Underwriting Standards - Lessons From the Past

Lending involves risk; sound underwriting insulates financial institutions from excessive risks that lead to increased credit losses. History shows that lending and, correspondingly, underwriting standards are generally procyclical. As competitive pressures increase for loan growth, banks may be enticed to ease underwriting standards to expand the loan portfolio in order to generate earnings. As conditions begin to deteriorate, this easing of underwriting standards, if carried too far, causes banks to face increased risk that is followed by rising losses and an eventual tightening of underwriting standards.

The Federal Reserve Board’s April 2014 Senior Loan Officer Opinion Survey on Bank Lending Practices provides support that institutions, particularly large banks, are again easing credit standards in response to competitive pressure. Survey data indicate that easing was predominant in the administration of pricing, loan covenants and credit line size. Anecdotal comments from community bank supervisors in the Ninth District also suggest that banks feel competitive pressure to ease their underwriting. We hear from banks that they are currently turning down deals but warning that they cannot keep up that practice forever. Thus, it seems timely to again emphasize the importance of proper underwriting and risk management practices, particularly as the lessons of the most recent financial crisis become more remote.

Consistently sound underwriting is essential to maintaining safety and soundness of financial institutions. This principle is not new and was previously communicated in SR letters 95-36¹ and 98-18² nearly two decades ago.

These supervision letters encouraged banks to exercise sound underwriting practices despite competitive pressure. The recent adjustments to ease standards may be appropriate if done prudently by banks that had significantly tightened credit standards in response to serious credit problems and weak banking conditions. In 1995, SR letter 95-36 noted, “In today’s intensely competitive lending markets, however, there is the potential that some banks may be relaxing, or be inclined to relax, lending terms and conditions beyond prudent bounds in efforts to obtain new customers or retain existing customers.” Is this déjà vu all over again?

SR 95-36 notes that the decision to alter lending terms and standards (and risk-taking) can result from board and senior management decisions to adjust policies and procedures. Alternatively, these changes may reflect more subtle revisions resulting from how policies and procedures are applied in practice. Nevertheless, either process must include appropriate risk management to ensure that all credit risks are properly identified, monitored and controlled, and that loan pricing, terms or other safeguards against nonperformance are consistent with the level of risk taken. Just as bank senior managers and boards must be aware of changes in policies and practices, we expect examiners to be alert to changes in loan policies and credit underwriting terms and conditions and to discuss their findings with bank management and, if necessary, the board of directors. In the last crisis, both bankers and examiners who did not keep routine track of small relaxations of terms, conditions and pricing were surprised at how incremental changes added up to a substantive decline in underwriting standards over time.

In a 1998 study of observed lending practices, SR 98-18 highlights six core elements to maintain strong credit discipline and assure that credit decisions are well-informed, balanced and prudent. Those practices include:

1. Formal credit policies that communicate the bank’s risk appetite and provide specific guidance and measurement standards along with a consistent process for approving and monitoring exceptions.
2. Formal credit approval processes that are independent of line lending functions.
3. Standardized loan approval documents that promote consistent financial analysis, collateral valuation, guarantor support and covenant provisions.
4. Use of forward-looking tools to assess projections and various scenarios that focus on key determinants of performance.
5. Risk rating systems that accurately assess quantitative and qualitative considerations to evaluate credit risk at inception and during the life of the loan.
6. Management and lender information systems that support the approval process and ongoing monitoring of portfolio composition and risk positions.

The current competitive banking market is placing pressure on banks to ease credit standards. As market and economic conditions continue to stabilize, additional pressures to ease standards are likely. While not new, prudent lending practices that are supported by robust risk management programs should be integral for any decision to ease standards. The old adage that “bad loans are made during good times,” coupled with the adage, “those who forget the past are doomed to repeat it,” should be appropriately considered when evaluating a decision to ease credit standards.

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