Exit Strategy. In the recent financial crisis, community banks often found it difficult to quickly and profitably dispose of CRE acquired when a real estate borrower defaulted. However, it can be even more difficult to secure and then dispose of accounts receivable, inventory, or property and equipment acquired when a CI borrower defaults. Often, a community bank may find that an effective exit strategy for CI collateral involves third-party vendors, such as factoring companies that specialize in this area.
Monitoring and Reporting
Bank management should develop reporting to track specific elements of CI lending, such as accounts receivable and inventory valuation at the individual loan or line level, over-credit-line reporting, as well as CI sub-category reporting. CI sub-category reporting is particularly helpful in assessing concentrations in CI lending. Given the variety of industries, business cycles, and collateral in a community banks CI portfolio, measuring concentrations at the sub-category level will provide management with better indicators of concentration risk.
Internal and external loan review, as well as internal audit, should provide assurance that CI loans are underwritten in accordance with policy, that credit administration activities are timely and comprehensive, and that emerging portfolio issues are identified promptly. A bank may choose to focus its review efforts on CI loans originated in the previous 12 months, those with larger-dollar credit exposures, borrowers with a history of frequent delinquencies, and borrowers with a history of covenant violations. Bank management may also need to consider outsourcing some aspects of internal audit if current audit staff does not have sufficient experience to audit CI lending activities.
Information gleaned from monitoring and reporting will also be helpful in establishing appropriate provisions for losses on CI loans. Management should review the Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL) for guidance on establishing appropriate ALLL levels when entering into new lending areas for which historical loss information may not be available. 6
Finally, management should consider performance expectations for the CI sub-categories and for the portfolio as a whole under more adverse conditions. 7 For example, if management determines that a large proportion of its borrowers provide products and services to one large business, a scenario analysis may assess the impact on the portfolio if the large business were to experience financial difficulties .
While this article touched on some of the risk management factors that bank management should consider when entering or expanding a CI lending program, it is not a comprehensive list. Each community bank will likely identify different gaps in its staffing, policies and procedures, or monitoring and reporting that need to be addressed. However, if a community banks management and board of directors determine that CI lending is an appropriate and viable business strategy, management should implement a plan to mitigate the identified gaps and establish appropriate controls before making the first loan.
The Federal Reserve has been very clear that bank lending to creditworthy borrowers plays an important role in the ongoing economic recovery. To avoid a repeat of the factors that contributed to the financial crisis, however, both bank supervisors and banking organizations should ensure that prudent underwriting practices are maintained throughout the credit cycle and that underwriting standards are not compromised by competitive pressures, investor demands, or the desire for rapid growth or increased market share.
- * The author would like to thank Kevin Cragholm, Tim Marder, Adrienne Thompson,and Dante Tosetti of the Federal Reserve Bank of San Francisco for their thoughtful contributions to earlier drafts of this article and Carmen Holly and Jinai Holmes of the Board of Governors for their thorough review of and contributions to the final article.