DETERIORATION OF LOAN UNDERWRITING STANDARDS

by David H. Baris, General Counsel

Recent warnings by the Acting Comptroller of the Currency of deteriorating loan underwriting standards in national banks have put national bank directors and others on notice of potentially serious consequences if appropriate action is not taken.

What responsibilities does a Board of Directors have in responding to these warnings?

Recent OCC Warnings

In recent weeks, the Office of the Comptroller of the Currency has intensified its efforts to warn bankers of deteriorating loan underwriting standards. In a September 1998 letter to national banks, the Acting Comptroller expressed her concerns about the continued easing in underwriting standards found in the 1998 OCC Survey of Credit Underwriting Practices. The Survey found the incidence of easing standards and increasing risk in commercial loans to be more widespread among the surveyed product categories than in prior years, such as longer terms, less restrictive covenants, fewer guarantees, and weaker collateral positions. Underlying her heightened concerns seems to be a fear that we may be heading for a recession.

The letter also relates that OCC examiners have been instructed to review a fresh sample of new credits in every national bank and to provide new, "hard" conclusions about the extent to which current underwriting practices conform to sound credit policies and standards as well as to the bank’s own policies. The letter pointedly added that "when weaknesses point to fundamentally unsafe or unsound conditions, special supervisory action will be taken."

The Acting Comptroller’s letter was addressed not just to the Chief Executive Officers of national banks; in an unusual step, the letter was also addressed to the members of the bank’s Board of Directors.

Other federal banking agencies have also expressed concerns about weakening credit underwriting standards.

Along with statements about deteriorating loan underwriting standards, the Acting Comptroller has stated that she is "troubled that loan-loss reserves as a percent of loans are falling even as underwriting standards slip. It causes you to wonder if reserves should continue to shrink."

These warnings have been accompanied by reports that examiners may have begun to apply tougher standards in reviewing credits for classification. Others have suggested that the examiners are beginning to question the methodology used by banks to calculate the loan loss reserve.

Responding to Regulatory Warnings

The FDIC has stated that the most common suits against outside directors by the FDIC as receiver of failed banks either "involved insider abuse or situations where the directors failed to heed warnings from regulators, accountants, attorneys or others that there was a significant problem in the bank which required correction." Although the federal banking agency warnings on credit underwriting standards are general in nature and may have no applicability to a particular bank, the Board of Directors of a bank places itself at risk if it ignores the warnings only to discover later that overly liberal credit underwriting standards caused significant losses in the bank.

Under standards of care applied to bank directors, directors are not personal guarantors that their bank will succeed, or that their bank will not have loan losses. But they are obligated to act as prudent persons in supervising the bank. If they do not heed the warnings of banking agencies (even warnings that are general in nature), there is a potential argument that the directors failed to act in a manner consistent with their fiduciary duties. Bank directors are also susceptible to civil money penalties, which could be imposed for engaging in an unsafe or unsound banking practice.

Procedural Aspects of Responding to Regulatory Warnings

After-the-fact judgments about whether bank directors met their fiduciary duties involve not just substantive issues, but how the Board actually reached its decision. If the Board evaluates the regulatory warning that credit underwriting standards have deteriorated, but has concluded that the bank’s standards are prudent, it may need to show how it reached that determination. Similarly, if the Board decides that standards need to be tightened, it may need to demonstrate how it arrived at that decision and how it monitored the implementation of the changes to assure the desired result.

The first "procedural" step is to assure that management has been instructed to advise the Board of any regulatory warnings appropriate for Board notice or review. Not all regulatory warnings should necessarily be disseminated to directors, so long as the appropriate management persons review the correspondence and take appropriate action. But with regard to strong warnings concerning the lending function – the most basic and potentially risky activity engaged in by banks - the Board should have copies of the materials for review, particularly when the correspondence is addressed to the Board and its members.

Once the Board has received the regulatory warning in writing, it should place the issue as an agenda item for a full Board meeting. The Board could refer the matter to a Board Committee or review the matter itself.

The minutes of the Board meeting should reflect the review conducted by the Board or its Committee and its conclusions. Without adequate minutes reflecting the deliberate character of the Board review, it will be difficult to prove later (sometimes, in court cases, ten years later or more) that such a review actually occurred.

Substantive Issues

The overriding cause of most bank failures has always been loan losses. That is why it is essential that the Board focus much of its attention on the quality of the loan portfolio. As the OCC Survey of Credit Underwriting Practices points out, the main reason that loan underwriting standards are deteriorating is competitive pressure. Nonetheless, the Board of Directors cannot let competitive pressures compel the bank to engage in lending that puts the bank at risk.

The FDIC has pointed out that many lawsuits filed by the FDIC against directors of failed banks involve directors who "failed to establish proper underwriting policies and to monitor adherence thereto, or approved loans that they knew or had reason to know were improperly underwritten…"

What should the Board’s substantive review of the bank’s underwriting standards entail?

For starters, the Board should focus on whether the bank’s credit underwriting standards have become looser, and, if so, whether the current standards are prudent. Just because credit underwriting standards have become looser does not mean that the current standards are imprudent; the Board must inquire with its management and loan review people to determine whether the looser standards should remain in place. Particular attention should be given to the possibility that the U.S. may suffer a recession in the near future. The chances of a recession were remote only six months ago, but given the recent turmoil in foreign markets, economists generally believe that the risk of a recession is now somewhat greater.

The Board should also evaluate whether the bank’s loan policy reflects the current standards being used by loan officers. If the loan policy does not reflect current standards and numerous exceptions to policy exist, then the loan policy needs to be amended, assuming that the Board is satisfied that the standards being used are prudent. If the standards are too loose, the Board will need to give management direction to insure that loans will not be granted under such standards, and steps would need to be taken to monitor loans that were approved under the looser standards.

Just because the bank has not yet suffered any unusual or heightened loan losses or past-dues does not mean that the bank’s underwriting standards have not slipped to the point that the bank is vulnerable to losses if a recession ensues.

The Board should also evaluate whether there has been any significant shift in loan categories that may indicate greater assumption of risk (for example, a significant decline in residential loans and an increase in loans to purchase raw land). If the bank has entered or plans to enter a new facet of lending, the Board needs to satisfy itself that the bank has qualified personnel to handle the new lending area, that the loan policy adequately addresses the new area, and that the reserve for loan losses will be sufficient to cover foreseeable potential losses from the new activity.

Issues tangentially related to credit underwriting standards also need to be addressed. For example, the Board should evaluate the adequacy of the loan review function in the bank, the audit function to detect loan quality and administration deficiencies, credit administration issues, the informational reporting of the status of loans to the Board, and the methodology used in calculating the loan loss reserve.

This broad review of the lending function of the bank could also encompass the fundamental question of the role of the Board of Directors in the approval of loans.

A bank Board is not required to approve loans except certain insider loans as required by law and regulation. Directors can delegate the entire lending approval function to management and lending officers. Many large banks do just that; but, typically, community bank Boards assume some role in approving loans. Often, community bank Boards approve only the largest loans or the loans which represent exceptions to policy – in other words, potentially the most risky loans that the bank will make.

Community bank Boards have good business reasons to approve certain loans. In a small community, Board members may posses information about a prospective borrower that may not show up in a loan file. But, as is evident in the FDIC statement previously quoted and in a study by the American Association of Bank Directors of RTC lawsuits filed against directors of failed savings institutions, the personal liability risks of a director may be heightened by the fact that the Board approved a loan that later was charged off.

That is why AABD believes that it is important that if the Board approves loans, the loan policy should make it clear what the approval means – and doesn’t mean. The loan policy should indicate that any Board loan approval does not involve a "de novo" review of the underlying material and file, that the Board is relying on the loan officer’s documents and recommendations, and on other bank personnel and outside experts, and that the "approval" of the Board is more akin to a "no objection" vote to the loan officer’s approval of the loan. The policy should make explicit that management and loan personnel have the primary responsibility for the entire lending function other than the Board’s oversight duties to establish policy and monitor the compliance with policy and bank performance.

Finally, regulatory warnings about loan underwriting standards, overclassification of loans in the examination process, increased regulatory pressure to add substantial amounts to the loan loss reserve, and bank reaction to these regulatory events could run the risk of a self-fulfilling prophecy. In other words, if banking agencies were to scare banks away from granting not just excessively risky loans, but also prudent loans to their community, then a recession could be triggered simply by the widespread contraction of credit. We hope that the banking agencies will not do that, and it is incumbent on bank Boards of Directors not to become too restrictive in their credit extensions. Boards of Directors will need to find ways to curb excesses without cutting off the supply of credit to the communities they serve.