Loan Review As an Enterprise Risk Tool Post-COVID-19

Loan review can be a critical component of a banking institution’s enterprise risk management (ERM) framework. A loan review’s primary function is to validate the underwriting, servicing and current risk grade of the borrower and is an essential function for all institutions in managing credit risk with their loan portfolio in accordance with its strategic planning and risk appetite.

An effective loan review process and function serves to satisfy management with multiple components of an ERM process, inclusive of risk identification, risk assessment, risk monitoring and reporting, and validation. As an independent function, loan review is designed to provide the board with an objective assessment of portfolio management and credit quality, as well as performing an effective challenge with regards to risk grade changes. Collaboration and communication across the key stakeholders within a loan review is critical to a sustainable process and improving the risk culture of the institution. Loan review personnel should have a direct pipeline and access to lenders, as well as the appraisal reviewers, but they also should make sure that regional credit officers are in the feedback / reporting loop on any loan review findings.

An effective loan review process and function should serve to satisfy multiple components of an ERM process, with risk identification acting as one of the main deliverables. One facet of risk identification for a loan review function is identifying and escalating any problem loans in the portfolio to the credit officer, as well as identifying weaknesses in loan documentation and credit file reporting. Traditional loan review functions will utilize a systematic focus on risk metrics defined within the loan underwriting process as the source of the institutions credit risk appetite. The traditional approach will identify the current state of these metrics and report them objectively as meeting the standards of policy or falling outside of its range. The results of this type of review provide a basis to subjectively assign a probability of default rating, usually a risk grade for a loan or relationship as defined by the institution’s policy. While these metrics may vary by institution, they will typically focus on the specific performance of a loan and the related borrowing entity. Such measures as payment history, annual cash flow and debt service coverage, as well as secondary cash flow generated globally from alternative income sources, usually attached to the credit relationship through the pledge of other income producing collateral or personal and corporate sponsorship of credits. Validation of such metrics produces an assessment of a policy defined risk grade. While most policies allow subjectivity in such a grade assignment, traditional loan review processes tend to utilize these metrics in making the subjective assignment.

Additional risk identification occurs with the validation of loan servicing requirements. Typical institution policies require certain levels of financial and performance monitoring, which are typically validated by traditional loan review processes. These generally relate to the acquisition and analysis of updated financial information to be utilized in the testing of financial covenants that represent an expected level of performance for the loan and the borrowing entity.

The traditional approach often serves as more of a validation than a risk assessment. While establishing an independent risk grade facilitates a form of risk assessment, it is often limited to the structural metrics outlined by the institution’s policy and does not provide for other objective and subjective attributes that contribute to risk. An effective loan review process should also serve to assess risk, as well as expand the process of risk identification.

While policies often define systematic parameters for loan review sampling, such as dollar exposure thresholds, loan review should encompass more than a systematic selection and review of loans. Loan portfolios should be segmented based on characteristics that share similar risks, such as industry, geography and product types, while considering the systematic macro-economic metrics that impact these segments. Then, within these risk components, the loan review process should consider specific transactions and their performance in relation to the institution’s risk appetite. Such factors should be a deliberate consideration of transactional risk grades. Considering transactional risk, the risk migration of these portfolio segments should also be assessed and measured in relation to the trends of the systematic macroeconomic metrics.

Once the traditional loan review process has been completed, reporting generally provides for a listing of exceptions and recommended risk grade changes. While process recommendations may be written, the description of the identified risks, their relationship to the institution’s risk appetite, risk movement trends and methodologies to control the level of risk are often not considered. Additionally, this information is often not integrated in the policy setting and management decision-making process, creating a communication gap in the culture of the institution. While this process provides information to assess both threats and opportunities in the management process, this information is often underutilized by the institution in the strategic and day to day management within the credit culture.

Loan review should provide leadership with information on emerging risks and market trends in order to better manage its portfolio within limits and chosen risk appetite, rather than repackaging risks that are already acknowledged. Portfolio-wide exception reporting should serve to drill down to specific segments and lenders as needed. Benchmarking the bank’s portfolio against peer portfolios can enable valueadded insights on performance.

It is paramount to avoid a perception of loan review as an audit function in which the key stakeholders hope to surprise you with unintentional consequences. Loan review should be considered as a key contributor to an institution’s macroportfolio credit risk management rather than being perceived as a robotic function using a transactional loan-by-loan approach. Institutions should re-prioritize the focus of their loan review functions to place more emphasis on credit rather than technical exceptions. The loan review rating scale should also warrant more conclusion-based findings (including recommendations), rather than a report laden largely with facts that do not share a common denominator.

In summary, loan review functions can help leverage ERM tools and methodologies to enhance their bank’s strategic thinking and planning in identifying pertinent opportunities, emerging risks and threats and improve risk-adjusted decision-making. This must be positioned and structured as a dynamic, continuous process focused on protecting the bank’s value proposition rather than being positioned as a regulatory compliance exercise.

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The information set forth in this material contain the analysis and conclusions of the author(s) based upon his/her/ their research and analysis of industry information and legal authorities. Such analysis and conclusions should not be deemed opinions or conclusions by DHG or the author(s) as to any individual situation as situations are fact specific. The reader should perform its own analysis and form its own conclusions regarding any specific situation. Further, the author(s) conclusions may be revised without notice with or without changes in industry information and legal authorities.


Dave Niles
Partner, DHG Financial Services


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