Warning: Traditional Loan Review May Cause Banks Trouble in the Future 

December 2014

Warning: Traditional Loan Review May Cause Banks Trouble in the Future 

There’s no doubt that the loans your bank made in the post-recession years are going to change down the road, when interest rates rise and the economy swings yet again. But will your loan review process spot that shift in time?

Odds are it won’t.

And that will cause big trouble when it comes to a bank’s strategic and capital planning. Any bank that relies solely on their existing loan classification system (whether supported or not with a loan review process) will end up with unanticipated losses and charge-offs.

Regulators who have had the benefit of seeing the impact of the 2008 recession across the entire banking landscape have recognized this limitation. They no longer look at historical performance to assess how your bank will fare in the future.  Instead, they now want to see how your capital will perform under a two-year severe economic downturn. The loans your bank has made will each react differently to such a downturn, depending on loan vintages and their concurrent economic conditions.

Seemingly identically classified loans with different vintages will have substantially different probability of default (PD) and loss given default (LGD) levels in the future.   

Estimating PDs and LGDs is important for a bank for its own internal use, but it is also vital in M&A analysis. M&A is nothing more than a compressed contribution to a bank’s long-term strategic plan. Having the correct assumptions about loan performance becomes even more critical in the evaluation of potential targets.

Traditional loan review worked well in a stable environment and was reflected in the regulatory Basel 1 and Basel 2 structures. But after the 2008 recession, it has become more of a checkbox exercise that measures and validates a bank’s internal classification system, based on pre-recession criteria.

“In this new world, the value of the loan review process has become fairly limited, not just for regulatory action, but also for helping a bank with its strategic planning,” said Invictus Consulting Group Chairman Kamal Mustafa.  “The point is that the traditional loan review process that ignores vintage is useless. Two loans within the same classification level but with different vintages would have dramatically different PDs and LGDs. Banks that ignore these issues –and there are many because community banks are not required to stress test themselves– are compromising their own strategic and capital planning process. And that is an extremely dangerous compromise in these uncertain and volatile economic times.”

Some market participants believe that loan review is the same as or a substitute for stress testing. Similar to traditional balance sheet or call report analysis, loan review is based on historical and current environments.  Stress testing is the only forward-looking way to evaluate the performance of loans in different economic environments and determine their impact on capital adequacy.

The Office of the Comptroller considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”

The guidance noted that while many banks routinely conduct interest rate sensitivity analysis, they often don’t have “similar processes in place to quantify risk in loan portfolios, which often are the largest, riskiest, and highest earning assets.”