Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
Verification of loan proceeds is one of the most valuable
and effective loan examining techniques available to the
examiner and often one of the most ignored. This
verification process can disclose fraudulent or fictitious
notes, misapplication of funds, loans made for the benefit
or accommodation of parties other than the borrower of
record, or utilization of loans for purposes other than those
reflected in the bank's files. Verification of the
disbursement of a selected group of large or unusual loans,
particularly those subject to classification or Special
Mention and those granted under circumstances which
appear illogical or incongruous is important. However, it
is more important to carry the verification process one step
further to the apparent utilization of loan proceeds as
reflected by the customer's deposit account or other related
bank records. The examiner should also determine the
purpose of the credit and the expected source of
repayment.
Examination Procedures regarding loan portfolio analysis
are included in the Examination Documentation Modules.
Loan Discussion
The examiner must comprehensively review all data
collected on the individual loans. In most banks, this
review should allow the majority of loans to be passed
without criticism, eliminating the need for discussing these
lines with the appropriate bank officer(s). No matter how
thoroughly the supporting loan files have been reviewed,
there will invariably be a number of loans which will
require additional information or discussion before an
appropriate judgment can be made as to their credit
quality, relationship to other loans, proper documentation,
or other circumstances related to the overall examination of
the loan portfolio. Such loans require discussion with the
appropriate bank officer(s) as do other loans for which
adequate information has been assembled to indicate that
classification or Special Mention is warranted.
Proper preparation for the loan discussion is essential, and
the following points should be given due consideration by
the examiner. Loans which have been narrowed down for
discussion should be reviewed in depth to insure a
comprehensive grasp of all factual material. Careful
advance preparation can save time for all concerned.
Particularly with regard to large, complicated lines, undue
reliance should not be placed on memory to cover
important points in loan discussion. Important weaknesses
and salient points to be covered in discussion, questions to
be asked, and information to be sought should be noted.
The loan discussion should not involve discussion of
trivialities since the banker's time is valuable, and it is no
place for antagonistic remarks and snide comments
directed at loan officers. The examiner should listen
carefully to what the banker has to say, and concisely and
accurately note this information. Failure to do so can result
in inaccuracies and make follow-up at the next examination
more difficult.
Loan Analysis
In the appraisal of individual loans, the examiner should
weigh carefully the information obtained and arrive at a
judgment as to the credit quality of the loans under review.
Each loan is appraised on the basis of its own
characteristics. Consideration is given to the risk involved
in the project being financed; the nature and degree of
collateral security; the character, capacity, financial
responsibility, and record of the borrower; and the
feasibility and probability of its orderly liquidation in
accordance with specified terms. The willingness and
ability of a debtor to perform as agreed remains the
primary measure of a loan’s risk. This implies that the
borrower must have earnings or liquid assets sufficient to
meet interest payments and provide for reduction or
liquidation of principal as agreed at a reasonable and
foreseeable date. However, it does not mean that
borrowers must at all times be in a position to liquidate
their loans, for that would defeat the original purpose of
extending credit.
Following analysis of specific credits, it is important that
the examiner ascertain whether troublesome loans result
from inadequate lending and collection policies and
practices or merely reflect exceptions to basically sound
credit policies and practices. In instances where
troublesome loans exist due to ineffective lending practices
and/or inadequate supervision, it is quite possible that
existing problems will go uncorrected and further loan
quality deterioration may occur. Therefore, the examiner
should not only identify problem loans, but also ascertain
the cause(s) of these problems. Weaknesses in lending
policies or practices should be stressed, along with possible
corrective measures, in discussions with the bank's senior
management and/or the directorate and in the Report of
Examination.
Loan Classification
To quantify and communicate the results of the loan
appraisal, the examiner must arrive at a decision as to
which loans are to be subjected to criticism and/or
comment in the examination report. Adversely classified
loans are allocated on the basis of risk to three categories:
Substandard; Doubtful; and Loss.
Loans (12-04) 3.2-40 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation