Financial Update (October-December 1998)

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Did You Know?

Commercial Lending Standards
Are Easing, Fed Report Says

H ave banks eased lending standards for commercial loans? In a recent review of asset quality, credit standards and lending practices, the Federal Reserve determined that banks have indeed significantly eased their lending standards largely because of intense competition to attract customers. If carried too far, such easing could undermine a bank's financial health, especially if the economy weakens, the Fed review indicated.

The Fed found that projections of a borrower's future performance were present in only 20 to 30 percent of the loan approval documents reviewed . . .

Review of Lending Standards

Banking supervisors, including the Federal Reserve, have been on the alert for the emergence of lax lending practices as statistics for the banking industry have shown potential problem business loans to be at historically high levels.

In response to supervisory and industry concerns, Federal Reserve supervision staff recently conducted an intensive review of lending terms and standards as part of a loan quality assessment project. The Fed closely examined hundreds of loans from banks throughout the country, comparing loans made in late 1997 to those made in late 1995. The Board of Governors recently issued this review of commercial lending standards in a supervisory letter to each Reserve Bank and foreign and domestic banking organizations supervised by the Fed.

The Fed review highlights the importance, to both banks and regulators, of forward-looking supervisory practices and the importance of risk-based examinations. Additionally, the Fed supervisory letter stresses that evaluations of bank asset quality and underwriting practices — whether done by bankers or bank supervisors — should consider the strength of a loan portfolio not only under current or favorable conditions but also under stressful circumstances, including periods of possible economic adversity.

Review Results

While the Fed review did show the potential for problem business loans, it also found that the Fed's normal supervisory process did not indicate any unusual amount of underwriting weakness in bank lending. Nonetheless, Board supervisory staff reemphasized the importance of banks' maintaining sound lending practices and adhering to their own internal policies and procedures in regard to commercial lending, particularly in today's competitive lending environment.

And since there is no indication that the competitive pressures to ease lending terms will subside, supervisory experience strongly suggests that now is a critical time for banks to maintain their lending discipline and to continue to enhance their controls and practices, according to the Fed supervisory letter. Additionally, the Fed warned that banks should not rely unduly on the benign experiences of the past several years in assessing the underlying risks of current and future borrowers.

Based on its findings, the Fed recommended that its examiners devote special attention to three areas of lending activity that may reflect the current state of credit discipline at an institution: the use of formal forward-looking analysis in the loan approval process, appropriate pricing of loans to the risks they represent and lending to real estate investment trusts (REITs).

First, the Fed found that projections of a borrower's future performance were present in only 20 to 30 percent of the loan approval documents reviewed and that formal analysis for "downside" scenarios was even less common. The Fed recommended that banks give sufficient consideration to potential negative events or developments that might limit borrowers' ability to fulfill their loan obligations. These developments include changes in interest rates, sales revenues and operating expenses that could adversely affect borrowers' ability to repay.

Second, many recent reports about the degree of easing in lending standards prominently cite significant decreases in loan spreads, and the Fed review was consistent with these findings. As a result, the Fed advised examiners to review a bank's loan pricing policies and practices to assess whether the institution might be unduly weighting the short-term benefit of retaining or attracting new customers while giving insufficient consideration to potential longer-term consequences. The Fed said that banks should incorporate into the pricing decision the appropriate risk of loss on the loans being considered.

Third, the Fed urged examiners to pay particular attention to REITs because several institutions have increased their exposure to these organizations by hundreds of millions of dollars over the past year. While the review indicated there did not appear to be any substantial safety and soundness issues with regard to loans currently being extended to REITs, the Fed did ask examiners to remain informed about developments in an institution's loans to these organizations.

Sound Lending Practices

In addition to reporting on areas where increased supervisory attention appears to be warranted, the Fed also recommended several sound lending practices to help institutions maintain strong credit discipline. These practices include the formulation and use of formal credit policies and staff approval of transactions, thorough and standardized loan approval documents, forward-looking tools in the loan approval process, an internal risk rating system and appropriate management and lender information.

The Fed's supervisory letter and loan quality assessment project can be found on the Board of Governor's web site at http://www.federalreserve.gov/boarddocs/staffreports/.