Over the past several years, confusion has grown concerning acceptable and proper methods and techniques for credit union member business loan classification and risk ratings. This dilemma surprises no one as the credit union industry has not established a uniform system for business loan classification and risk ratings.
The Federal Financial Institutions Examination Council adopted a uniform regulatory classification schematic of loss, doubtful, substandard or special mention.
The NCUA opted-out of the FFIEC uniform regulatory classification definitions and does not require credit unions to adopt a uniform regulatory classification schematic of loss, doubtful, substandard or special mention. Rather, the NCUA requires a credit union to apply an internal loan grade based on its evaluation of credit risk. The term "classify" within the credit union industry has typically meant "individually review to apply a percentage reserve" for allowance for loan and lease losses purposes.
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With no standardized business loan classification or risk-rating definitions, credit unions, especially those new entrants to business lending, tend to apply loan grades and risk ratings developed for consumer loans prior to the credit union's involvement in business lending. As one might imagine there exists a wide variation of MBL loan classification definitions and risk-rating systems throughout the credit union industry.
Rapid growth in the number of credit unions entering the business loan arena, coupled with significant increased credit union MBL volume, exasperates the lack of uniformity and consistency in loan classification. Internal, external, audit and regulatory reviews all struggle to identify and assess safe and sound policies, practices and procedures for classification and risk ratings among credit unions.
With rapid MBL growth, credit union auditors and regulatory examiners are finding themselves somewhat behind the learning curve in MBL credit quality review, analysis and risk-rating determination. Business loans differ significantly from consumer loans. MBL risk assessment and loan classifications are more complex and do not fit standard consumer loan risk-rating methodologies or techniques. At times, auditors, consultants, loan review professionals and regulatory examiners are recommending credit unions adopt MBL risk rating and loan classification techniques and procedures that are not appropriate.
Attempting to adopt a consumer loan grading and rating system for business lending is problematic. The use of a consumer loan-based risk-grading matrix with mathematical formulas based on assigned risk-weighted criterion is difficult, if not impossible, to apply to business lending. At best a matrix of this type can represent one minor tool utilized in the initial business loan underwriting process. This mathematical risk-assessment scoring matrix added little or no value for monitoring and risk rating business loans thereafter.
Credit union MBL classification and risk-rating procedures have been criticized by auditors and regulators for not having an adequate risk-rating matrix based on mathematical risk-weighted criteria that consistently and uniformly identifies business loan risk classifications. This criticism may be founded for credit unions when policies and procedures include some sort of risk-rating matrix for business loans or business loan credit administrators have not adopted alternative procedures.
Credit unions that have well defined sound MBL loan classification and risk-rating policies, procedures and definitions, coupled with uniform application of those concepts, should not be criticized for not having or utilizing some form of risk-rating mathematical matrix. In fact, credit unions that voluntarily adopt and apply the FFIEC uniform regulatory classification definitions for business loans should be held at a higher standard than credit unions that attempt to utilize a MBL style mathematical rating matrix. Auditors, loan review specialists and regulatory examiners should be criticizing credit union MBL functions for not establishing safe and sound uniform classification definitions that are not identical to or mirror those set forth by the industry.
Credit unions who participate in business lending should voluntarily adopt the FFIEC uniform regulatory classification definitions for business loans. Internal, external and regulatory loan review examiners need to possess the expertise and experience necessary to adequately examine safe and sound MBL lending policies, practices, procedures and loan classification and risk-rating accuracy.
Brian Robertson is president of PCMS Inc.
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