Loan Policy Guidelines

A Comprehensive Loan Policy

Rather than incorporating everything into a single loan policy document, many banks find it is better to divide their loan policy into a series of documents. For example, a bank may have separate policies related to lending for:

Loan administration. Loan categories (such as commercial, real estate, consumer

installment and agricultural). Environmental risk. Collections, charge-offs, and recoveries. Loan review and loan grading. Loan loss reserves. Fair lending (for example, ensuring loans are made to all credit-

worthy applications regardless of the race, age, or gender of the borrower).

Because a bank’s lending practices can have implications for its other risk exposures, it is important that the loan policy take into account these risks as well. For example, loans are not a very liquid asset. When a bank makes loans, all else equal, it becomes less liquid, meaning it has fewer funds available to make more loans and to meet its other operating needs. The loan policy, in addition to addressing lending, must also address the bank’s other needs. For instance, your bank’s loan policy may have a statement that limits the proportion of its assets in loans (perhaps loans are limited to 60 percent of bank assets). The intent of this limit may be to preserve the bank’s liquidity position.

These policies can be written by the board, a board committee or delegated to senior management. Regardless of who drafts the policies, directors are required to review and approve the contents of the final policy statement because the board is ultimately responsible for the bank. Once approved and put into operation, these policies should be reviewed, revised as experience dictates and approved at least annually by the board.

By establishing effective policies, directors determine the parameters within which the bank’s lending function operates. This is important because directors often are not involved in individual credit decisions, except in their roles as members of the loan committee or when they are examining loans involving more than the normal credit risk that come to the board for approval.

Although policies differ from bank to bank, a loan or loan administration policy will often address the following issues:

The overall composition of the loan portfolio including the proportion of the bank’s funding sources that may be used for lending, the types of loans that may be granted, and, if appropriate, the maximum percentage of the overall portfolio allowable for each loan category. These considerations affect liquidity, asset and liability management and concentration issues.

The required controls over the loan portfolio and the lending function such as procedures for loan approval and the booking of loans, including documentation requirements.

Individual credit requirements and standards, loan underwriting criteria and loan application requirements. The heart of the bank’s lending business is granting sound, collectible loans. Therefore, these standards should be set so that they result in a portfolio of sound loans, but shouldn’t be so stringent that they screen out legitimate borrowers or inadvertently discriminate against a class of potential borrowers that is protected by antidiscrimination laws.

An independent internal loan review and loan program. This is an essential element for the ongoing monitoring of the lending function.

A methodology for ensuring the adequacy of the allowance for loan and lease losses and the resulting reserves. Normally, management will calculate and recommend the provisions and reserves for loan losses, but the directors are ultimately responsible for its adequacy.

Acceptable concentrations of credit (amount of funds and, hence, bank capital committed) to individual borrowers, related borrowers or to specific types of industry (agricultural, auto, real estate or aircraft manufacturers, for example). With respect to these concentrations, banks often establish an in-house lending limit, an amount less than the legal lending limit. Some banks adopt this limit to diversify risk, but then include in their policy a procedure for approving larger loans on a case-by-case basis.

Geographic trade area in which the bank will lend. Many banks define their trade area as the area from which a high percentage, such as 75 or 80 percent, of their loan and deposit business is derived. In defining the trade area, it is important the bank ensures that no low or moderate-income areas are excluded.

Lending outside the trade area. Out-of-territory loans inherently carry higher risk than do comparable loans closer to home, if for no other reason than their physical remoteness and the resulting servicing difficulties. There can be a sound and logical reason for an out-of-territory loan,

however, and, as a result, policies often include a procedure for consideration and approval of such loans.

Limits on purchased loans. Factors often considered include asset and liability management (liquidity and market risk exposures), concentration of credit issues and credit quality matters such as whether purchased loans meet the bank’s underwriting and servicing standards.

Loans to bank insiders. Bank insiders are directors, officers and principal shareholders. Loans to insiders are the subject of specific regulatory restrictions, examiner scrutiny and restrictive legal limits. They therefore require special attention by the board of directors. Some banks choose to impose even stricter in-house limits that go beyond legal limits on loans to any one insider and to his or her related interests, as well as on the aggregate of loans to all insiders. Violations of the loans to insider rules can result in fines and penalties.

Approval authority and delegation based on an individual loan officer’s expertise and experience. This also includes the manner and degree of involvement of the directors, through their loan committee or comparable function. The objective is to delegate authority to loan officers, commensurate with safety and soundness considerations, for the sake of efficiency, while retaining director involvement for unusual or large credits. Individual officer's lending approval limits should be geared to his or her experience: The senior commercial lending officer may have an approval limit that approaches the bank’s legal or in-house lending limit in size, while the junior installment officer may have a limit of only a few thousand dollars. Some banks permit two or more loan officers to approve a loan jointly and “pool” their individual lending limits. Many banks require loans over a certain size to be approved by a loan committee consisting of senior lending officers and one or more outside directors.

Loan administration. Loan administration covers all aspects of individual loans and the overall loan portfolio, including loan applications and documentation, approval, servicing, collection and loan review.

Loan participations. To meet the needs of larger borrowers and to increase loan income, many community banks utilize loan participation agreements in which two or more banks share in the ownership of a loan. Because these arrangements can present unique risk issues, banks involved in participations should have policy guidelines for participation agreements. The policy should require a complete analysis of the credit quality of obligations to be purchased, evaluation of the collateral and the maintenance of full credit information for the life of the participation.

Secondary market loans. Loans to be sold in the secondary market, such as 1-4 family residential loans, also have a unique set of requirements and must follow strict standards. Banks involved in this type of lending should have policy guidelines that address such matters as originating, underwriting, and servicing of secondary market loans.

Fair lending. Fair lending has come to the forefront of regulatory concern. It is to the benefit of all banks to address fair lending issues in the loan policy, both to ensure that the bank does not accidentally violate the fair lending regulations and to demonstrate that it is committed to the principles of fair lending.

Other miscellaneous issues included are such matters as nonaccrual loans, collections and charge-offs, concentrations of credit, credit file maintenance, financing of other real estate, lender liability, loan pricing, maximum maturities, maximum ratio of loan amount to collateral value, appraisal guidelines and off-balance-sheet activities.

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