EM-22.5 Category: Topic:

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1 EM-22.5 Categry: Tpic: Published: 08/20/2014 Lan Prtfli Management Lan Underwriting Overview Lan underwriting is ne f the mst critical aspects f the verall lan prtfli management (LPM) functin. Sund underwriting n individual lan transactins, administered under a framewrk f wellcnceived underwriting standards and supprting cntrl prcesses, is an indispensable cmpnent f an effective prtfli management system. Lan underwriting exemplifies an institutin s credit culture in actin and, if dne successfully, results in lan prtflis with risk and return characteristics cmmensurate with the bard s risk appetite and strategic bjectives, as well as safety and sundness cnstraints. Lan underwriting standards and practices will vary based n the nature f an institutin s territry, prtfli, risk prfile, and ther factrs. As such, institutins can use a variety f practices t satisfactrily carry ut, dcument, and reprt n the lan underwriting functin. Examiners shuld cnsider this as they apply the cncepts, strategies, and questins utlined belw. Examinatin Prcedures and Guidance General 1. Prcess fr Establishing Standards: Evaluate the sufficiency f the institutin s prcess fr establishing underwriting standards, including the level f bard invlvement. Guidance: Underwriting standards represent the single mst imprtant piece f underwriting directin that an institutin prvides t staff. Underwriting standards prvide the fundatin fr an effective lan underwriting prcess as they define the desired level f creditwrthiness fr individual brrwers and prvide unifrm criteria fr evaluating lans with similar characteristics. Additinally, underwriting standards prvide a mechanism fr reinfrcing the institutin s risk appetite with staff. Given the critical nature f underwriting standards, the bard shuld have an apprpriate level f invlvement in identifying the institutin s risk appetite and establishing r changing underwriting standards. The extent f bard invlvement can vary, as discussed belw. Evaluative questins and items t cnsider when examining prcesses fr establishing underwriting standards include: Develping Standards: Des the institutin have adequate prcesses fr develping underwriting standards? Institutins shuld have a lgical prcess r apprach t develping underwriting standards. The fllwing are sme typical ways t accmplish this: FCA Examinatin Manual Page 1 Lan Underwriting

2 Have experienced staff cmplete studies f significant industries, lending prgrams, r ther categries f lans based n histrical, current, and prjected infrmatin. These studies and the resulting standards wuld typically address the financial cnditin, perfrmance, and ther desired characteristics f successful peratrs in the industries being financed. Have tpical specialists participate in develping standards by prviding their expertise in specific industries r lending prgrams. Benchmark the standards f ther lenders that cnduct similar types f lending. Cnsider ther techniques and infrmatin as discussed elsewhere in this mdule, such as Cmbined System Risk Rating Guidance (CSRRG) prbability f default (PD) rating criteria, prtfli perfrmance, lss experience, and desired changes in target markets. Maintaining Standards: Des the institutin have an adequate prcess fr maintaining underwriting standards? Institutins shuld have a defined and structured prcess fr peridically reevaluating underwriting standards. Cnsideratins include: The agricultural lending envirnment is subject t ever-changing cnditins and variables. D nt autmatically assume that underwriting standards that facilitated past lending success will ensure future success. New r changing cnditins and variables warrant practive cnsideratin f crrespnding adjustments in underwriting standards. All underwriting standards shuld be reviewed peridically. An annual review cycle is cmmn. Sme institutins review all standards at the same time while thers review a prtin f the standards at different times thrughut the year (particularly institutins that have a large number f standards acrss many different prtfli segments). Peridic reviews f underwriting standards shuld address a wide range f cnsideratins fr example, changing ecnmic and market cnditins, prtfli and prtfli segment perfrmance, business plan gals and bjectives, new r planned lending prgrams, etc. The varius techniques applicable t initial develpment f underwriting standards are als applicable t peridic reevaluatins, such as industry r prtfli segment studies, use f tpical specialists, benchmarking t ther lenders, CSRRG criteria, etc. Bard Invlvement and Directin: Des the bard cnduct an annual review and affirmatin f underwriting standards? Is the bard sufficiently invlved when making changes t standards? A key rle f the bard is t determine the apprpriate risk appetite fr the institutin as part f establishing strategic underwriting directin and standards. As a best practice, the bard shuld als cnduct an annual review and affirmatin f underwriting standards. The need fr bard invlvement in apprving new r revised underwriting standards, hwever, can vary based n the nature f the standards. Bard review and apprval is mre critical if the institutin has a relatively limited number f underwriting standards and changes t standards are rare. Fr example, if an institutin changes its lng-standing cre underwriting standards, which are utilized n a large percentage f the prtfli, the need fr bard understanding and apprval is high. In FCA Examinatin Manual Page 2 Lan Underwriting

3 cntrast, significant bard invlvement may nt be practical if there are many underwriting standards, unusual r highly technical standards fr unique r specialized prtfli segments, r a high frequency f changes. Fr example, the need fr bard invlvement is lwer n less substantive technical changes, such as adjusting credit scre requirements r mdifying financial ratis fr mre specialized industry standards. In such cases, management shuld at least keep the bard infrmed f changes t standards. 2. Adequacy f Standards: Evaluate the adequacy f underwriting standards, including any related guidelines. Guidance: An institutin s underwriting standards must reflect the cmpsitin f the prtfli by reasnably addressing each f the majr cmmdities r industries financed. Standards shuld address risks inherent in specific industries and reflect the financial cnditin and perating perfrmance levels cnsistent with successful peratrs in that industry wh can withstand a reasnable level f adversity. It is particularly imprtant that new lan prgrams and ther grwth areas be guided by apprpriate underwriting standards. Ultimately, the use f slid underwriting standards helps prtect an institutin s capital frm unsafe and unsund lending practices. FCA Regulatin (g) prvides specific requirements fr establishing measurable lan underwriting standards. Situatins where institutins have nt adpted measurable standards warrant clse scrutiny and apprpriate criticism. Evaluative questins and items t cnsider when examining the adequacy f underwriting standards include: Apprpriateness f Standards: D the institutin s varius underwriting standards set the bar high enugh t ensure risk frm lan underwriting activities is cmmensurate with the institutin s financial cnditin and perfrmance and risk management capabilities? In evaluating the adequacy f underwriting standards, cnsider the fllwing: Standards shuld be apprpriate fr the institutin s risk-bearing capacity. Standards shuld cntain bjective and measurable criteria and address all apprpriate credit factrs. Standards shuld nt simply prvide ranges in financial r prductin ratis fr lw, medium, and high risk. These situatins are mst likely a cncern unless the institutin clearly delineates which ratis serve as the benchmarks t justify underwriting the credit, t identify exceptins, and t trigger the need t identify ffsetting strengths. Standards shuld cnsider cncentratin risks faced by the institutin, such as cmmdity r industry and lan size. Fr example, standards culd be mre stringent if the institutin has a heavy cncentratin in a particular industry r the market segment is dminated by large lans. Alternatively, institutins may adjust ther risk management practices t address the cncentratin risk instead f changing the underwriting standards. Sme institutins may use enterprise guidelines (r similar terminlgy) as part f their lan underwriting guidance. These guidelines likely equate t underwriting standards if they represent the primary drivers and analysis benchmarks fr FCA Examinatin Manual Page 3 Lan Underwriting

4 underwriting decisins. If such guidelines exist that in effect represent underwriting standards, examiners shuld evaluate them accrdingly. Examiners are encuraged t determine hw the subject institutin s underwriting standards cmpare with the standards used by ther Farm Credit System (System) institutins with similar types f lending. Mapping t Risk Rating Criteria: Hw d underwriting standards map t bth the institutin s internal PD risk rating criteria and System-wide rating criteria? One f the mst effective methds t evaluate the adequacy f underwriting standards is t determine hw the standards map t PD risk rating criteria. Cnsider the fllwing: The CSRRG develped by the System cntains detailed financial metrics fr measuring brrwer financial strength and perfrmance acrss a wide range f industries they finance. Refer t the applicable CSRRG appendices, but recgnize the guidance calls n institutins t establish their wn bjective criteria fr applicable industries, giving cnsideratin t reginal, ecnmic, and ther differences. Underwriting standards define the quality f new vlume that an institutin desires t add t its prtfli. The CSRRG defines a PD 6 brrwer as gd quality, a PD 7 as average, a PD 8 as adequate, a PD 9 as minimally acceptable, and a PD 10 as Special Mentin. With this in mind, standards that map t a PD 6 culd be viewed as cnservative and standards that map t a PD 7 r 8 wuld typically be cnsidered reasnable. Standards that crrelate t a PD 9 r 10 are cncerning and warrant particular scrutiny. If underwriting standards d nt map t the institutin s internal r System-wide PD rating criteria in an intuitive r expected manner, further fllw-up and scrutiny are warranted. Thrugh management discussin and analysis, determine the reasns and whether the underwriting standards create unwarranted vulnerability t riginating weak credits. Significant differences between internal and the Systemwide PD rating criteria shuld be evaluated as part f the Risk Identificatin examinatin wrkprgram. Sme institutins might highly integrate underwriting standards with PD risk rating systems and guidance. If this apprach is taken, the institutin shuld clearly identify what cnstitutes minimum underwriting expectatins, identify what cnstitutes an underwriting exceptin, and prvide differential PD rating guidance by industry. Fr market segments that wuld typically warrant specific underwriting standards, the institutin shuld have PD rating criteria tailred t that market segment. This guidance shuld identify financial perfrmance levels in each credit factr that are needed t justify specific ratings. The integrity, accuracy, and granularity f the institutin s PD rating guidance and prcess must be rbust befre it culd als effectively guide the underwriting functin. Standards fr Majr Lan Types/Prgrams: Are there significant prtfli segments r lan prgrams where specific, custmized underwriting standards are nt in place but shuld be? The need fr underwriting standards fr a particular prtfli segment is primarily driven by cncentratin and vlume levels f that segment r the presence f unique risk factrs. Nte that while a cncentratin r significant vlume in a particular segment may nt exist tday, an institutin s plans t grw appreciably within a segment culd warrant setting custmized standards n the frnt end f that planned grwth. Unique risk factrs t cnsider may include lack f staff experience with a particular FCA Examinatin Manual Page 4 Lan Underwriting

5 prgram r industry, and brrwer r lan characteristics that differ significantly frm the institutin s cre prtfli, such as a segment dminated by large lans r specialized cllateral. The fllwing are sme prtfli segments t cnsider when evaluating whether an institutin has sufficient standards in place: Individual cmmdities r industries Part-time versus full-time farmer Large lans Yung, beginning, r small brrwers Screcard lending Husing and ther cnsumer lans Unsecured lending New lending prgrams Livestck integratr and grwer lans Prject, cnstructin, r expansin financing Leveraged lending (i.e., mre than industry-nrmal leverage) Missin-related investments Lan participatins and syndicatins, including capital markets Out-f-territry lending Other credit needs lending Lans with specialized cllateral Lans in nn-cre industries Lans fr, r secured by, land in transitin (see FCA Examinatin Bulletin ) Lans secured by land with limited r n incme-prducing capability (e.g., recreatinal prperty) Lans dependent n capital gains r asset sale incme fr repayment Changes t Standards: Were changes, r lack f changes, t underwriting standards reasnable and apprpriate? Evaluate any changes made since this wrkprgram was last cmpleted, drawing n examinatin guidance prvided thrughut this wrkprgram. If n changes were made, institutins shuld be able t supprt the reasns fr nt making changes. Cnsider any management cncerns with current standards and crrespnding plans fr change. In assessing whether changes are needed t underwriting standards, be mindful f areas where changes may be warranted in light f past, recent, changing, r emerging cnditins. Fr example, cnsideratins may include: Likely need fr increased wrking capital r repayment capacity requirements n livestck and crp lans in respnse t an nging envirnment f heightened vlatility in agriculture. Nte that liquidity metrics that measure the amunt f wrking capital relative t the size f peratins (e.g., wrking capital as a percent f adjusted grss incme) may be mre effective than a traditinal current rati measurement. Ptential need fr lwer lan-t-value standards r ther underwriting adjustments n real estate and hme lans, especially in an envirnment where land values are changing significantly. Cllateral underwriting standards at r near the 85 percent regulatry maximum warrant extensive scrutiny. Refer t the Cllateral Risk Management examinatin wrkprgram fr related discussin and guidance. Ptential need fr higher credit scre requirements n screcard and cnsumer lans, depending n prtfli perfrmance, vulnerability t changing r mre vlatile ecnmic cnditins, etc. FCA Examinatin Manual Page 5 Lan Underwriting

6 Cmpliance with Standards: Has the institutin prvided staff with adequate directin fr analyzing and dcumenting cmpliance with underwriting standards? At a minimum, credit directin shuld meet the requirements f FCA Regulatin (i). In additin, cnsider the fllwing when evaluating the adequacy f directin fr supprting cmpliance with underwriting standards: D credit narrative templates include a sectin n cmpliance with underwriting standards? Is staff suppsed t justify exceptins t underwriting standards in credit narratives by identifying ffsetting strengths in ther credit factrs? Has management identified what cnstitutes an ffsetting strength? Is the definitin f an ffsetting strength reasnable? Are lans with exceptins t underwriting standards subject t mre restrictive lending apprvals? Fr example, d lending staff have mre limited delegated lending authrity levels n lans with underwriting exceptins than n lans withut exceptins? 3. Other Directin & Practices: Evaluate ther underwriting-related directin as well as techniques fr adjusting underwriting practices based n rganizatinal perfrmance, actual and anticipated changes in the lending envirnment, and prtfli planning. Guidance: Institutins shuld effectively cmmunicate underwriting expectatins t staff, and assess if changes are needed t underwriting practices in respnse t, r in anticipatin f, changing cnditins. In additin t underwriting standards, institutins can cmmunicate expectatins and any desired changes in underwriting practices t staff in many frms. The bard has a key rle in cmmunicating underwriting expectatins thrugh mechanisms such as plicies, incentive cmpensatin prgrams, targeted exceptin rates, new lan quality gals, and changes in target markets. Management prvides mre direct cmmunicatin t staff n underwriting expectatins thrugh items such as credit prcedures, credit letters, staff meetings, delegated authrities, and lan cmmittee feedback. Examiners shuld be cgnizant that a lack f actin in ne area can be ffset by actins in anther. Fr example, sme institutins may decide t leave underwriting standards unchanged. Hwever, the bard and management can still cmmunicate a mre cnservative underwriting philsphy by giving directin t staff t underwrite fewer credits with less favrable ratings (e.g., lans rated PD 8 and 9) r reduce the rate f underwriting exceptins. When assessing whether apprpriate changes were made t underwriting practices, it is imprtant t evaluate the cllective actins taken t adjust underwriting. Evaluative questins and items t cnsider when examining the adequacy f ther underwritingrelated guidance and practices include: Plicy Directin: Des underwriting-related bard plicy directin effectively define the institutin s risk appetite and cmply with FCA Regulatins? Underwriting-related bard plicies shuld set the tne at the tp fr the institutin s underwriting activities. The scpe and cmplexity f the prtfli and lending peratins shuld drive the depth f cverage f underwriting-related tpics in bard plicies. Any changes t underwriting plicies shuld be reasnable based n the institutin s financial cnditin and perfrmance, prtfli risk FCA Examinatin Manual Page 6 Lan Underwriting

7 levels, the risk envirnment, and prtfli risk management capabilities. At a minimum, underwriting-related plicies must meet the applicable requirements f FCA Regulatins , , , , and Incentive Cmpensatin: D incentive cmpensatin plans prmte sund lan underwriting and the institutin s credit gals and bjectives? Cnsideratins include: Incentive plans shuld reflect a reasnable and healthy balance between prtfli quality, prtfli prfitability, and vlume grwth. Changes (r lack f changes) in incentive plans shuld be cnsistent with the ecnmic envirnment and the institutin s risk prfile. Credit-related incentives shuld be cnsistent with and supprtive f credit and underwriting-related business plan gals and bjectives. Incentive plans shuld cntain apprpriate cntrls (e.g., credit quality, credit administratin, and earnings qualifiers) t ensure payments are nt made r are reduced when prtfli cnditins are weak r deterirating. Delegated Authrities: D delegated authrities reflect apprpriate cntrls that facilitate sund lan underwriting? Cnsideratins include: Delegated authrity levels shuld reflect bth staff experience and skill levels. Authrity levels shuld als cnsider the institutin s risk-bearing capacity, with a lan cmmittee typically used fr transactins f substantial size. Authrity threshlds als need t cnfrm t prir apprval requirements frm the district bank. Mre restrictive delegatins are cmmn fr higher-risk credit actins, such as lans with less favrable risk ratings (PD r Lss Given Default), newer lending prgrams, lans with underwriting exceptins, unsecured lans, prject r cnstructin financing, lans t specialized industries r with specialized cllateral, ut-fterritry lans, etc. Lan actins apprved under individual delegatins at the senir management level are typically screened and recmmended fr apprval by junir credit staff. This prmtes training and cllabratin, and allws persnnel at multiple levels t cntribute their expertise and perspective. Changes (r lack f changes) in delegated authrities shuld cnsider internal and external audit and review results, the ecnmic envirnment, and current and prjected credit risk levels. Changes in Underwriting Practices: Has the institutin adequately adjusted its underwriting practices based n prtfli quality and perfrmance and actual r anticipated changes in the lending envirnment? Institutins may use varius means t change r redirect underwriting practices that d nt invlve changing underwriting standards. Underwriting directin may cme in the frm f targeted exceptin rates, directin based n PD ratings, changes in target markets, r revised practices in respnse t lan lsses. Guidance may als cme in a mre general frm such as staff meeting infrmatin, prcedure changes, credit letters t staff, r general management cmmunicatins t staff (fr example, intranet pstings and s). In situatins where the institutin has nt made any (r very limited) substantive changes t underwriting practices, cnsider whether factrs such as minimal lan lsses, mdest prtfli FCA Examinatin Manual Page 7 Lan Underwriting

8 deteriratin, adequate risk-bearing capacity, previusly sund underwriting practices, and a slid credit culture were present t negate the need fr tightening underwriting practices. Where applicable, cnsider whether similar factrs were present t supprt decisins t implement less restrictive underwriting practices t facilitate grwth and better serve the marketplace. As previusly discussed, the bard and management have varius means t cmmunicate underwriting directin and related changes. Prvided belw are additinal insights int sme f the mst cmmn methds. N requirements exist fr an institutin t use any particular methd. Als, changes in underwriting practices shuld be cnsidered based n bth psitive and negative changes in the lending envirnment. Refer t the Analysis & Reprting prcedure, as infrmatin frm that prcedure wuld prvide valuable infrmatin the institutin shuld be cnsidering when determining the need t mdify underwriting directin r practices. Exceptin Levels: If the institutin utilizes exceptin levels r targets t cmmunicate underwriting expectatins t staff, cnsider the fllwing: The institutin culd direct a mre cnservative (lenient) underwriting apprach by establishing exceptin targets that are lwer (higher) than past exceptin levels. Guidance fr underwriting based n exceptins can be further segmented by areas f risk, such as certain industries, new versus existing custmers, renewals versus lan actins where new vlume is apprved, ut-f-territry vlume versus lans within the territry, lan participatins/syndicatins, etc. Guidance shuld include tangible and measureable criteria rather than simply a general message t reduce (r increase) the number f exceptins. Guidance n underwriting exceptins shuld be reasnable cnsidering the institutin s verall risk prfile and credit quality trends. Fr example, has the institutin launched effrts t lwer exceptins in respnse t credit challenges (r raise exceptin rates if warranted by psitive cnditins)? PD Ratings: If the institutin cmmunicates underwriting expectatins based n PD ratings, cnsider the fllwing: The institutin culd direct a mre cnservative underwriting apprach by directing staff t limit underwriting and new vlume activity n accunts with less favrable ratings, such as PD 8 r 9. The institutin culd direct staff t pursue crrectin r cllectin, r encurage refinancing, n accunts with less favrable ratings, such as PD 10 and wrse, and PD 8 r 9 in certain situatins r industries. Guidance fr underwriting based n PD ratings can be further segmented by areas f risk, such as specific industries, new versus existing custmers, renewals versus lan actins where new vlume is apprved, ut-f-territry vlume versus lans within the territry, lan participatins/syndicatins, etc. Guidance shuld include tangible and measureable criteria rather than simply a general message t reduce r limit vlume with less favrable PD ratings. The PD rating prcess must be rbust and sund fr this type f underwriting directin t be effective. Institutins with limited granularity in risk rated vlume (e.g., mst Acceptable vlume cncentrated in nly a few PD rating categries) wuld nt be well suited fr this type f underwriting directin. Changes in Target Markets: If the institutin utilizes target markets (r changes in target markets) t cmmunicate underwriting directin, cnsider the fllwing: FCA Examinatin Manual Page 8 Lan Underwriting

9 Has the institutin adjusted the markets, custmers, r industries it is fcusing n t practively manage its expsure t high risk market segments? Effrts t change target markets shuld be supprted by vlume gals r prjectins, revised prtfli parameters (e.g., industry and lending prgram risk parameters), and ther bjective criteria such as effrts t reach all segments f ptential brrwers. Examples f changes in target markets may include: Reducing ut-f-territry lending. Decreasing the emphasis n capital markets activity, such as purchasing lan participatins/syndicatins. Reducing marketing emphasis r increasing the quality emphasis n industries where the institutin is highly cncentrated. Reducing lending activity in industries that are nt cmmn t the institutin s territry r are utside credit staff s cre cmpetencies. Decreasing lending activity in specialized lending prgrams (fr example, prject r cnstructin financing, ther credit needs, etc.). Increasing utreach effrts and lending activities t market segments that may have been underserved. Are changes in target markets reasnable cnsidering the institutin s verall risk prfile and credit quality trends? Lan Lsses: If the institutin experienced ntable lan lsses recently, cnsider the fllwing: Des the institutin have prcedures r a prcess in place t cnduct pst-mrtem analyses n lans r lan prgrams where significant lsses r widespread quality deteriratin have ccurred? Lessns learned frm these analyses shuld be used t adjust underwriting and due diligence practices. Is the depth f these analyses sufficient and d they address the underlying cause f the lsses r deteriratin? 4. Lan Structure, Terms, & Cnditins: Evaluate the sufficiency f credit directin, guidance, and practices fr lan structure, terms, and cnditins. Guidance: Effective lan underwriting cannt be accmplished withut adequate lan structuring and apprpriate lan terms and cnditins. Perids f grwth and strng ecnmic cnditins can inherently cause an institutin t becme mre lax in its credit practices. When the ecnmic cycle changes, weaknesses in lan structure, terms, and cnditins becme evident in the frm f deterirating credit quality and increased lan lsses. Institutins shuld cntinually reassess guidance and practices related t lan structures, terms, and cnditins. Prper lan structures, terms, and cnditins are critical t managing and cntrlling risk. Revlving term facilities, interest nly lans, and term lans that require little r n principal amrtizatin during the life f the lan are a few f the many examples f lan structures that can impact risk. The use f such structures shuld be well justified as part f the underwriting prcess. At times, brrwer quality and histry with the lender justify favrable structures, terms, and cnditins. Hwever, institutins can get drawn int excessive cvenant lite lending with lan terms, cnditins, r structures that are nt cmmensurate with the brrwer s financial capacity and cause elevated risk in the credit facility. Market cnditins ften cntribute t less restrictive underwriting terms, cnditins, and structures, especially during favrable business cycles. While institutins may adjust FCA Examinatin Manual Page 9 Lan Underwriting

10 their practices t be cmpetitive in such envirnments, they must als remain prudent t ensure the resulting risks are apprpriately managed. Evaluative questins and items t cnsider when examining the apprpriateness f lan structures, terms, and cnditins include: Guidance: Is there adequate directin t staff (plicies, prcedures, and ther management directin) regarding expectatins fr lan structures, terms, and cnditins? In particular, guidance shuld address the types f items discussed belw and be cnsistent with actual institutin practices. Any significant recent changes shuld be clsely evaluated. Als, cnsider if lan review findings (internal credit review and FCA) cnfirm sund and apprpriate executin f credit directin regarding lan structure, terms, and cnditins. Lan Cvenants: Des credit directin prvide sufficient guidance n establishing and mdifying lan cvenants? Lan cvenants prvide lenders an excellent mechanism fr cntrlling risk in the underwriting prcess. Cvenants that limit capital purchases, specify minimum wrking capital, equity, r cash flw levels, r require submissin f brrwing base, financial, r prductin infrmatin prvide lenders valuable tls fr managing risk in individual lan transactins. Related guidance culd address items such as when quarterly r mnthly financial and inventry reprting is required, when t use and hw t set financial cvenants, and when it's acceptable t mdify cvenants. Where applicable, credit directin shuld als address cvenant lite transactins, including the institutin s appetite fr such assets and mitigating factrs that need t be present t justify underwriting them. Lan Apprval Cnditins: D guidance and practices sufficiently address lan apprval cnditins? Lan apprval cnditins (e.g., requirements fr insurance, assignments f prceeds, csigners, equity investrs, and crss cllateralizatin r crss default agreements) can materially help cntrl risk in the underwriting prcess. General Lan Structuring Cnsideratins: D guidance and practices result in lan payments being matched t the timing f the brrwer s cash flw, rather than being reliant n asset sales? Situatins exist where asset sales can be a planned r typical part f nging business peratins, such as self-liquidating lans invlving the current assets f a business r the rderly sale f assets as part f retirement planning. Hwever, transactins where the brrwer s cash flw is unstable r unpredictable because it's reliant n asset sales r capital gains incme shuld be rare and apprached with cautin. A cre lending principle is that lans are meant t be repaid with cash frm peratins. Repayment shuld nt be dependent n ne-time, unusual items such as the sale f cllateral r prductin assets. A cmpetitive landscape cmbined with pressures t grw the prtfli can cause sme lenders t deviate frm this cre principle. Balln Structures: Is the use f balln payment structures apprpriately cntrlled and managed? Sme institutins use balln structures, particularly n mrtgage lans, t help manage lan pricing and credit risk. Institutins need t be careful nt t view the balln structure as a basis t supprt accepting greater risk in a lan r utilizing weaker credit standards. The shrter maturity may create additinal servicing ptins, but des nt ensure an institutin will be able t exit the lan at maturity if desired. The presence f a balln structure shuld nt cmprmise quality expectatins at the time f lan riginatin. Interest-Only Lans: Is adequate guidance in place fr lan prgrams that feature interestnly payment terms? Is the use f interest-nly terms apprpriate? Institutins shuld prvide directin t staff n the apprpriate use f interest-nly lan structures. This shuld include addressing risk mitigatin expectatins, such as mandatry asset sales, FCA Examinatin Manual Page 10 Lan Underwriting

11 excess cash flw sweeps, and evaluating lans using a nrmal amrtizatin. Any significant changes t guidance r practices regarding the use f interest-nly lans shuld be adequately supprted and reasnable relative t the institutin s verall risk prfile. Additinal cnsideratins include: T what extent des the institutin use interest-nly lan structures? Use lan database queries and management discussins t identify this, with particular scrutiny f interest-nly real estate transactins. Shrt-term revlving lines f credit cntrlled by prperly-structured brrwing base arrangements fr apprpriate asset-based lending wuld typically nt be a cncern. Are risk levels reasnable n these types f lans? Segment interest-nly lan expsure by brrwer risk rating as necessary t gauge risk levels. Institutins shuld typically reserve interest-nly structures fr high quality custmers. 5. Analysis & Reprting: Evaluate the sufficiency f institutin prcesses fr analyzing the surces, nature, and quality f new lan vlume; identifying, analyzing, and reprting lan underwriting exceptins; and cnducting any ther underwriting-related analyses. Guidance: Prcesses t identify, analyze, and reprt lan underwriting results and cmpliance with standards are a critical cmpnent f the underwriting functin. Institutins shuld analyze prtfli quality and perfrmance t identify areas f cncern needing t be addressed thrugh revised underwriting practices. This analysis shuld determine if underwriting practices are achieving desired credit bjectives cnsistent with the institutin s risk tlerance, r if underwriting adjustments are needed. An analysis f underwriting exceptin levels, trends, and related infrmatin can prvide valuable insight int an institutin s underwriting practices. Exceptin levels and trends, in particular, can serve as a predictive indicatr f future credit quality as lans nt meeting all standards are typically mre vulnerable t adversity. Mnitring trends in underwriting exceptins and ther related infrmatin can alert management and the bard that adjustments t underwriting practices are necessary, befre weak underwriting becmes evident via credit quality deteriratin. Evaluative questins and items t cnsider when examining an institutin s analysis and reprting n lan underwriting activity include: Analyzing New Vlume: Des the institutin adequately identify and reprt the surces, quality, and risk prfile f new lan vlume? Lan underwriting encmpasses a brad spectrum f lan actins, including renewals, refinancings, and new lan vlume t existing r new custmers. An institutin s effrts t analyze underwriting perfrmance shuld address all lan actins, but an in-depth review f new vlume activity is particularly imprtant. Institutins have greater ptins and flexibility n these lan actins cmpared t thse invlving vlume a custmer already has with the institutin. Even institutins with static lan vlume trends underwrite a sizable amunt f new vlume every year t ffset regular lan pay-dwns and pay-ffs. New vlume activity shuld be analyzed t determine nt nly the amunt, but als the surces and quality. Management shuld reprt t the bard a summary f results frm these analyses. When examining an analysis f new vlume, cnsider whether the institutin has reasnably defined what cnstitutes new vlume and whether the analysis and related reprting: FCA Examinatin Manual Page 11 Lan Underwriting

12 Identifies underwriting activity that invlves bna fide new vlume (since the lending decisin is mre discretinary cmpared t underwriting actins that invlve renewals t existing custmers r prtective advances t stressed custmers). Addresses new vlume quality trends (e.g., risk ratings) and if new lan quality is cnsistent with institutin underwriting directin and bjectives. Segments new vlume by factrs such as lan type, industry, and riginatin prcess (traditinal underwriting by institutin, screcard, lan participatin purchases, etc.). Identifies if new vlume surces are cnsistent with institutin directin and bjectives cncerning target markets. Identifies ther key characteristics, such as the amunt f new vlume t existing brrwers versus new brrwers r brrwers within the territry versus utside the territry. Fr example, new vlume riginated t existing custmers within the chartered territry shuld likely exhibit a different risk prfile than ut-f-territry lan participatin vlume t new brrwers with n track recrd with the institutin. Underwriting Exceptin Prcesses: Are sufficient prcesses in place t identify and analyze lan underwriting exceptins? When evaluating the lan underwriting exceptin prcess, be mindful f cmmn cncerns such as: Assuming all lans were written under cre underwriting standards. As a result, lans written under enterprise guidelines r ther categries with unique standards are nly cmpared against cre standards. Identifying exceptins by number f custmers r lans, but nt by vlume. Cvering nly a prtin f the prtfli, such as lans written under cre standards, while lans written under specialized standards are nt addressed in exceptin reprting. Similarly, adjustments may be needed in exceptin reprts t ensure unique r specialized lans are nt measured against underwriting standards that were nt fully applicable t them. Having data integrity cncerns in brrwer lan infrmatin r shrtcmings in the methdlgies used t extract infrmatin fr identifying exceptins, resulting in inaccurate exceptin infrmatin. (During lan review activities, examiners may want t watch fr lans where credit narratives indicate underwriting exceptins ccurred and review exceptin reprts t cnfirm they were included.) Cntent f Exceptin Analyses: Is the cntent f underwriting exceptin analyses adequate? Basic underwriting exceptin analyses wuld typically identify lans with exceptins t standards and prvide a summary n the percent f lan activity with exceptins. An effective summary wuld als prvide infrmatin n ttal exceptins t each standard. Cnsiderable judgment is necessary t determine what further stratificatins are warranted in lan underwriting exceptin analyses. Factrs t cnsider include makeup f the prtfli, lending t new versus existing custmers, engagement in ut-f-territry lending, etc. The fllwing are pssible ways that exceptin analyses and reprts culd be stratified t ensure effective analysis f underwriting activity: FCA Examinatin Manual Page 12 Lan Underwriting

13 Type f lan r custmer (agricultural mrtgage, cnsumer, perating, intermediate term, participatins, capital markets, etc.) Cmmdity r industry New custmers versus existing custmers Lan renewals r refinancings versus new lans r new vlume In-territry versus ut-f-territry vlume Vlume f lans with mre than ne exceptin Lans with exceptins, but als material quantifiable ffsetting strengths Risk ratings Lan size Branch lcatin Lan fficer Bard Reprting n Exceptins: Des the bard receive sufficient, peridic reprts that identify lan vlume with underwriting exceptins? Reprts shuld summarize infrmatin such as aggregate exceptin rates, the rate f exceptins t each standard, the vlume f lans with mre than ne exceptin, and the trend in exceptin levels. Additinal reprting culd address exceptins based n stratificatins such as thse listed abve t further delineate a pattern r practice. A best practice is t include a narrative summary with each exceptin reprt. This summary culd address items such as whether the amunt, type, and trends f exceptins pse acceptable risk, whether the level f exceptins are within expectatins r targets, and if changes r crrective actins t underwriting practices are necessary based n exceptin levels and trends. A cmmn frequency f exceptin reprts is quarterly, with summary infrmatin frm past quarters t allw trending f infrmatin. Other Analysis/Reprts: Des the institutin effectively use ther types f analyses and reprts t evaluate underwriting perfrmance? The extent that an institutin needs t drill dwn int its underwriting perfrmance will depend n risk and vlume levels f specific prtfli segments. Using tls such as the System PD risk rating system can help management analyze and better understand the institutin s underwriting perfrmance. PD risk ratings at lan riginatin and risk rating migratins since riginatin prvide valuable data that can be quite revealing. While there are many types f analyses that can be cmpleted, the fllwing are examples f best practices that can help an institutin draw definitive cnclusins n whether underwriting practices are achieving desired bjectives and results: Lan quality (risk rating) and perfrmance characteristics (past dues, nnaccruals, and chargeffs) stratified by underwriting segment and trended ver time. Lan quality, risk rating migratins, and perfrmance characteristics stratified by year f riginatin. Fr example, perfrmance cncerns may nt be evident when lking at a brad prtfli segment such as lans t a specific industry. Hwever, when lan perfrmance is segmented by riginatin year, it may becme evident that lans written during certain time frames are perfrming less favrably than the prtfli as a whle. Perfrmance differences ver time between lans that meet standards and thse that d nt. This analysis may include evaluating what types f exceptins tend t cause lan perfrmance t break dwn and the impact f mre than ne underwriting exceptin. FCA Examinatin Manual Page 13 Lan Underwriting

14 Assessment f ecnmic and ther market factrs that might impact brrwer perfrmance and thus warrant changes t underwriting practices. 6. Transactin Testing: Examine individual lans t assess cmpliance with FCA and the institutin s lan underwriting guidance and applicable laws and regulatins, and t evaluate effectiveness f underwriting-related internal cntrls. Guidance: The examinatin f underwriting practices shuld be supplemented as necessary with transactin testing cnducted as part f FCA s lan review. The primary bjectives f underwriting-related transactin testing are t: Determine if the institutin is fllwing its established underwriting directin. Verify the accuracy f underwriting reprting and analysis. Validate findings develped when cmpleting ther parts f this wrkprgram. The fllwing types f lans shuld be cnsidered fr underwriting-related transactin testing: Lans with exceptins t underwriting standards. Lans t new custmers and lans representing new mney t existing custmers, with special emphasis n lans t custmers with less favrable PD ratings. Lan expsures in prtfli segments that may be utside the institutin s primary areas f expertise, such as lans in nn-cre industries, lan participatins/syndicatins, ut-fterritry vlume, start-up prject r cnstructin financing, and lans t fund expansin activities. New lans r new mney t existing custmers in industries r prtfli segments where management has issued specific guidance t adpt mre cnservative underwriting. FCA Examinatin Manual Page 14 Lan Underwriting