Loan Audit and Scoring System Keeps Portfolio Risks Low
"Given what happened with the S&L's, it is very important that financial institutions today have some kind of loan audit program and risk scoring system in place," states Sharon Hardy, CFE, Internal Audit Manager and Compliance Officer for Brotherhood Bank & Trust, a mid-sized ($290 million in assets, $3+ billion in trust assets) institution in Kansas City, KS. "Bank regulators have strongly recommended that commercial banks establish some type of risk grading methodology, independent of the loan department." Brotherhood Bank & Trust has taken the recommendation seriously, with a multi-phase loan review, audit, and scoring system.
Pre-Loan Reviews
The first phase is the traditional pre-loan credit review process, conducted by the loan department. "Before the loan proposal goes to the loan committee, a loan officer conducts a financial analysis and rates and grades the proposal," states Hardy. The bank recently implemented a formal rating system for the loan officers to use, requiring them to go through all of the informatlon they receive from the applicant. An important element of the rating system is that it does not consider collateral during the initial stages. "The last thing we want to do is be compelled to liquidate assets," explains Hardy. Upon completion of the review and rating system, the loan officer presents the findings to the loan committee to see if the loan will be funded. Post-Loan Reviews
After loans have been approved, the loan department conducts its own follow-up reviews to assess the wisdom of the loans and to determine if any need to be placed on the "watch list." Post-Loan Audits
Audits. While these internal procedures tend to be very effective in ensuring low-risk portfolio, the bank recently instituted an independent loan review audit program to further help ensure portfolio safety. While such practices are common in large banks (which usually have fully-staffed audit departments), they are less common in smaller banks. As Internal Audit Manager, Hardy is responsible for this audit process at Brotherhood Bank & Trust. "Given auditors' emphasis on independence and objectivity, the placement of loan review and credit analysis in our function seems logical," she notes. "Our audits help us identify any potential risk loss in the commercial and consumer loan portfolios, especially helping us identify any 'sleepers' that may have been overlooked," she continues. Risk Scoring.
Brotherhood Bank & Trust has taken the effort even a step further. Rather than arranging just for standard audits, the bank has implemented formal credit risk scoring systems for the auditors to follow. The risk scoring element of the audit provides additional objectivity, according to Hardy. "Auditing is often based on gut-level feelings," she explains. "Risk rating systems, on the other hand, have specific criteria and are quantitative. Regardless of what you know about the borrower, the risk rating system guides the process." The audit and scoring system looks at:
- financial analysis (capacity, collateral, capital);
- documentation and credit file content (credit history, repayment program, etc.)
- compliance to regulatory policy (including completion of the appropriate compliance documents)
- the character of the borrower;
- the earnings flow;
- asset/liability structure;
- debt capacity;
- the borrower's financial reporting;
- guarantees;
- amortization;
- terms/documentation;
- vulnerabilities.
"We then factor these together to an overall risk rating score," continues Hardy. Procedures vary to some extent for each type of loan consumer or commercial. To begin with, though, Hardy and her colleagues pull a sample of the disbursed loans to audit and score independently, with no knowledge at the time of how they were scored by the original loan officer. Consumer. "We conduct a sampling audit and rating of consumer and real estate loans under $100,000 on a quarterly basis," states Hardy. The scoring system is based on database software, which grades the loans from 1 to 5 (1 being most desirable, 5 being doubtful). "We then add other documentation, including repayment evaluation and financial statement analysis," states Hardy. Commercial. Commercial loan audits and ratings occur more frequently. Most frequently are commercial loans of $150,000 or more; slightly less frequently are commercial loans of $100,000 or more. The bank uses Robert Morris & Associates's formal rating system, which is considered the leading guide for commercial loan review. "We select a sample from each loan officer from each loan period," states Hardy. "We give the loan officer a worksheet to complete on each of the loans we select. We then conduct our own analysis, looking at a number of things, including credit profile, loan purpose, collateral, and repayment history. We then compare the loan officer's assessment with ours and come up with an overall grade." Hardy submits all final reports to the audit committee of the board of directors. Benefits
As mentioned earlier, the audit program and formal scoring system help the bank identify any potential risks in the loan portfolios. Prior to submitting reports to the audit committee, Hardy classifies them. There are a number of detailed classifications. Examples:
Special Mention. This is a loan that causes the audit team some concern, but nothing serious enough in the near future. "We simply place this loan on the 'watch list' for special attention and monitoring over time," she told sales. Substandard or Doubtful. A loan that falls into one of these two categories may prompt the bank to create a reserve for the loan, based on regulatory requirements. "This would be a percentage of the outstanding loan, maybe as low as 10% or as high as 50~, depending on the loan," reports Hardy. The audit and scoring process has an additional benefit. The results provide a learning experience for the loan officers, helping them identify concerns in future loan requests that they might otherwise overlook. Editor's Note: The above article originally appeared in the Credit & Collection Manager's Letter, a newsletter purchased by Credit Today in 2006. This article originally appeared prior to 2000.
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