Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
Management weaknesses in this area are almost certain to
lead to eventual loan losses. Problems can also develop
when management, technically sound in some forms of
lending, becomes involved in specialized types of credit in
which it lacks expertise and experience.
Lack of Supervision
Loan problems encountered in this area normally arise for
one of two reasons:
• Absence of effective active management supervision
of loans which possessed reasonable soundness at
inception. Ineffective supervision almost invariably
results from lack of knowledge of a borrower's affairs
over the life of the loan. It may well be coupled with
one or more of the causes and sources of loan
problems previously mentioned.
• Failure of the board and/or senior management to
properly oversee subordinates to determine that sound
policies are being carried out.
Lack of Attention to Changing Economic
Conditions
Economic conditions, both national and local, are
continuously changing, management must be responsive to
these changes. This is not to suggest that lending policies
should be in a constant state of flux, nor does it suggest
that management should be able to forecast totally the
results of economic changes. It does mean, however, that
bankers should realistically evaluate lending policies and
individual loans in light of changing conditions. Economic
downturns can adversely affect borrowers' repayment
potential and can lessen a bank's collateral protection.
Reliance on previously existing conditions as well as
optimistic hopes for economic improvement can,
particularly when coupled with one or more of the causes
and sources of loan problems previously mentioned, lead
to serious loan portfolio deterioration.
Competition
Competition among financial institutions for growth,
profitability, and community influence sometimes results in
the compromise of sound credit principles and acquisition
of unsound loans. The ultimate cost of unsound loans
outweighs temporary gains in growth, income and
influence.
Potential Problem Indicators by Document
The preceding discussions describe various practices or
conditions which may serve as a source or cause of weak
loans. Weak loans resulting from these practices or
conditions may manifest themselves in a variety of ways.
While it is impossible to provide a complete detailing of
potential "trouble indicators", the following list, by
document, may aid the examiner in identifying potential
problem loans during the examination process.
• Debt Instrument - Delinquency; irregular payments
or payments not in accordance with terms; unusual or
frequently modified terms; numerous renewals with
little or no principal reduction; renewals that include
interest; and extremely high interest rate in relation to
comparable loans granted by the bank or the going rate
for such loans in the bank's market area.
• Liability Ledger - Depending on the type of debt,
failure to amortize in a regular fashion over a
reasonable period of time, e.g., on an annual basis,
seasonally, etc.; and a large number of out-of-territory
borrowers, particularly in cases where these types of
loans have increased substantially since the previous
examination.
• Financial and Operating Statements - Inadequate or
declining working capital position; excessive volume
or negative trend in receivables; unfavorable level or
negative trend in inventory; no recent aging of
receivables, or a marked slowing in receivables;
drastic increase in volume of payables; repeated and
increasing renewals of carry-over operating debt;
unfavorable trends in sales and profits; rapidly
expanding expenses; heavy debt-to-worth level and/or
deterioration in this relationship; large dividend or
other payments without adequate or reasonable
earnings retention; and net worth enhancements
resulting solely from reappraisal in the value of fixed
assets.
• Cash Flow Documentation - Absence of cash flow
statements or projections, particularly as related to
newly established term borrowers; projections
indicating an inability to meet required interest and
principal payments; and statements reflecting that cash
flow is being provided by the sale of fixed assets or
nonrecurring situations.
• Correspondence and Credit Files - Missing and/or
inadequate collateral or loan documentation, such as
financial statements, security agreements, guarantees,
assignments, hypothecation agreements, mortgages,
appraisals, legal opinions and title insurance, property
insurance, loan applications; evidence of borrower
credit checks; corporate or partnership borrowing
authorizations; letters indicating that a borrower has
suffered financial difficulties or has been unable to
meet established repayment programs; and documents
Loans (12-04) 3.2-38 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation