Loan Structure Observations & Associated Risks
Author: Mark Janson
The Federal Reserve recently released the results of its Senior Loan Officer Opinion Survey on Bank Lending Practices. Let’s compare those results to the observed lending practices of clients served by BKD’s Loan Review Services team—specifically, some 150 financial institutions ranging from $75 million to $10 billion in total assets.
The team’s focus is in commercial lending, including commercial and industrial, commercial real estate and agricultural loans, so this article will look at these lending areas. In our review work, we’ve observed many of the same changes in lending practices noted in the Fed survey. The changes in loan structure and monitoring continue to be discussed by regulators and loan review professionals. Here are five commonly observed changes in loan structure and their impacts on associated risk:
- We are seeing increased use of 30-year amortizations for the financing of apartment buildings and office buildings. Before they became common 10 years ago, 25-year amortizations were frowned upon; in unique circumstances, a 30-year amortization would be seen. In the past 12 to 18 months, our loan review practice has seen increased use of 30-year amortizations. While the principal payback and reduction period on these loans has been lengthened, the repayment risk has increased.
- In response to competitive pressures, many recently underwritten/booked loans now contain limited or no guarantees or have the guarantees rolling off completely once a project achieves a required level of debt service coverage for a designated period of time. The elimination or reduction in guarantees reduces secondary support for many loans and increases associated risk levels.
- Also, 85 percent loan-to-value (LTV) ratios are increasing for all types of commercial real estate loans. During the last recession, when real estate values were on a serious and extended decline, loans made with higher initial LTV ratios often led to higher losses and reserve requirements.
- Financial reporting requirements for many sizes of borrowing relationships recently have been relaxed. For startup businesses, monthly interim financial reporting was common, while we increasingly see requirements for quarterly or semiannual financial statements. Where audited financial statements formerly were required, a reviewed financial statement now is required, supplemented with company tax returns. With the reliance on financial information to understand and evaluate a borrower’s repayment ability and financial condition, quality financial information remains important.
- More financial institutions are asking questions on the level and reporting of loan policy exceptions. We continue to observe increased policy exceptions and regulatory scrutiny over the tracking and reporting of policy exceptions. The need for increased exception tracking and reporting appears to correspond with increasing numbers of loan policy exceptions. Often, we hear exceptions are necessary to retain an existing loan at renewal or compete with neighboring financial institutions.
With many financial institutions vying for loan growth, the need to meet or beat the competition with higher LTV ratios, reduced financial reporting requirements, longer repayment terms and fewer guarantees increases the overall risks associated with these loans. Too many of these concessions in a commercial loan portfolio can lead to increased problems if the economy slows.
By tracking and reporting these and other exceptions, bank management can understand the levels of exceptions in their portfolios, and audit committees can understand the increased risk accumulating in the bank’s portfolios.
For more information, contact your BKD advisor.