By Michele Renz
Written loan policies, approved by the Board of Directors and adhered to by management in practice, are of upmost importance in managing risk within a credit union’s loan portfolio. Loans approved in accordance with established internal control procedures and prescribed underwriting criteria are within the level of credit risk pre-determined to be acceptable within the portfolio considering the credit union’s complete financial picture. Loans approved that are not in accordance with established internal control procedures or outside of the prescribed underwriting criteria are exception loans.
I have yet to come across a credit union that does not allow exception loans; as a matter of fact, many loan policies specifically allow for the approval of such loans. This makes sense as it is the primary mission of credit unions to help its members, especially its members with proven credit history. To reject a loan application from a long-time member who has consistently paid on numerous loans to the credit union over the past 10 years because he or she is 2% over the policy-established debt-to-income ratio isn’t serving the need of a proven, credit-worthy member, nor does it make good business sense for the credit union.
Arguably, one exception loan will likely not make much of a difference; however, it is undeniable that each and every approved exception increases the credit risk within a loan portfolio beyond the level of risk pre-determined by the Board of Directors as acceptable. Not only do approved exceptions increase credit risk within the portfolio, but they also increase the credit union’s exposure to fair lending risk. Therefore, it is of utmost importance to understand how many exception loans exist within your portfolio and the overall aggregate effect of these risks within the loan portfolio.
Following are four components of an effective exception loan management program:
Defining Exception Loans. First and foremost, in a quality exception loan management program, the Board of Directors must ensure that loan policies clearly define a process for approving exception loans. Exception loans should require additional approvals outside the normal loan approval process and the extent of additional approvals should commensurate with how far an exception loans falls outside of the established underwriting criteria. For example, a compromise on a loan that falls a few points outside of the established credit score range or a reduction in interest rate due to a competitive situation may only require the approval of the lending manager (or CEO in smaller institutions) in addition to the lending officer. However, a decision on a loan that violates several of the established criteria or relates to an employee or other related party may not require only the additional approval of the CEO, but the lending committee and/or the board of directors as well.
File Documentation. Exceptions must be required to be well documented within the loan file. A standard exception reporting form should be used where independent exception decisions can be documented, visible, and stand on their own within the loan file. Denied exceptions should also be documented in this manner. This is especially important to diminish fair lending risk.
Exception Reporting. A loan exception reporting system must be put in place and executed. An exception reporting system should include the reporting approved and denied exceptions, individually and in the aggregate, to the Board of Directors. The individual reporting should include the reasoning for each exception decision reached. The aggregate reporting should include the total number of exceptions considered, approved, and denied. Increased reporting of exceptions over time may indicate trends resulting in an increased level of credit risk within the portfolio. The number of exceptions reported and subsequent charge-off activity may provide an indication that loan policies are too general or too restrictive, thus requiring examination and possible adjustment of policies to coincide with the desired level of risk to be assumed in achieving the financial and membership goals of the credit union.
Loan Reviews. To determine the effectiveness of your loan exception compliance system, periodic independent loan review audits should be performed to determine that loans are being processed according to stated procedures and in compliance with loan underwriting criteria set forth in the credit union loan policy. For any loans identified as exceptions that have not been reported, a reason can be determined and action taken to revise or improve procedures or to train staff accordingly.
A loan policy can never cover every possible lending or underwriting situation that your members will present with; making loan exceptions will continue to be a standard lending practice. An effectively implemented and executed exception loan management program is integral tool in helping credit union management monitor credit risk within a lending portfolio.