Loan Review:
A Critical Element of Effective
Portfolio Risk Management
By Donna Nails
May 2010
Introduction
All lending involves risks. Lenders control risk on the front end by developing and using
strong underwriting policies and procedures. Once a loan is originated, lenders use loan
portfolio management to manage risk. One critical element of a strong portfolio
management system is the loan review. This Technical Assistance Memo explains what a
loan review is, why it is important, how a CDFI can use a loan review, and the steps
involved in conducting a loan review. It includes a sample loan review report table of
contents and forms.
What Is a Loan Review and Why Is It Important?
Effective loan portfolio management is crucial to controlling credit risk. In order to
control risk, however, a CDFI must know the types and levels of credit risk in its
portfolio. Loan review is an important tool which can help CDFIs identify this risk. A loan
review provides an assessment of the overall quality of a loan portfolio. Specifically, a
loan review:
• Assesses individual loans, including repayment risks.
• Determines compliance with lending procedures and policies.
• Identifies lapses in documentation.
• Provides credit risk management priority findings.
• Recommends practices and procedures to address findings.
• For CDFIs that risk-rate their loans, a loan review evaluates risk grades and their
accuracy.
This publication is made possible
by the generous support of the
Citi Foundation.
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A thorough and correctly completed loan review provides management and the board of
directors with objective and timely data on loan portfolio quality and recommendations
for addressing weaknesses.
What a Loan Review Is Not
A loan review is not a portfolio review: Unlike a portfolio review, a loan review does not
assess geographic, borrower, or other concentrations that can increase portfolio risk.
A loan review is not a portfolio trend analysis: The loan review assesses loan quality at a
specific point in time. This point is called the focal date. That said, depending on the
sample reviewed, a review team may detect trends for a type of loan such as a specific
industry or loan size.
A loan review is not an assessment of the loan loss reserve: Even though the risk rating
for each individual loan reviewed will be evaluated, a loan review does not provide an
overall opinion of the adequacy of the loan loss reserve. However, a large percentage
(defined as 10% or more of the portfolio reviewed) of risk rating downgrades may
indicate an inaccurate loan loss reserve.
How Do CDFIs Use Loan Reviews to Reduce Risk?
CDFIs use loan reviews to a) identify issues, and b) learn what modifications can be
made to lending procedures, policies, and practices to address those issues. CDFIs that
fail to address problems early are prone to suffering from systemic weaknesses which
can lead to deterioration in portfolio quality, thus reducing profitability and sustainability.
If a CDFI’s risk grades are used to determine its loan loss reserve, another important
element of a loan review is the evaluation of the risk grades of individual loans.
Additionally, if the loan review is conducted by an independent party, it can be
particularly helpful in assessing incidences of fraud and theft that can directly affect the
CDFI’s bottom line.
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What Are the Steps Involved in a Loan Review?
A loan review can be broken down into three steps: 1) pre-file review; 2) file review;
and 3) post-file review. The specifics of each step are outlined below.
Pre-file Review
Prior to the file review, the loan review team will complete two tasks.
1) Review Documents: The loan review team will review the following documents:
• Loan Policy and Underwriting Guidelines including risk grade system and loan
loss reserve policy
• Watch List and Problem Loan Report
• Delinquent Loan Report
• List of all loans outstanding including the Note Number, Name of Borrower,
Original Loan Amount, Original Note Date, Maturity Date, Current Risk Rating,
Outstanding Balance, Available Balance, number of days past due and the
number of times greater than 30, 60, 90 days past due
2) Select Loan Sample: In most cases, it is impractical for the loan review team to
review an entire portfolio; therefore, the loan review team will review a subset of files to
assess the portfolio quality. Prior to conducting the file review, the team must select the
sample of loans to be included in the review.
Sample selection is part art and part science. The goal is to select a sample that is large
and diverse enough to enable the reviewer(s) to identify all issues and understand if an
issue is systemic or limited. There is no clear set of rules for selecting a sample;
therefore, we strongly recommend that the loan review team include an individual who
is experienced in sample selection. To provide an idea of the variables that determine
the appropriate size and composition of a sample, we offer these guidelines and
observations.
The sample should include a proportional amount of each product. It should also include
the types of loans that offer the greatest risk such as large loans, new products, and
problem loans. The sampling percentage will vary based on the type of loans, the
number of different loan products, and the size of the portfolio. Generally, the total
dollar percentage of the portfolio reviewed should be no less than 25% for portfolios
with outstanding balances of over $30 million. The percentage may be higher for smaller
portfolios or portfolios with a number of different products. A loan portfolio that consists
of business loans will need a larger sample size because the underwriting and
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monitoring of such loans are usually not standardized. If the loan portfolio consists of a
single homogenous product such as single family residence mortgages that are
underwritten in a consistent way, a smaller sample size (10-15% of total portfolio
outstanding) may be sufficient. Selecting an appropriate sample is critical: if the sample
is not representative of the portfolio, the value of the loan review results will be
compromised. Be sure your loan review team includes an individual that has experience
in sample selection.
File Review
After determining the sample, the review team will develop a schedule for the file
review. The amount of time spent on the file review depends on the size and the quality
of the portfolio. Normally, however, a review team will examine files for three to five
days. The review team will send the list of loans in the sample to the CDFI’s
management so that they can have the loan files available when the team begins its
work.
At the beginning of the file review, the loan review team needs to ensure that the
management and staff of the CDFI have reviewed the scope of work, including the list of
loans in the sample, and understand the purpose of the file review. If needed, an
orientation meeting should be held between the loan review team and the management
of the CDFI. At this time, the review team may provide a short list of “surprise” loans to
management.
The loan review will consist of meetings with lending staff including loan administration
to understand the lending process and procedures from intake to closing. The loan
review team will also be reviewing underwriting and collateral files to ascertain the
underwriting, monitoring, and documentation practices. During a file review, it is
common practice for a team member to meet with management or the lender to discuss
individual loans. If the loan product is homogeneous and underwriting is consistent, it is
recommended that the team discuss a minimum of 10% of the loans with the loan
officer. If the loans are less standardized or the monitoring file documentation is
insufficient, a loan review team should discuss a higher percentage of loans. A meeting
with a loan officer may provide information such as specific communication between a
loan officer and borrower that is not documented in the file.
The file review covers seven distinct but related areas. For each area, the loan review
team evaluates adherence to the CDFI’s lending policies and procedures, and assesses
the CDFI against industry best practices. For example, a CDFI may require that a loan
officer only provide collateral coverage review based on market value of the asset. A
loan review team may recommend that the loan analysis also include a liquidation value
of collateral since it may provide a more realistic value if a CDFI takes possession of the
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asset and needs to sell it in a timely manner. Another example is when a CDFI does not
require written documentation of communication between loan officers and clients. The
best practice would be documentation of all conversations between loan officers and
clients especially any pertaining to late payments.
The loan review checklist contains the sections listed below.
a) Credit Initiation: Review of initial underwriting including analysis of the
following: financial statements; primary and secondary source of repayment;
management; and appraisal.
b) Loan Structuring: Evaluation of repayment terms against the borrower’s ability
to repay and industry best practices; guarantees; environmental indemnification;
and other loan terms.
c) Loan Approval Procedures: Review of written approval procedures and
policies.
d) Credit/Collateral File Documentation: Verification of all relevant initial and
ongoing documentation. Review of post-closing procedures for outstanding
items.
e) Normal Loan Monitoring: Verification of ongoing monitoring, as appropriate.
f) Problem Loan Management: Evaluation of problem loan management
including reporting to senior management and downgrading of delinquent loans.
g) Loan Workout Management: Review of action plans and work out
agreements for seriously delinquent loans.
At the conclusion of the file review, the loan review team will conduct an exit meeting
with the management of the CDFI to orally present their preliminary findings,
conclusions and recommendations.
Post-file Review
Following the on-site file review, the loan review team will issue a formal report
summarizing its findings, conclusions and recommendations. An initial draft report will
be issued solely to the CDFI’s management for its response. Upon receipt of
management’s response, a final report will be issued to the CDFI. The final report will
include management’s response.
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Description of a Loan Review Report
The main sections of the written loan review report are:
a. Summary Results: This section presents the findings grouped by priority level.
High priority findings are defined as violations in policy that could result in civil
money penalty or loss of principal. Moderate priority findings are those that are
not in line with the CDFI’s policies or practices. Low priority findings offer
suggestions towards adhering to industry-wide best practices. The majority of
the findings will be reflective of systemic issues within a loan portfolio.
b. Summary of Risk Rating Recommendations: This section provides general
and specific information for loans that the loan review team recommend be
downgraded or upgraded. See Appendix B for sample forms for presenting this
information.
c. Credit Risk Management: This section presents the findings and
recommendations by loan review checklist category.
d. Financial or Documentation Exceptions: This section is a list that outlines
any specific documents (financial or other) that are missing from the files.
As noted above, management is provided with a draft report. Management can provide
a written response to the recommendations which will be incorporated into the final
report.
Who Should Conduct a Loan Review? How Long Will It Take? How Often
Should a Loan Review Be Performed?
A CDFI’s risk management department or internal audit department, or a team of
external consultants, can complete a loan review. The most important feature of any
review team is independence. Therefore, anyone who is currently involved in the lending
process including credit committee members should not be on the team. The most
appropriate loan review team will have lending and credit experience. One issue with
many organizations is that it may have staff who have appropriate experience but who
have never completed a loan review before. The use of a consultant to lead a first loan
review, select the sample, develop the loan review checklist template, and complete the
loan review with the experienced CDFI personnel along side can provide these personnel
with the training and oversight that give them the capacity to confidently and
competently complete the next loan review.
The length of time spent on a loan review ultimately depends on the size of the CDFI.
On average, however, the review process from requesting the documents to receipt of
the final report should take between 30-45 days.
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In theory, a CDFI would have annual loan reviews or, in the case of large CDFIs, semi-
annual reviews. However, the cost of conducting a review may be prohibitive. Therefore,
medium and small CDFIs may consider bi-annual reviews if the loan review reports do
not indicate that there are any significant issues within the loan portfolio. Since
management is to use the loan review as an assessment, a loan review with a number
of medium and high priority findings may indicate heightened credit risk and warrant a
follow up loan review within 12 or fewer months.
Most Common Deficiencies Found
Credit Initiation and Loan Structuring
• Excessive lender analysis of borrower’s management style, product concept, etc.
with limited or no analysis of borrower’s financial information.
• Over-reliance on projected net income instead of historical net income.
• Lack of independent analysis of participations purchased from other institutions.
• Lack of documentation regarding physical inspection of business and/or
collateral.
Loan Approval Procedures
• Lack of evidence of approval in file.
Credit/Collateral Documentation
• Lack of follow-up process after loan closing to ensure receipt of all loan
documentation.
• No evidence of insurance in place (expired insurance certificate in file).
• Incorrect naming of CDFI’s role on insurance certificate (i.e., additional insured
instead of mortgagee).
• Lack of system to confirm payment of taxes and renewal of insurance policies.
• Lack of documentation regarding physical inspection of business and/or
collateral.
• Late receipt of financial statements (missing or outdated financial statements).
Normal Loan Monitoring
• Lack of documentation (phone calls/visits) of monitoring by loan officer.
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Problem Loan and Workout Loan Management
• Lack of documentation of agreement with borrower.
• Unrealistic action plan.
• Loan was not downgraded.
• Lack of evaluation of possible losses.
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Appendix A. Sample Table of Contents for a Loan Review Report
1) Executive Summary
a) Overview: Include nature of review (full or sample), date of file review, and
names of reviewers.
b) Scope: State number of files reviewed and amount ($ and % of portfolio) as
of specific focal date.
c) Areas Warranting Favorable Mention: Present specific example of areas that
can be noted as being best practice or outstanding.
d) Summary Results: Present findings in high, moderate and low priority.
2) Loan Review Summary
3) Summary of Recommended Risk Rating Changes
4) Credit Management Review: Provide synopsis of findings and recommendations
for each of the following sections including a rating of satisfactory or needs
improvement.
a) Credit Analysis and Underwriting
b) Loan Structuring
c) Loan Policy and Approval Procedures
d) Credit and Collateral File Documentation
e) Normal Loan Monitoring and Servicing
f) Problem Loan Management
g) Work Out Management
5) Documentation Exceptions: List borrower and description of exception such as
final title documents not in file or certificate of insurance in file has expired.
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Appendix B. Summary of Recommended Risk Rating Changes
This section of the Loan Review Report includes summary and detailed information on
the loans recommended for upgrading or downgrading. Sample formats for presenting
this information follow.
Summary of Loans Recommended for Upgrading and Downgrading
Total Recommended for Upgrade
% of Loans Reviewed Recommended for Upgrade
% of Total Portfolio Recommended for Upgrade
Total Recommended for Downgrade
% of Loans Reviewed Recommended for Downgrade
% of Total Portfolio Recommended for Downgrade
Specific Loan Upgrade/Downgrade
Borrower Name Amount Outstanding
Risk Ratings
Loan Review Team CDFI
Loans Recommended for Downgrade or Upgrade
Name of Borrower:
Nature of Business:
Related Borrowers:
Date of Loan:
CDFI Grade:
Date of Grading:
Total Original Amount:
Balance at Focal Date:
Recommended Risk Grade:
Primary Source of Repayment:
Secondary Source of Repayment:
Rationale for Recommended Risk Grade:
Repayment History:
Loan Administration Recommendations:
Management Response:
