s size, complexity, loan types, risk profile, and risk management practices. The institution’s board of directors or appropriate board committee typically approves the scope of the credit risk review on an annual basis or whenever significant interim changes are made in order to adequately assess the quality of the current portfolio.

The guidance expects the credit risk review scope to be risk-based and include these eleven items:

? Loans over a predetermined size;

? A sufficient sample of smaller loans, new loans, and new loan products;

? Loans with higher risk indicators, such as low credit scores, high credit lines, or those credits approved as exceptions to policy;

? Segments of loan portfolios, including retail, with similar risk characteristics such as those related to borrower risk, e.g. credit history, transaction risk, e.g. product and/or collateral type, or other risk factors as appropriate;

? Segments of the loan portfolio experiencing rapid growth;

? Exposures from non-lending activities that also pose credit risk;

? Past due, nonaccrual, renewed, and restructured loans;

? Loans previously adversely classified and loans designated as warranting the special attention of the institution’s management;

? Loans to insiders or related parties;

? Loans to affiliates;

? Loans constituting concentrations of credit risk and other loans affected by common repayment factors.

Whether your organization is big or small, this scope list casts a very wide across an organization’s credit extensions.?Like Alice wandering through Wonderland for a way out, loan review is on the hook for cleaning a lot of fish at the end of the day.?

Summary and Closing: Does Scope Give You the Creeps?

Princeton University’s computer science professor Edward Felten warned, “The problem - when you cast your net that wide - is you inevitably catch something you don't want to catch.”?One way to avoid overfishing and keep scope reasonable is to compare the guidance’s eleven scope items with your own scope to see if you all the items covered so you can bring your own scope into line with the guidance:

?

?

?

In-scope Items from

Interagency Guidance In your scope

-yes or no? If no, why? actions needed to add to scope

1-Loans over a

predetermined size

2- A sufficient sample

of smaller loans, new

loans, and new loan products

3- Loans with higher

risk indicators, such as

low credit scores,

high credit lines,

or those credits approved

as exceptions to policy

4- Segments of loan

portfolios, including retail,

with similar risk

characteristics such as those

related to borrower risk,

e.g. credit history, transaction

risk, e.g. product and/or

collateral type, or other risk

factors as appropriate

5- Segments of the loan

portfolio experiencing

rapid growth

6- Exposures from

non-lending activities

that also pose credit risk

7- Past due, nonaccrual,

renewed, and restructured

loans

8- Loans previously adversely

classified and loans designated

as warranting special attention

of management

9- Loans to insiders

or related parties

10- Loans to affiliates

11- Loans constituting

concentrations of credit risk

and other loans affected

by common repayment factors

Because loan review teams tend to have a wide range of experiences, they are especially vulnerable to scope creep, so if scope is not properly defined, documented, or controlled, a loan review team may find itself going down an unproductive and self-destructive path, wasting the organization’s resources, missing deadlines, weakening team communication, and, ultimately, ruining the team’s chance of bringing closure to its assignments.?Like Alice’s Mad Hatter complained, “It takes all the running you can do to keep in the same place.?If you do want to get somewhere else, you must run at least twice as fast as that.”?Now that you have scoped out this topic, next time we will dig deep into loan review depth, and, well, that’s a deep subject, too.

[i] Interagency Guidance on Credit Risk Review Systems, FIL-55-2020, May 8, 2020