Asset Quality. Contents

Transcription

1 Asset quality is a critical part of your financial analysis of an institution because it directly impacts the evaluation of other component areas such as capital, earnings, and liquidity. The assessment of asset quality focuses on identifying credit risks that arise from the institution s assets and management s ability to identify and control these risks. Contents Objectives... 3 Resources... 3 Icons... 4 Chapter 1: Introduction to... 5 Defining... 5 Introduction Summary... 6 Chapter 2: Offsite Analysis... 7 Review the Balance Sheet Structure... 8 Identify the Types and Levels of Off-Balance Sheet Items... 9 Analyzing the Levels and Trends of Key Ratios Summary Ratios on Page Key Ratios on Page Key Ratios on Pages 8 and 8A Offsite Analysis Summary Chapter 3: Onsite Analysis Followup on Concerns Identified During Offsite Analysis Balance Sheet and Account Data Internal and External Audit Reports September 2015 Page 1

2 Financial Institution Analysis School Corporate (Strategic) Plans Independent Loan Review Reports Concentration Reports Complete an Asset Review Determine the Volume and Severity of Adversely Classified Assets Adverse Classification Ratios Determine Management s Impact Underwriting Standards Credit Administration Practices Loan and Investment Policies Reducing Problem Credits Assign an Rating Onsite Analysis Summary Page 2 September 2015

3 Financial Institution Analysis School Objectives After completing this topic, you will be able to: Identify balance sheet structure and off balance sheet information related to asset quality. Interpret key UBPR ratios used to analyze asset quality. Analyze the adverse classification ratios to identify potential credit risk exposure. Identify management practices that make a bank vulnerable to asset quality deterioration. Resources The following resources are available in the FIAS Independent Study. The Expert Model for Assessing which serves as consolidated job aid for key ratios and considerations and may be used for analysis activities. A link to the Uniform Financial Institutions Rating System composite ratings and component ratings from FDIC Statements of Policy, Uniform Financial Institutions Rating System. September 2015 Page 3

4 Financial Institution Analysis School Icons The following icons are used in this document. Directs you to open an example from the topic screen. Directs you to open an exercise from the topic screen. Directs you to open a document or go to a Web site. Page 4 September 2015

5 Financial Institution Analysis School Chapter 1: Introduction to In this stage of your career, you have not had much exposure to asset quality. In this school, your focus is primarily centered on assessment of capital, earnings, liquidity and sensitivity to market risk. However, you will assess asset quality UBPR ratios and evaluate the qualitative analysis results completed by seasoned examiners. You will draw conclusions about asset quality and assess how asset quality findings can impact other CAMELS components. Your analysis of a bank s exposure to asset quality risk involves collecting and analyzing two types of information: The bank s financial information, including the balance sheet structure and volume of past-due loans, which are typically analyzed during the offsite portion of the examination. Your review should help detect where credit exposure may lie and the levels and trends of such exposure. Managerial information, which defines what bank management does to effectively identify, measure, monitor, and control risks related to asset quality. Analysis of this information is done during the onsite portion of the examination. Defining Asset quality reflects bank management s ability to identify, measure, monitor, and control credit risk. Credit risk is the debtor s ability to pay per contractual terms. Asset quality issues impact all areas of the bank and are often the main factor affecting the institution s well-being and the central cause of weaknesses in problem institutions. Asset quality is often the central cause of weakness in problem financial institutions. Asset quality represents the existing and potential risks associated with a bank s: Loan and investment portfolios. Generally, investments that offer higher yields or interest rates also carry more risk. A bank s earning assets are typically in two categories: Loans typically are the largest asset on the balance sheet and they possess more risk of loss and risk to bank capital than securities. For this reason, loans have a higher reward or yield. In assessing asset quality, examiners focus most of their time on reviewing the quality of loans in the bank s portfolio because they represent the largest threat to bank capital. Securities typically are the second largest type of asset on the balance sheet and generally possess less credit risk than loans. However, some September 2015 Page 5

6 Financial Institution Analysis School securities contain significant credit risk, and therefore the bank expects a higher return or interest rate paid for taking on that risk. In addition to potential credit risk, a security may have significant interest rate and/or liquidity risk. Other real estate owned. In many cases, banks collateralize loans with real estate. When a borrower defaults, the bank takes possession or title to the real estate in lieu of the borrower s outstanding debt. This repossessed real estate is reported as Other Real Estate (ORE) owned. This asset has no stated yield, and depending on the type of real estate, may be difficult for the bank to resell without taking a loss or providing favorable financing. Many states have statutes that limit the time a bank can hold other real estate on their books. Other assets. Generally, other assets consist of fixed assets and accrued interest. When a loan is adversely classified, the corresponding other asset (i.e., accrued interest) is also adversely classified. Off-balance sheet transactions. The most common form of off-balance sheet activity is a bank committing to advance loan proceeds to customers at future dates. These loan commitments are very common in real estate construction and development. This commitment poses a risk to the bank, as the bank may be obligated to advance the additional proceeds despite the borrower becoming financially distressed. Commitments may also be granted under lines of credit or for the origination of new loans. Introduction Summary Asset quality represents the existing and potential risks associated with a bank s: Loan and investment portfolios Other real estate owned Other assets (fixed assets and accrued interest) Off-balance sheet transactions In this school, you will learn to analyze the bank s asset quality component. In the next chapter, you will learn about the tasks of the offsite analysis. Your offsite review should help detect where credit exposure may lie and the levels and trends of such exposure. Page 6 September 2015

7 Financial Institution Analysis School Chapter 2: Offsite Analysis The offsite analysis of asset quality should identify the extent to which a bank is exposed to credit risk. It centers on data and ratios related to the loan portfolio because loans traditionally present the greatest degree of risk and exposure. The results of the offsite analysis should identify any concerns or issues for onsite followup. You will review the following information during the offsite analysis: Previously identified asset quality deficiencies (e.g., adversely classified items, credit administration issues, asset concentrations) as noted in prior Reports of Examination (ROEs), prior examination workpapers, and file correspondence (e.g., formal letters, communication between the bank and FDIC) maintained on RADD. Key management reports to better pinpoint risk and establish the scope of the examination. Key asset quality reports are available for both loans and investments. Loan Reports. During the offsite analysis, examiners are usually able to obtain loan reports, including the bank s internal watch list; reports which detail past due, nonaccrual and restructured loans; and a list of loans to directors and officers. Review of these reports aids examiners in assessing the level of portfolio risk and also assists in developing the list of credits that will be reviewed during the examination. Investment Reports. A detailed security inventory report allows examiners to better evaluate the composition of the investment portfolio and individual holdings and identify investments that may be of concern and require further review. Your main task during the offsite analysis involves examining the bank s UBPR to: Review the balance sheet structure. Identify the types and levels of off-balance sheet items. Analyze the level and trend of key ratios. These three items are discussed in more detail on the following pages. September 2015 Page 7

8 Financial Institution Analysis School Review the Balance Sheet Structure A review of the bank s balance sheet structure will provide an overall picture of the bank s asset composition and help identify assets that expose that bank to credit risk. When reviewing the UBPR you should focus on both the level and trend of information. UBPR data that provides balance sheet structure information for analyzing asset quality include: Page 4, Balance Sheet $ provides the dollar amounts of assets and liabilities for the bank. Page 6, Balance Sheet Percentage Composition provides the bank s overall asset and liability composition as a percentage of its average assets. Review Page 6 to determine: Asset types representing the largest percentage of average assets. The percentage of net loans and leases to average assets. The percentage of available-for-sale and held-to-maturity securities to average assets. Other asset types that may represent a significant percentage of average assets. Trends in the asset composition. Page 7A, Analysis of Credit Allowance and Loan Mix provides the mix of loans in the bank s loan portfolio. Loans represent the majority of most banks asset structure and ordinarily present the greatest amount of credit risk. Different types of loans carry varying amounts of credit risk. For example commercial real estate loans typically present more credit risk than one-to-four family residential mortgage loans. Banks that have a higher percentage of commercial loans are exposed to a greater possibility of credit risk. Review Page 7A to determine: Loan types representing the largest portion of the loan portfolio. The risk level of loans (i.e., if the institution generally has high- or low-risktype loans or a mixture of both). Trends in the loan mix. Page 8 September 2015

9 Financial Institution Analysis School Page 7B, Analysis of Concentrations of Credit provides a breakdown of the loan portfolio in relation to the bank s capital position. Information on this page can be used to determine if the bank has an exposure to riskier types of credit and the level of the exposure in relation to the capital position. It can also be used to determine if the bank has holdings of commercial real estate loans in excess of guidelines detailed in the joint 2006 regulatory Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. Thresholds are 100 percent of total capital for acquisition, development, and construction loans and 300 percent for total commercial real estate loans, excluding those for owner occupied properties. (The overall threshold also requires 50 percent CRE growth within the last 36 months). Enhanced oversight by management is expected for these concentrations. Review Page 7B to determine: The level of higher risk loans in relation to the bank s capital position. Trends in risk exposure of loans in relation to capital levels. Page 10A, Liquidity and Investment Portfolio provides the distribution of the bank s securities portfolio. U.S. Treasury and Government agency securities present little, if any, credit risk. Other securities (e.g., corporate bonds, municipal securities, trust-preferred securities, private-label securities, and collateralized mortgage obligation (CMO) tranches) could expose the bank to greater credit risk. If you identify any of these securities, you will want to examine them further during the onsite analysis to assess their risks and ensure management is properly monitoring and controlling these risks. Review Page 10A to determine: The types of securities that represent the largest percentage of total assets. The risk level of securities. Trends in the securities mix. Identify the Types and Levels of Off-Balance Sheet Items Off-balance sheet items are obligations that may need to be fulfilled in the future. Certain off-balance sheet items typically result in an equivalent increase in bank assets if the contingencies convert into actual assets. These items can expose banks to credit risk. During the offsite analysis of asset quality, review Page 5 of the UBPR to determine the types and levels of off-balance sheet activity. There are three primary off-balance sheet items that could expose a bank to credit risk. September 2015 Page 9

10 Financial Institution Analysis School Unfunded commitments. A loan commitment is a written agreement, signed by the borrower and the bank, that details the terms and conditions under which a loan of up to a specified amount will be made. The commitment will have an expiration date and can be irrevocable, making it an unconditional guarantee by the bank to lend funds when the borrower requests them. Banks commonly extend loan commitments in the form of a line of credit, a type of commitment by which the bank will lend funds (up to a certain amount), accept payments, and then re-lend those funds over a specified period of time. For example, a bank may extend a seasonal line of credit to a retail firm. The retail firm can use the credit as working capital to support investment in inventory and carry account receivables. At the end of the season, after goods have been sold and receivables collected, the firm is able to repay the line of credit using the cash received from those sources. Construction loan commitments are also common and include a commitment to advance funds during the completion/construction of a project. Letters of credit. There are two types of letters of credit: A commercial letter of credit, which is a document that facilitates the movement of goods between a buyer and a seller by providing a means of payment. If the seller meets the conditions set forth in the letter of credit, the seller will be paid by the bank. A standby letter of credit, which is an irrevocable commitment on the part of the issuing bank to make payment to a designated beneficiary if the bank s customer defaults on an obligation or fails to perform a required service. Letters of credit can expose the bank to increased credit risk because of their irrevocable nature. Even if the customer s financial condition deteriorates, the institution cannot rescind the letter of credit. Large numbers of letters of credit could indicate higher credit risk exposure. Assets securitized or sold with recourse. Asset securitization is the sale of a pool of assets. This practice generally consists of packaging loans for sale to a third party for issuance in the secondary or public market. Two common asset types that are securitized are one-to-four family residential loans and credit cards. For one-to-four family residential loans, typically the selling bank does not retain significant residual credit risk, provided the loan satisfies agreed upon criteria. Page 10 September 2015

11 Financial Institution Analysis School For credit cards, the selling bank typically retains some amount of residual credit risk. The selling bank may be asked to retain a higher percentage of the credit risk if the pool is of poor-quality or high-risk. If securitized or assets sold with recourse are noted on the UBPR, follow up with management during the onsite analysis to assess its approach to these activities and the magnitude of the credit risk involved. In the following examples, review the balance sheet structure and off-balance sheet items to determine the bank s risk profile. These examples include UPBR Pages 4, 5, 6, 7A, 7B, 10A and an expert analysis of each page. Balance Sheet / Off-Balance Sheet Example 1 Balance Sheet / Off-Balance Sheet Example 2 Analyzing the Levels and Trends of Key Ratios Key asset quality ratios can be found on UBPR Pages 1, 7, 8, and 8A. Recognizing and understanding these ratios is important because they can signal potential asset quality problems, which adversely affect other component areas. For example, a bank experiencing asset quality problems will likely have diminished loan yields due to nonaccrual loans. Analyzing specific ratios on Pages 1, 7, 8, and 8A can help identify potential asset quality problems. Additionally, asset quality problems can also lead to increased provision expenses as well as higher overhead costs due to increased legal fees and collection expenses. This in turn reduces earnings or results in losses which impacts capital formation. Problem assets are less liquid and could expose the institution to losses if sold. Conversely, strong asset quality generally results in sustained yields, which lead to strong earnings performance and capital augmentation. These ratios are central to the offsite analysis of asset quality. Your understanding of the ratios will help you interpret the bank s overall condition and will point out areas for follow up while onsite. Summary Ratios on Page 1 The summary ratios under Loan and Lease Analysis on Page 1 of the UBPR provide some insight into the level of risk within a bank s loan and lease portfolio. September 2015 Page 11

12 Financial Institution Analysis School These ratios provide an overview of losses on average, how they compare with peer, and any noteworthy trends. Keep in mind that there are no benchmarks for these summary ratios because each bank s asset quality position is unique. Five ratios are key to your analysis: Net Loss to Average Total Loans and Leases Earnings Coverage of Net Losses (X) Loan and Lease Allowance to Total Loans and Leases Total Loans and Leases 90 Plus Days Past Due Rest + Nonac + RE Acq to Equity Capital and the ALLL Net Loss to Average Total Loans and Leases This ratio indicates the annualized level of net loan and lease losses (charge-offs minus gross recoveries) relative to the average volume of total loans. [Total of LN & LS charge-offs gross recoveries] annualized Average total LN & LS When reviewing this ratio, consider the: Level. In general, higher ratios indicate a higher level of risk while lower ratios indicate less risk in the loan portfolio. However, keep in mind that UBPR data is based on what the bank reports. If management is not recognizing loan losses appropriately and on a timely basis, the ratio may not reflect the actual level of risk. Trend. If the most recent ratio is significantly higher or lower than those reported in prior periods, further review of recoveries and charge-offs is warranted. Earnings Coverage of Net Losses (x) This ratio indicates the bank s ability to absorb potential losses through core earnings. Net operating income before taxes, securities gains or losses, and extraordinary items + provision for LN & LS losses Net LN & LS losses Page 12 September 2015

13 Financial Institution Analysis School When reviewing this ratio, consider the: Level. A higher ratio is better because it indicates a greater ability to absorb potential losses through earnings. If the ratio is less than 1, the bank s earnings prior to provisions will not cover its losses; either because the bank s losses are so high that they exceed earnings or because net operating income is so low that it does not cover the losses. Trend. Changes to the bank s operating income or loan losses influence this ratio. For example: If the bank Increases its net operating income Experiences an increase in loan and lease losses Then The ratio will increase, indicating that the bank s earnings have a greater ability to absorb loan and lease losses. The ratio will decrease, indicating that the bank s earnings have less ability to absorb losses through earnings. Loan and Lease Allowance to Total Loans and Leases This ratio represents the ability of the allowance for loan and lease losses (ALLL) to absorb losses within the loan and lease portfolio. ALLL balance Total LN & LS When reviewing this ratio consider the: Level. A higher ratio indicates a greater ability to cover loan losses. This ratio will vary significantly depending on the bank s lending activities and portfolio quality. Trend. In general this ratio should be stable or increasing. Also, the trend of the ratio should be consistent with changes in the risk profile of the loan portfolio. If the ratio is decreasing yet loan portfolio risk is increasing, further investigation during the onsite analysis is warranted. Additional UBPR data, including: The bank s historic losses and recoveries (Page 7) Changes in the loan mix (Page 7A) The level of non-current and past due loans and leases (Pages 8 and 8A) September 2015 Page 13

14 Financial Institution Analysis School During the onsite analysis, you will reassess any preliminary conclusions you made during the offsite analysis. For example, the ALLL may need to be adjusted due to adverse loan classifications, asset quality trends, and/or management s performance (e.g., underwriting, collection practices, administration). Total Loans and Leases 90 Plus Days Past Due and Loans on Nonaccrual This ratio and its subsets is one of the best indicators of asset quality problems in the UBPR. Information is provided for both loans on nonaccrual and those loans that are past due 90 days or more and still accruing interest. The total of these items is referred to as non-current loans. Total LN & LS 90+ Days Past Due and Loans on Nonaccrual Gross Loan and Leases When reviewing this ratio consider the: Level. A lower ratio indicates that non-current loans are a small proportion of a bank s gross loans. A high ratio may indicate asset quality problems. Several things can influence this ratio. For example: If Collection efforts are stepped up and the amount of delinquent loans are reduced The loan volume increases Loan renewal practices are liberal Then The ratio will decrease. Non-current loans and leases will become a smaller proportion of total loans, making this ratio smaller. However, it may not address the root cause of previously high levels of non-current loans (e.g., administration weaknesses may still be present). The ratio will be understated as loans that would potentially become past due are renewed. Trend. In general look for a low level and a decreasing or stable trend. A ratio that is high relative to peer and increasing indicates a deteriorating loan portfolio that requires further investigation. Page 14 September 2015

15 Financial Institution Analysis School Rest + Nonac + RE Acq to Equity Capital and the ALLL This ratio captures the volume of problem assets in relation to equity capital and the ALLL. For purposes of this ratio, problem assets include restructured troubled debt (TDRs), regardless of whether it is past due or not; nonaccrual loans; and non-investment other real estate owned. It does not include loans past due days that are not restructured or loans past due 90 days or more that are not on nonaccrual. This ratio can be an indicator of asset quality concerns; however, it will be understated if management fails to place loans on nonaccrual and/or recognize TDRs. Also, while the ratio is somewhat similar to the examination Adversely Classified Items Coverage Ratio, which will be covered later in this module, there may be significant differences between the two. This is because exam classifications often include additional assets, including adversely classified loans that are not past due, that are past due 90 days or more that are not on nonaccrual or loans 30 to 89 days but not restructured, or that are past due 90 days or more but not on nonaccrual. Restructured Loans and Leases + Nonaccrual Loans + Acquired Real Estate Equity Capital + ALLL When reviewing this ratio consider the: Level. Higher ratios indicate a higher level of risk while lower ratios indicate less risk. Keep in mind that management s failure to place loans on nonaccrual and properly recognize TDRs can result in an understated ratio. Trend. An increasing trend coupled with a higher level can be cause for concern and is a red flag. In the following examples, review the summary ratios on Page 1 and read an expert analysis of the data. Summary Ratios Example 1 Summary Ratios Example 2 September 2015 Page 15

16 Financial Institution Analysis School In the following exercise, you will analyze the summary ratios on Page 1 and determine whether or not they raise any asset quality concerns. Summary Ratios Exercise Key Ratios on Page 7 After reviewing Page 1 summary ratios, ratios on Pages 7, 8, and 8A can help identify specific loan categories in which the bank has suffered losses and/or is exposed to increased risk. This will help determine where to focus the onsite analysis. There are two important asset quality ratios on Page 7 of the UBPR: Recoveries to Prior Credit Loss Net Losses by Type of Loan and Lease Recoveries to Prior Credit Loss This ratio determines how recoveries in the current year compare to the prior year s recorded losses. Gross credit recoveries in the current year (annualized) Gross credit losses of the preceding year When reviewing this ratio consider the: Level. A higher ratio is better because it indicates that the bank has strong recovery efforts. How management addresses losses and how much emphasis it puts on collection efforts will influence the ratio and your analysis of it. For example, management can improve recoveries by employing: A conservative charge-off policy, which means the bank charges off problem credits well before there is no possibility of recovering losses (i.e., the bank is able to recover some of what it has booked as loss). Aggressive collection efforts. A low ratio may indicate that management has difficulty collecting problem credits or is delaying loss recognition. Page 16 September 2015

17 Financial Institution Analysis School Trend. It is common for this ratio to be volatile. In addition, this ratio can easily be skewed for a number of reasons including a significant charge-off or recovery occurring in a prior period or recovery occurring the same period as the charge-off. Refer to raw data at the bottom of Page 7 for a more accurate perspective of distortions to this ratio (e.g., unusual charge-offs or recoveries in a given period). Net Losses by Type of Loan and Lease On Page 1, you looked at the Net Loss to Average Total Loans and Leases ratio, to gain an overall perspective of losses at the institution. The Net Losses by Type of Loan and Lease ratios indicate the level of losses experienced within each specific loan category (e.g., real estate loans, construction and land development loans, and one-to-four family mortgages). Year-to-date net LN & LS losses in the category (annualized) Year-to-date average loans in the category A negative value indicates a net recovery for that type. Analyze the: Level. In general, lower ratios are better because they indicate that losses for a particular type are a small proportion of average loans for that type. A high level of losses within a particular loan type may indicate underwriting, collection, or asset quality problems for that type of lending. Trend. Significant increasing trends in any type may likely indicate potential problems for that loan type. Keep in mind that you must factor in the bank s loan mix when analyzing individual loan types. For example, if loss levels appear high for a given type, be sure to consider whether that category represents a significant proportion of the bank s portfolio by reviewing loan mix data on UBPR Page 7A. In the following examples, review the key ratios on Page 7 and read an expert analysis of the data. UBPR Page 7 Example 1 UBPR Page 7 Example 2 In the following exercise, you will analyze the key ratios on Page 7 and determine whether or not they raise any asset quality concerns. September 2015 Page 17

18 Financial Institution Analysis School UBPR Page 7 Exercise Key Ratios on Pages 8 and 8A Pages 8 and 8A provide an analysis of past due, nonaccrual, and restructured loans and leases. Ratios on these pages provide data that feed into the non-current loan information on Page 1. There are two key sections to review: Non-Current Loans and Leases Volume The Percentage of Non-Current Loan and Lease by Loan Type Non-Current Loans and Leases When analyzing the level of non-current loans and leases, begin by reviewing the bottom of Page 8. This section summarizes the dollar amount of all loans and leases that are: Past due 90 days and over In non-accrual status Considered non-current (the sum of the above bullets) This page also provides information on loans that are past due days. After you review of the bottom of Page 8, then review the past due/non-current loan information for individual loan types on Pages 8 and 8A, with special attention to the aggregate portfolio ratios displayed on Page 8A. The aggregate information appears after information for the individual loan types. The Percentage of Non-Current Loans and Leases by Loan Type These ratios provide information about the distribution of delinquent loans and leases. For each loan type, non-current loans are shown as a percentage of the gross loan and lease balance for the type. These ratios are shown on Pages 8 and 8A. For each loan and lease type, the formula for this ratio is: Non-current LN & LS (by type) Gross LN & LS balance (by type) Page 18 September 2015

19 Financial Institution Analysis School When reviewing these ratios, consider the: Level. A lower ratio is better. If delinquency levels are high for a given type, consider whether the type represents a significant proportion of the loan portfolio. A high level of non-current and past due loans and leases within a type indicates potential underwriting or asset quality problems. Trend. A decreasing trend is good. However, while a dramatic decline between reporting periods may indicate significant asset quality improvement; it may also be the result of liberal renewal policies, or inaccurate reporting by management. An increasing trend indicates increased asset quality concerns. In addition to reviewing the volume and level of noncurrent loans and leases, also consider the amount of loans past due days and the overall past due ratio which is listed near the bottom of Page 8A. While loans past due days are not as much of a concern as non-current loans, they are still indicative of borrower repayment problems and could ultimately migrate to non-current status. For this reason, it is important to consider these loans in your analysis. In addition to reviewing each individual loan type, look across all types to determine if delinquent and non-accrual loans are isolated in one or a few types or if they appear to be spread across all types. Also, review information for the total loan portfolio captured near the bottom of Page 8A to determine the overall level of portfolio risk. If delinquent and nonaccrual loans are: Widespread across many types Isolated in one or a few types Then The bank may have a systemic problem in its lending practices. There may be economic factors influencing the level of delinquent and non-accrual loans in that type. Asset quality problems may be limited to a particular lending department within the bank. In the following examples, review the key ratios on Pages 8 and 8A and read an expert analysis of the data. UBPR Pages 8 and 8A Example 1 UBPR Pages 8 and 8A Example 2 September 2015 Page 19

20 Financial Institution Analysis School In the following exercise, you will analyze the key ratios on Pages 8 and 8A and determine whether or not they raise any asset quality concerns. UBPR Pages 8 and 8A Exercise Offsite Analysis Summary Your offsite analysis of UBPR data should give you an indication of the bank s level of risk relative to asset quality. You will follow up with any issues or concerns during the onsite analysis. To conduct an offsite analysis of UBPR data for asset quality: Review the bank s balance sheet structure (Pages 4, 6, 7A, 7B,and 10A) Identify the types of levels of off-balance sheet items (Page 5) Analyze the levels and trends of key ratios (Pages 1, 7, 8, and 8A) As part on the offsite analysis, you will also review previously identified asset quality deficiencies as noted in prior ROEs, prior examination work papers, file correspondence, and key management reports. Page 20 September 2015

21 Financial Institution Analysis School Chapter 3: Onsite Analysis The information collected during the offsite analysis will help determine what to focus on when at the institution. However, the information collected during the onsite analysis is the major factor in assessing asset quality. During the onsite analysis, the loan review team completes the following activities: Follow up on concerns identified during the offsite analysis. Complete a qualitative review of the institution s assets. Determine the volume and severity of adversely classified assets. Determine management s ability to identify, measure, monitor, and control risk related to asset quality. Assign an asset quality rating and prepare supporting comments. Follow Up on Concerns Identified During Offsite Analysis During the offsite analysis, you reviewed the UBPR information to assess the institution s financial condition and identify areas of concern about the bank s risk profile as reflected in its asset mix and level of off-balance sheet activity. Additional information to review while on site may include: Balance sheet and account data Internal and external audit reports Strategic and business plans Independent loan review reports Concentration reports Balance Sheet and Account Data During the onsite analysis, the team reviews the bank s balance sheet to identify: Changes that have occurred since the UBPR review. For example, the balance sheet may now show that the bank holds other real estate. In distressed real estate markets, these assets may become voluminous and negatively impact asset quality. September 2015 Page 21

22 Financial Institution Analysis School Other information that is not evident from the UBPR. For example: The accounts that make up the UBPR category of other assets, such as investments in insurance policies. Separate balance sheet accounts for non-accrual loans, other real estate sold on contract, or other assets acquired and held (repossessed) for debts previously contracted. Due from bank accounts and other miscellaneous asset accounts for the presence of stale items or unsupported assets. All these items will influence the team s view of the bank s asset quality. Internal and External Audit Reports Information from internal and external audit reports can help the examination team: Determine the credibility of the bank s financial statements. For example, assume a bank invests in complex financial instruments or other unusual assets at values that management cannot adequately support and you cannot confirm. An internal or external audit of these assets will provide an opinion as to whether the financial statements give a true and fair depiction of the bank s financial position and will allow the team to carry out their examination responsibilities. Learn important information concerning the bank s operations and conditions about which the team has not been informed. This shared information will be helpful during an examination. Strategic Plans A bank s strategic plan will provide information about the Board of Directors short-term and long-range goals for the bank and how they will be achieved. The plan addresses issues such as: Asset growth Earnings performance Capital formation Acquisitions or mergers New markets or products Resolution of high-risk concerns Management succession Page 22 September 2015

23 Financial Institution Analysis School The plan will help the team gain an overall understanding of the bank and influences that may affect the bank s present and future asset quality. Independent Loan Review Reports Independent loan review reports: Help you determine if management properly identified adversely classified loans and included them on their internal watch list. If not, you should follow up with management to determine the reason for the difference in loan grading. Provide summary information on the credits that were reviewed independently, which can be useful during the review of loans by examiners. Provide an assessment of credit administration practices and any related weaknesses. Concentration Reports Management uses concentration reports to monitor concentrations of credit. A concentration exists when the institution has advanced or committed a large amount of credit to an individual or related group of borrowers or a particular industry. A higher exposure to an individual or industry results in increased risk as any financial difficulties with the borrower or distress in an industry could have a more pronounced effect on asset quality due to the higher exposure. Management is expected to have effective systems in place for monitoring concentrations and should adopt reasonable policy limits. Loan concentrations of 25 percent or more of Total Capital by individual borrower, small interrelated group of individuals, single repayment source or individual project or loan concentrations of 100 percent or more of Total Capital by industry, product line, and type of collateral should be reported on the concentrations page of the report of examination. Concentration listings for other assets such as investment securities should be based on the same criteria, but should be reflected as a percentage of Tier 1 Capital. You may list concentrations of any amount if they raise concerns. Commercial real estate (CRE) loan concentrations in excess of thresholds developed by the regulatory agencies should also be placed in the examination report. These thresholds are 100 percent of total capital for acquisition, development, and construction loans and 300 percent for total commercial real estate loans, excluding those for owner occupied properties. (The overall 300 percent threshold also requires 50 percent CRE growth within the last 36 months). September 2015 Page 23

24 Financial Institution Analysis School Complete an Asset Review To have a complete understanding of the bank s asset quality, the team must thoroughly review the institution s assets, including loans, securities, other real estate owned, and other assets and off-balance items. To conduct this review, the loan examination review team: Reviews selected loan files to assess each borrower s ability to repay through current and anticipated cash flow and the value of the collateral. Reviews loan monitoring controls, such as segregation of duties, levels of authority, and the process for funding loans. Discusses loans with bank management and documents the results on line sheets. Identifies questionable securities and reviews information for potential adverse classification. Reviews other assets, including other real estate owned and repossessions. The results of the asset review are a critical input in the asset quality assessment. A substantial proportion of poor quality assets will not only impact the rating of asset quality, but may also: Hinder the bank s earnings performance. Impact the bank s capital position and formation. Adversely affect the bank s cash flow and liquidity posture. Affect management s ability to oversee problem credits. Determine the Volume and Severity of Adversely Classified Assets The loan review team spends a significant part of the onsite examination analyzing loans and other assets. An important aspect of asset quality is the level and severity of adversely-classified assets. Page 24 September 2015

25 Financial Institution Analysis School There are three adverse classification categories: Substandard. Loans that are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Doubtful. Loans that have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable. Loss. Loans that are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. In addition to the adverse classifications, there are two other dispositions: Special Mention. An asset with potential weaknesses that deserves management s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution s credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Note: The Special Mention category is not to be used as a means of avoiding a clear decision to classify a loan or pass it without criticism. Neither should it include loans listed merely for the record when uncertainties and complexities, perhaps coupled with large size, create some reservations about the loan. If weaknesses or evidence of imprudent handling cannot be identified, inclusion of such loans in Special Mention is not justified. Ordinarily, Special Mention credits have characteristics which corrective management action would remedy. Often weak origination and/or servicing policies are the cause for the Special Mention designation. Pass. Loans that present the least risk. They provide no distinct possibility of loss or risks sufficient to warrant adverse classification. September 2015 Page 25

26 Financial Institution Analysis School Adverse Classification Ratios Once the team has determined adverse classifications, the following three ratios will provide more information about the impact adversely classified loans and other assets have on the bank s risk profile. Adversely Classified Items Coverage Ratio Total Adversely Classified Assets to Total Assets Total Adversely Classified Loans and Leases to Total Loans and Leases These ratios are included on the Examination Data and Ratio page of the Report of Examination (ROE). Adversely Classified Items Coverage Ratio This ratio is a measure of the level of credit risk relative to the bank s capital level and ALLL. It is the most commonly referenced asset quality ratio. It reflects the aggregate level of all items classified as substandard, doubtful, and loss in relation to Tier 1 Capital and the ALLL. Adversely classified items Tier 1 Capital + the ALLL A lower ratio is desirable as a higher ratio indicates increased exposure to poorquality assets and off-balance sheet items. A higher ratio may also indicate less ability to absorb the consequences of bad loans. Total Adversely Classified Assets to Total Assets This ratio indicates the aggregate level of all assets classified as substandard, doubtful, and loss in relation to total assets. Adversely classified assets Total assets A lower ratio is desirable as a higher ratio indicates increased exposure to poorquality assets. Page 26 September 2015

27 Financial Institution Analysis School Total Adversely Classified Loans and Leases to Total Loans and Leases This ratio indicates the aggregate level of all loans and leases classified as substandard, doubtful, and loss in relation to total loans and leases. Adversely classified LN & LS Total LN & LS A lower ratio is desirable as a higher ratio indicates increased exposure to poorquality assets. In the following examples, review the Adverse Classification ratios from a ROE excerpt and read an expert analysis of the data. Adverse Classification Ratios Example 1 ASSET QUALITY Substandard Doubtful Loss Total Loans and Leases 1, ,665 Securities Other Real Estate Other Assets Other Transfer Risk Subtotal 1, ,735 Contingent Liabilities Totals at Exam Date 9/30/20x4 1, ,735 Totals at Prior Exam 9/30/20x3 1, ,501 Totals at Prior Exam 9/30/20x2 1,067 1,067 Exam Date 9/30/20x4 Exam Date 9/30/20x3 Adversely Classified Items Coverage Ratio Total Adversely Classified Assets/Total Assets Adversely Classified Loans and Leases/Total Loans Exam Date 9/30/20x2 September 2015 Page 27

28 Financial Institution Analysis School Expert Analysis In this example, the three ratios indicate that the bank has a relatively high exposure to credit risk. The Adversely Classified Items Coverage Ratio shows that classified items total percent of the bank s Tier 1 Capital and ALLL and is trending upward. The percent indicates that adverse classifications represent more than half of the bank s capital and reserves, and reflects a heightened risk profile. In addition, over 5 percent of the bank s total assets and nearly 8 percent of its loan portfolio are adversely classified. This is substantial and worthy of requiring management to initiate immediate corrective action. Two factors demonstrate the deterioration of asset quality: The increase in the volume and level of adversely classified assets. A greater proportion of assets classified in the more severe categories (doubtful and loss) than at previous examinations. The condition of the loan portfolio and the bank s asset quality as a whole will require more human resources for monitoring and controlling risk and could hamper earnings and other CAMELS components. Adverse Classification Ratios Example 2 ASSET QUALITY Substandard Doubtful Loss Total Loans and Leases 1,471 1,471 Securities Other Real Estate Other Assets Other Transfer Risk Subtotal 1,471 1,471 Contingent Liabilities Totals at Exam Date 3/31/20x4 1,471 1,471 Totals at Prior Exam 12/31/20x2 2,552 2,552 Totals at Prior Exam 12/31/20x1 1,882 1,882 Exam Date 3/31/20x4 Exam Date 12/31/20x2 Exam Date 12/31/20x1 Adversely Classified Items Coverage Ratio Total Adversely Classified Assets/Total Assets Adversely Classified Loans and Leases/Total Loans Page 28 September 2015

29 Financial Institution Analysis School Expert Analysis In this example, the bank s asset quality is strong. The three ratios indicate that the bank does not have credit quality concerns or great exposure to credit risk, and that its asset quality has improved. Adverse classifications spiked upward at the 12/31/20x2 exam but then retracted to a level below the 12/31/20x1 exam. The Adversely Classified Items Coverage ratio totals only percent; the lowest level recorded during the three exam cycles, and reflects a minimal amount of risk in relation to capital and reserves. This is a level that can be adequately monitored and controlled. Less than 2 percent of the bank s total assets and slightly more than 3 percent of the bank s loans are adversely classified. These levels also show that management is controlling and maintaining the risk level at an easily managed tolerance level. The fact that no assets were adversely classified as Doubtful or Loss at the last three exams illustrates that the exposure to the risk of loss is not high. In the following exercise, you will analyze adverse classification ratios for a sample bank and determine whether the bank s asset quality has improved or deteriorated. Adverse Classification Ratios Exercise Determine Management s Impact Management has a significant impact on asset quality because it determines the asset mix and risk tolerance levels. Therefore, management should have policies and procedures in place that are necessary to identify, measure, monitor, and control risks associated with asset quality. Primary examples are management s responsibility for developing the bank s: Underwriting standards Credit administration practices Loan and investment policies Strategy for reducing problem credits Management s actions to determine the asset mix and risk tolerance levels significantly impact asset quality. September 2015 Page 29

30 Financial Institution Analysis School Underwriting Standards Loan underwriting is a detailed credit analysis that the lender conducts before granting a loan. It is an analysis of a potential borrower s credit needs and ability to pay. The analysis is based on: Credit information furnished by the borrower, such as employment history and operating and financial statements. Publicly available information, such as the borrower s annual report (if a publicly traded entity.) The borrower s credit history, which is detailed in a credit report. When defining the terms and structure of the credit, the lender will weigh the repayment ability of the borrower as well as the purpose of the credit (sources and uses of funds). To ensure consistent underwriting practices, management should have underwriting standards in place that address items such as: Selection of risks (e.g., secured versus unsecured loans and lending to certain industry segments). Preliminary analysis (e.g., initial loan or investment analysis). Minimum borrower repayment capacity (Debt Service Coverage ratios). Collateral loan to value requirements. Terms (e.g., loan rates and contract length, investment maturities). Loan pricing (e.g., pricing loans to compensate for higher risk loans such as subprime). Weak underwriting standards make a bank vulnerable to asset quality deterioration. When asset quality problems are identified, consider the institution s underwriting standards as a possible cause. Page 30 September 2015