Why Loan Policy Exceptions Matter

Is your board of directors aware of how many loan policy exceptions exist in the bank’s loan portfolio? Do they know what types of exceptions are being made? These are two very important questions and ones that Federal Reserve examiners are asking during your examinations. Your directors approve the bank’s loan policy based on their knowledge of your market(s) and their risk tolerance, so it makes sense that they should know how often and what types of exceptions are being made to those policies. Banks with effective credit risk practices will have the ability to answer these questions.

Effectively tracking policy exceptions is a three-step process:

• First, exceptions must be identified during the origination process. This starts with the loan officer clearly identifying the exception in his or her approval memo along with any mitigating factors. The approving body, the board’s loan committee for example, will then be armed with the information they need to make a sound decision regarding the particular credit.
• Next, any exceptions or concessions during the life of the loan should be tracked as well — such as covenant waivers or debt service coverage ratios that fall below policy minimums.
• Lastly, exceptions should be tracked on a portfolio level. This could take several forms depending on what exceptions are acceptable in your institution. One method is to simply track the dollar volume of loans that were made on an exception basis as a percentage of your portfolio. Taking it a bit further, exceptions could be tracked by type (e.g., loan-to-value, debt service coverage ratio, rate, term, etc.) and then by portfolio segment.

Following this three-step process should paint a more complete picture of the exceptions to the board’s approved loan policy. As an added benefit, tracking trends in the various exception types can serve as an early warning indicator by revealing the potential buildup of risk in your portfolio.

Once management and the board have a clear picture of the volume and type of exceptions being made, they can make decisions regarding the loan policy, competition and other strategic areas. For example, if one type of exception is granted frequently, the board may want to reconsider their approved policy. On the other hand, if exceptions are being made to compete with the bank down the street, the board may decide that making those exceptions is not in the bank’s best interest. Either way, the board cannot make any strategic decisions without the data. So can your institution answer the two questions raised above?

If we have piqued your curiosity, our Credit Risk Hot Topics webinar presented in May of 2019 covers this in more detail.