LOANS Section 3.

INTRODUCTION..............................................................3 Credit Card-related Merchant Activities ...................... 33

LOAN ADMINISTRATION .............................................3 OTHER CREDIT ISSUES .............................................. 34
Lending Policies .............................................................3 Appraisals .................................................................... 34
Loan Review Systems ....................................................4 Valuation of Troubled Income-Producing Properties
Credit Risk Rating or Grading Systems .....................4 ................................................................................. 35
Loan Review System Elements ..................................5 Appraisal Regulation ............................................... 35
Current Expected Credit Losses (CECL) .......................6 Interagency Appraisal and Evaluation Guidelines ... 37
Allowance for Loan and Lease Losses (ALLL) .............6 Examination Treatment ........................................... 41
Responsibility of the Board and Management ...........7 Loan Participations ...................................................... 41
Factors to Consider in Estimating Credit Losses........7 Accounting .............................................................. 41
Examiner Responsibilities ..........................................8 Right to Repurchase ................................................. 42
Regulatory Reporting of the ALLL ............................8 Recourse Arrangements ........................................... 42
Accounting and Reporting Treatment ........................8 Call Report Treatment ............................................. 42
PORTFOLIO COMPOSITION..........................................9 Independent Credit Analysis.................................... 43
Commercial Loans .........................................................9 Participation Agreements......................................... 43
General .......................................................................9 Participations Between Affiliated Institutions ......... 43
Accounts Receivable Financing ................................... 10 Sales of 100 Percent Loan Participations................. 43
Leveraged Lending....................................................... 11 Environmental Risk Program ...................................... 44
Applicability ............................................................. 11 Elements of an Effective Environmental Risk
General ..................................................................... 11 Program ................................................................... 44
Risk Management Framework ................................. 12 Examination Procedures .......................................... 46
General Policies ....................................................... 12 LOAN PROBLEMS ........................................................ 46
Participations Purchased .......................................... 12 Poor Selection of Risks ................................................ 47
Underwriting Standards............................................ 12 Overlending ................................................................. 47
Credit Analysis ......................................................... 13 Failure to Establish or Enforce Liquidation Agreements
Valuation Standards ................................................. 13 ..................................................................................... 47
Risk Rating Leveraged Loans .................................. 14 Incomplete Credit Information .................................... 47
Problem Credit Management.................................... 14 Overemphasis on Loan Income ................................... 47
Reporting and Analytics ........................................... 15 Self-Dealing ................................................................. 47
Deal Sponsors........................................................... 15 Technical Incompetence .............................................. 48
Independent Credit Review ...................................... 16 Lack of Supervision ..................................................... 48
Stress Testing ........................................................... 16 Lack of Attention to Changing Economic Conditions . 48
Conflicts of Interest .................................................. 16 Competition ................................................................. 48
Oil and Gas Lending .................................................... 16 Potential Problem Indicators by Document ................. 48
Industry Overview .................................................... 16 SELECTING A LOAN REVIEW SAMPLE IN A RISK-
Reserve-Based Lending............................................ 17 FOCUSED EXAMINATION .......................................... 49
Real Estate Loans ......................................................... 22 Assessing the Risk Profile ........................................... 49
General ..................................................................... 22 Selecting the Sample ................................................... 49
Real Estate Lending Standards ................................. 22 Nonhomogeneous Loan Sample .............................. 50
Commercial Real Estate Loans ................................ 23 Homogeneous Pool Sample ..................................... 50
Real Estate Construction Loans ............................... 23 Determining the Depth of the Review ......................... 50
Home Equity Loans ...................................................... 25 Adjusting Loan Review ............................................... 51
Agricultural Loans ....................................................... 26 Accepting an Institution’s Internal Ratings ................. 51
Introduction .............................................................. 26 Loan Penetration Ratio ................................................ 51
Agricultural Loan Types and Maturities .................. 26 Large Bank Loan Review ............................................ 51
Agricultural Loan Underwriting Guidelines ............ 27 LOAN EVALUATION AND CLASSIFICATION ........ 52
Administration of Agricultural Loans ...................... 28 Loan Evaluation ........................................................... 52
Classification Guidelines for Agricultural Credit ..... 29 Review of Files and Records ....................................... 52
Installment Loans ......................................................... 30 Additional Transaction Testing ............................... 52
Lease Accounting ......................................................... 31 Loan Discussion .......................................................... 52
Direct Lease Financing............................................. 31 Loan Analysis .............................................................. 53
Lessor Accounting under ASC Topic 840................ 31 Loan Classification ...................................................... 53
Lessor Accounting under ASC Topic 842................ 31 Definitions ................................................................... 53
Examiner Consideration ........................................... 32 Special Mention Assets................................................ 54
Floor Plan Loans .......................................................... 32 Troubled Commercial Real Estate Loan Classification
Check Credit and Credit Card Loans ........................... 32 Guidelines .................................................................... 54

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Technical Exceptions ................................................... 55 Loan Covenants ........................................................... 74

Past Due and Nonaccrual ............................................. 55 Credit Rating Agencies ................................................ 74
Nonaccrual Loans That Have Demonstrated Sustained Overview of the Shared National Credit (SNC) Program
Contractual Performance .............................................. 56 ..................................................................................... 75
Troubled Debt Restructuring - Multiple Note Structure Definition of a SNC ................................................. 75
...................................................................................... 56 SNC Review and Rating Process ............................. 75
Interagency Retail Credit Classification Policy............ 56 SNC Rating Communication and Distribution Process
Re-aging, Extensions, Deferrals, Renewals, or ................................................................................. 75
Rewrites ................................................................... 57 Appeals Process ....................................................... 76
Partial Payments on Open-End and Closed-End Additional Risks Associated with Syndicated Loan
Credit ........................................................................ 58 Participations ............................................................... 76
Examination Considerations .................................... 58 CREDIT SCORING ........................................................ 76
Examination Treatment ............................................ 58 SUBPRIME LENDING .................................................. 77
Impaired Loans, Troubled Debt Restructurings, Introduction ................................................................. 77
Foreclosures, and Repossessions .................................. 59 Capitalization ............................................................... 78
Report of Examination Treatment of Classified Loans 61 Stress Testing ............................................................... 79
Issuance of "Express Determination" Letters to Risk Management ........................................................ 80
Institutions for Federal Income Tax Purposes .............. 62 Classification ............................................................... 82
CONCENTRATIONS...................................................... 63 ALLL Analysis ............................................................ 82
FEDERAL FUNDS SOLD AND REPURCHASE Subprime Auto Lending .............................................. 83
AGREEMENTS ............................................................... 64 Subprime Residential Real Estate Lending.................. 83
Assessing Bank-to-Bank Credit ................................... 65 Subprime Credit Card Lending .................................... 83
FUNDAMENTAL LEGAL CONCEPTS AND Payday Lending ........................................................... 84
DEFINITIONS ................................................................. 65 General .................................................................... 84
Uniform Commercial Code – Secured Transactions .... 66 Underwriting ............................................................ 84
General Provisions ................................................... 66 Payday Lending Through Third Parties ................... 85
Grant of Security Interest ......................................... 66 Concentrations ......................................................... 85
Collateral .................................................................. 66 Capital Adequacy .................................................... 85
Perfecting the Security Interest ................................ 66 Allowance for Loan and Lease Losses .................... 85
Right to Possess and Dispose of Collateral .............. 66 Classifications .......................................................... 86
Agricultural Liens .................................................... 67 Renewals/Rewrites .................................................. 86
Borrowing Authorization ............................................. 68 Accrued Fees and Finance Charges ......................... 86
Bond and Stock Powers................................................ 68 Recovery Practices .................................................. 87
Co-maker ...................................................................... 68
Loan Guarantee ............................................................ 69
Subordination Agreement ............................................ 69
Hypothecation Agreement............................................ 69
Real Estate Mortgage ................................................... 69
Collateral Assignment .................................................. 70
CONSIDERATION OF BANKRUPTCY LAW AS IT
RELATES TO COLLECTIBILITY OF A DEBT ........... 70
Introduction .................................................................. 70
Forms of Bankruptcy Relief ......................................... 70
Functions of Bankruptcy Trustees ................................ 71
Voluntary and Involuntary Bankruptcy ........................ 71
Automatic Stay ............................................................. 71
Property of the Estate ................................................... 71
Discharge and Objections to Discharge ....................... 71
Reaffirmation ............................................................... 72
Classes of Creditors...................................................... 72
Preferences ................................................................... 72
Setoffs .......................................................................... 73
Transfers Not Timely Perfected or Recorded ............... 73
SYNDICATED LENDING.............................................. 73
Overview ...................................................................... 73
Syndication Process ..................................................... 73

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LOANS Section 3.2

INTRODUCTION maintenance of written, up-to-date lending policies which

have been approved by the board of directors. A lending
Section 39 of the Federal Deposit Insurance Act, Standards policy should not be a static document, but must be
for Safety and Soundness, requires each federal banking reviewed periodically and revised in light of changing
agency to establish safety and soundness standards for all circumstances surrounding the borrowing needs of the
insured depository institutions. Appendix A to Part 364 of institution's customers as well as changes that may occur
the FDIC Rules and Regulations, Interagency Guidelines within the institution itself. To a large extent, the economy
Establishing Standards for Safety and Soundness, sets out of the community served by the institution dictates the
the safety and soundness standards that the agencies use to composition of the loan portfolio. The widely divergent
identify and address problems at insured depository circumstances of regional economies and the considerable
institutions before capital becomes impaired. Operational variance in characteristics of individual loans preclude
and managerial safety and soundness standards pertaining establishment of standard or universal lending policies.
to an institution’s loan portfolio address areas such as asset There are, however, certain broad areas of consideration and
quality, internal controls, credit underwriting, and loan concern that are typically addressed in the lending policies
documentation. of all banks regardless of size or location. These include the
following:
The examiner’s evaluation of an institution’s lending
policies, credit administration, and the quality of the loan • General fields of lending in which the institution will
portfolio is among the most important aspects of the engage and the kinds or types of loans within each
examination process. To a great extent, the quality of an general field;
institution's loan portfolio determines the risk to depositors • Lending authority of each loan officer;
and to the FDIC's insurance fund. Conclusions regarding • Lending authority of a loan or executive committee, if
the institution’s condition and the quality of its management any;
are weighted heavily by the examiner's findings with regard • Responsibility of the board of directors in reviewing,
to lending practices. Emphasis on review and evaluation of ratifying, or approving loans;
the loan portfolio and its administration by institution • Guidelines under which unsecured loans will be
management during examinations recognizes that loans granted;
comprise a major portion of most institutions’ assets; and, • Guidelines for rates of interest and the terms of
that it is the asset category which ordinarily presents the repayment for secured and unsecured loans;
greatest credit risk and potential loss exposure to banks. • Limitations on the amount advanced in relation to the
Moreover, pressure for increased profitability, liquidity value of the collateral and the documentation required
considerations, and a more complex society produce great by the institution for each type of secured loan;
innovations in credit instruments and approaches to lending. • Guidelines for obtaining and reviewing real estate
Loans have consequently become more complex. appraisals as well as for ordering reappraisals, when
Examiners therefore find it necessary to devote a large needed;
portion of time and attention to loan portfolio examination. • Maintenance and review of complete and current
credit files on each borrower;
← • Appropriate collection procedures including, but not
LOAN ADMINISTRATION limited to, actions to be taken against borrowers who
fail to make timely payments;
Lending Policies • Limitations on the maximum volume of loans in
relation to total assets;
The examiner's evaluation of the loan portfolio involves • Limitations on the extension of credit through
much more than merely appraising individual loans. overdrafts;
Prudent management and administration of the overall loan • Description of the institution's normal trade area and
account, including establishment of sound lending and circumstances under which the institution may extend
collection policies, are of vital importance if the institution credit outside of such area;
is to be continuously operated in an acceptable manner. • Guidelines that address the goals for portfolio mix and
risk diversification and cover the institution's plans for
Lending policies should be clearly defined and set forth in monitoring and taking appropriate corrective action, if
such a manner as to provide effective supervision by the deemed necessary, on any concentrations that may
directors and senior officers. The board of directors of exist;
every institution is responsible for formulating lending • Guidelines addressing the institution's loan review and
policies and to supervise their implementation. Therefore grading system ("Watch list");
examiners should encourage establishment and

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• Guidelines addressing the institution's review of the • To promptly identify loans with well-defined credit
Allowance for Loan and Lease Losses (ALLL) or weaknesses so that timely action can be taken to
ACL for loans and leases, as appropriate; and minimize credit loss;
• Guidelines for adequate safeguards to minimize • To provide essential information for determining the
potential environmental liability. appropriateness of the ALLL or ACL for loans and
leases;
Note: The allowance for credit losses on loans and leases • To identify relevant trends affecting the collectibility
or ACL for loans and leases is the term used for those banks of the loan portfolio and isolate potential problem
that adopted ASU 2016-13, which implements ASC Topic areas;
326, Financial Instruments – Credit Losses replacing the • To evaluate the activities of lending personnel;
allowance for loan losses used under the incurred loss • To assess the adequacy of, and adherence to, loan
methodology. policies and procedures, and to monitor compliance
with relevant laws and regulations;
The above are only guidelines for areas that should be • To provide the board of directors and senior
considered during the loan policy evaluation. Examiners management with an objective assessment of the
should also encourage management to develop specific overall portfolio quality; and
guidelines for each lending department or function. As with • To provide management with information related to
overall lending policies, it is not the FDIC's intent to suggest credit quality that can be used for financial and
universal or standard loan policies for specific types of regulatory reporting purposes.
credit. The establishment of these policies is the
responsibility of each institution's Board and management. Credit Risk Rating or Grading Systems
Therefore, the following discussion of basic principles
applicable to various types of credit will not include or Accurate and timely credit grading is a primary component
allude to acceptable ratios, levels, comparisons or terms. of an effective loan review system. Credit grading involves
These matters should, however, be addressed in each an assessment of credit quality, the identification of problem
institution's lending policy, and it will be the examiner's loans, and the assignment of risk ratings. An effective
responsibility to determine whether the policies are realistic system provides information for use in establishing an
and being followed. allowance when evaluating specific credits and for the
determination of an overall ALLL or ACL for loans and
Much of the rest of this section of the Manual discusses leases, as appropriate.
areas that should be considered in the institution's lending
policies. Guidelines for their consideration are discussed Credit grading systems often place primary reliance on loan
under the appropriate areas. officers for identifying emerging credit problems.
However, given the importance and subjective nature of
Loan Review Systems credit grading, a loan officer’s judgement regarding the
assignment of a particular credit grade should generally be
The terms loan review system or credit risk review system subject to review. Reviews may be performed by peers,
refer to the responsibilities assigned to various areas such as superiors, loan committee(s), or other internal or external
credit underwriting, loan administration, problem loan credit review specialists. Credit grading reviews performed
workout, or other areas. Responsibilities may include by individuals independent of the lending function are
assigning initial credit grades, ensuring grade changes are preferred because they can often provide a more objective
made when needed, or compiling information necessary to assessment of credit quality. A loan review system typically
assess the appropriateness of the ALLL or ACL for loans includes the following:
and leases.
• A formal credit grading system that can be reconciled
The complexity and scope of a loan review system will vary with the framework used by federal regulatory
based upon an institution’s size, type of operations, and agencies;
management practices. Systems may include components • An identification of loans or loan pools that warrant
that are independent of the lending function, or may place special attention;
some reliance on loan officers. Although smaller • A mechanism for reporting identified loans, and any
institutions are not expected to maintain separate loan corrective action taken, to senior management and the
review departments, it is essential that all institutions have board of directors; and
an effective loan review system. Regardless of its • Documentation of an institution’s credit loss
complexity, an effective loan review system is generally experience for various components of the loan and
designed to address the following objectives: lease portfolio.

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Loan Review System Elements performed annually, upon renewal, or more frequently when
factors indicate a potential for deteriorating credit quality.
Loan review policies are typically reviewed and approved A system of periodic reviews is particularly important to the
at least annually by the board of directors. Policy guidelines process of determining the ALLL or the ACL for loans and
include a written description of the overall credit grading leases, as appropriate.
process, and establish responsibilities for the various loan
review functions. The policy generally addresses the Scope of Reviews
following items:
Reviews typically cover all loans that are considered
• Qualifications of loan review personnel; significant. In addition to loans over a predetermined size,
• Independence of loan review personnel; management will normally review smaller loans that present
• Frequency of reviews; elevated risk characteristics such as credits that are
• Scope of reviews; delinquent, on nonaccrual status, restructured as a troubled
• Depth of reviews; debt, previously classified, or designated as Special
• Review of findings and follow-up; and Mention. Additionally, management may wish to
periodically review insider loans, recently renewed credits,
• Workpaper and report distribution.
or loans affected by common repayment factors. The
percentage of the portfolio selected for review should
Qualifications of Loan Review Personnel
provide reasonable assurance that all major credit risks have
Personnel to involve in the loan review function are been identified.
qualified based on level of education, experience, and extent
Depth of Reviews
of formal training. They are knowledgeable of both sound
lending practices and their own institution’s specific lending
Loan reviews typically analyze a number of important credit
guidelines. In addition, they are knowledgeable of pertinent
factors, including:
laws and regulations that affect lending activities.

Loan Review Personnel Independence • Credit quality;

• Sufficiency of credit and collateral documentation;
Loan officers are generally responsible for ongoing credit • Proper lien perfection;
analysis and the prompt identification of emerging • Proper loan approval;
problems. Because of their frequent contact with • Adherence to loan covenants;
borrowers, loan officers can usually identify potential • Compliance with internal policies and procedures, and
problems before they become apparent to others. However, applicable laws and regulations; and
institutions should be careful to avoid over reliance upon • The accuracy and timeliness of credit grades assigned
loan officers. To avoid conflicts of interest, management by loan officers.
typically ensures that, when feasible, all significant loans
are reviewed by individuals that are not part of, or Review of Findings and Follow-up
influenced by anyone associated with, the loan approval
process. Loan review findings should be reviewed with appropriate
loan officers, department managers, and members of senior
Larger institutions typically establish separate loan review management. Typically, any existing or planned corrective
departments staffed by independent credit analysts. Cost action (including estimated timeframes) is obtained for all
and volume considerations may not justify such a system in noted deficiencies, with those deficiencies that remain
smaller institutions. Often, members of senior management unresolved reported to senior management and the board of
that are independent of the credit administration process, a directors.
committee of outside directors, or an outside loan review
consultant fill this role. Regardless of the method used, loan Workpaper and Report Distribution
review personnel should report their findings directly to the
board of directors or a board committee. A list of the loans reviewed, including the review date, and
documentation supporting assigned ratings is commonly
Frequency of Reviews prepared. A report that summarizes the results of the review
is typically submitted to the board at least quarterly.
The loan review function provides feedback on the Findings usually address adherence to internal policies and
effectiveness of the lending process in identifying emerging procedures, and applicable laws and regulations, so that
problems. Reviews of significant credits are generally deficiencies can be remedied in a timely manner.

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Examiners should review the written response from term, rather than the annual loss rates commonly used under
management in response to any substantive criticisms or the existing incurred loss methodology. To properly apply
recommendations and assess corrective actions taken. an acceptable estimation method, an institution’s credit loss
estimates must be well supported.
Current Expected Credit Losses (CECL)
Similar to the ALLL, the ACL for loans and leases is
The Current Expected Credit Losses (CECL) methodology evaluated as of the end of each reporting period and reported
as implemented by FASB Accounting Standards in the Consolidated Reports of Condition and Income (Call
Codification (ASC) Subtopic 326-20, Financial Instruments Report). The methods used to determine ACLs generally
– Credit Losses – Measured at Amortized Cost applies to should be applied consistently over time and reflect
financial assets measured at amortized cost, net investments management’s current expectations of credit losses.
in leases, and off-balance-sheet credit exposures Changes to ACL for loans and leases resulting from these
(collectively, financial assets). For institutions that are SEC periodic evaluations are recorded through increases or
filers, excluding those that are “smaller reporting decreases to the related provisions for credit losses (PCLs).
companies” as defined in the SEC’s rules, the CECL
methodology is effective for fiscal years beginning January Throughout this Section 3.2, Loans, references pertaining
1, 2020, for institutions with calendar year fiscal years. For to the ALLL describe the incurred methodology and apply
all other institutions, (i.e., non-public institutions), only to institutions that have not yet adopted ASC Topic 326.
including those SEC filers that are smaller reporting As such, the methodology for impairment contained in ASC
companies, CECL will take effect for institutions with Subtopic 310-10, Receivables - Overall and collective loan
calendar year fiscal years beginning after December 15, impairment contained in ASC Subtopic 450-20,
2022, (i.e., January 1, 2023). Contingencies – Loss Contingencies has been superseded
and is not applicable for institutions that have adopted ASC
The CECL methodology does not apply to financial assets Topic 326 (CECL). Therefore, for those institutions that
measured at fair value through net income, including those have adopted CECL, examiners should refer to the Call
assets for which the fair value option has been elected; loans Report Glossary entry for “allowance for credit losses” and
held-for-sale; policy loan receivables of an insurance entity; the, “Interagency Policy Statement on Credit Losses,”
loans and receivables between entities under common issued May 8, 2020, via FIL 54-2020, for additional
control; and receivables arising from operating leases. information on the CECL methodology.
Available-for-sale debt securities are not covered under the
CECL methodology but are covered by ASC Subtopic 326- Allowance for Loan and Lease Losses (ALLL)
30, Financial Instruments – Credit Losses – Available-for-
Sale Debt Securities for institutions that have adopted ASC Each institution must maintain an ALLL that is appropriate
Topic 326. to absorb estimated credit losses associated with the held for
investment loan and lease portfolio, i.e., loans and leases
The allowance for credit losses or ACL for loans and leases that the institution has the intent and ability to hold for the
is a valuation account that is deducted from, or added to, the foreseeable future or until maturity or payoff. Each
amortized cost basis of financial assets to present the net institution should also maintain, as a separate liability
amount expected to be collected over the contractual term account, an allowance sufficient to absorb estimated credit
of the assets, considering expected prepayments. Renewals, losses associated with off-balance sheet credit instruments
extensions, and modifications are excluded from the such as loan commitments, standby letters of credit, and
contractual term of a financial asset for purposes of guarantees. This separate liability account for estimated
estimating the ACL for loans and leases unless there is a credit losses on off-balance sheet credit exposures should
reasonable expectation of executing a troubled debt not be reported as part of the ALLL on an institution’s
restructuring or the renewal and extension options are part balance sheet. Loans and leases held for sale are carried on
of the original or modified contract and are not the balance sheet at the lower of cost or fair value, with a
unconditionally cancellable by the institution. separate valuation allowance. This separate valuation
allowance should not be included as part of the ALLL and
In estimating the net amount expected to be collected, accordingly regulatory capital.
management should consider the effects of past events,
current conditions, and reasonable and supportable forecasts The term "estimated credit losses" means an estimate of the
on the collectibility of the institution’s financial assets. current amount of the loan and lease portfolio (net of
Under the CECL methodology, inputs will need to change unearned income) that is not likely to be collected; that is,
in order to achieve an appropriate estimate of expected net charge-offs that are likely to be realized for a loan, or
credit losses. For example, inputs to a loss rate method pool of loans. The estimated credit losses should meet the
would need to reflect expected losses over the contractual criteria for accrual of a loss contingency (i.e., a provision to

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the ALLL) set forth in generally accepted accounting Debt Securities Acquired with Deteriorated Credit
principles (U.S. GAAP). When available information Quality.
confirms specific loans and leases, or portions thereof, to be • The amount of allowance related to international
uncollectible, these amounts should be promptly charged- transfer risk associated with its cross-border lending
off against the ALLL. exposure.

Estimated credit losses should reflect consideration of all Furthermore, management’s analysis of an appropriate
significant factors that affect repayment as of the evaluation allowance level requires significant judgement in
date. Estimated losses on loan pools should reflect determining estimates of credit losses. An institution may
historical net charge-off levels for similar loans, adjusted for support its estimate through qualitative factors that adjust
changes in current conditions or other relevant factors. historical loss rates or an unallocated portion that can be
Calculation of historical charge-off rates can range from a supported through a similar analysis.
simple average of net charge-offs over a relevant period, to
more complex techniques, such as migration analysis. When determining an appropriate allowance, primary
reliance should normally be placed on analysis of the
Portions of the ALLL can be attributed to, or based upon the various components of a portfolio, including all significant
risks associated with, individual loans or groups of loans. credits reviewed on an individual basis. Examiners should
However, the ALLL is available to absorb credit losses that refer to ASC Subtopic 310-10 for guidance in establishing
arise from the entire portfolio. It is not segregated for any an allowance for individually evaluated loans determined to
particular loan, or group of loans. be impaired and measured under that standard. When
analyzing the appropriateness of an allowance, portfolios
Responsibility of the Board and Management evaluated collectively should group loans with similar
characteristics, such as risk classification, past due status,
It is the responsibility of the board of directors and type of loan, industry, or collateral. A depository institution
management to maintain the ALLL at an appropriate level. may, for example, analyze the following groups of loans and
The allowance should be evaluated, and appropriate provide for them in the ALLL:
provisions made, at least quarterly. In carrying out their
responsibilities, the board and management are expected to: • Significant credits reviewed on an individual basis
(i.e., impaired loans);
• Establish and maintain a loan review system that • Loans and leases that are not reviewed individually,
identifies, monitors, and addresses asset quality but which present elevated risk characteristics, such as
problems in a timely manner. delinquency, adverse classification, or Special
• Ensure the prompt charge-off of loans, or portions of Mention designation;
loans, deemed uncollectible. • Homogenous loans that are not reviewed individually,
• Ensure that the process for determining an appropriate and do not present elevated risk characteristics; and
allowance level is based on comprehensive, • All other loans that have not been considered or
adequately documented, and consistently applied provided for elsewhere.
analysis.
In addition to estimated credit losses, the losses that arise
For purposes of Reports of Condition and Income (Call from the transfer risk associated with an institution’s cross-
Reports) an appropriate ALLL for loans held for investment border lending activities require special consideration.
should consist of the following items: Over and above any minimum amount that is required by
the Interagency Country Exposure Review Committee to be
• The amount of allowance related to loans individually provided in the Allocated Transfer Reserve (or charged to
evaluated and determined to be impaired under ASC the ALLL), an institution must determine if their ALLL is
(Accounting Standards Codification) Subtopic 310-10, appropriate to absorb estimated losses from transfer risk
Receivables - Overall. associated with its cross-border lending exposure.
• The amount of allowance related to loans that were
individually evaluated for impairment and determined Factors to Consider in Estimating Credit Losses
not to be impaired, as well as other loans collectively
evaluated under ASC Subtopic 450-20, Contingencies Estimated credit losses should reflect consideration of all
– Loss Contingencies. significant factors that affect the portfolio’s collectibility as
• The amount of allowance related to loans evaluated of the evaluation date. While historical loss experience
under ASC Subtopic 310-30, Receivables –Loans and provides a reasonable starting point, historical losses, or
even recent trends in losses, are not by themselves, a
sufficient basis to determine an appropriate ALLL level.

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Management should also consider any relevant qualitative accept management’s estimates of credit losses in their
factors that are likely to cause estimated losses to differ from assessment of the overall appropriateness of the ALLL
historical loss experience such as: when management has:

• Changes in lending policies and procedures, including • Maintained effective systems and controls for
underwriting, collection, charge-off and recovery identifying, monitoring and addressing asset quality
practices; problems in a timely manner;
• Changes in local and national economic and business • Analyzed all significant factors that affect the
conditions; collectibility of the portfolio; and
• Changes in the volume or type of credit extended; • Established an acceptable ALLL evaluation process
• Changes in the experience, ability, and depth of that meets the objectives for an appropriate ALLL.
lending management;
• Changes in the volume and severity of past due, If, after the completion of all aspects of the ALLL review
nonaccrual, troubled debt restructurings, or classified described in this section, the examiner does not concur that
loans; the reported ALLL level is appropriate, or the ALLL
• Changes in the quality of an institution’s loan review evaluation process is deficient, recommendations for
system or the degree of oversight by the board of correcting these problems, including any examiner concerns
directors; and regarding an appropriate level for the ALLL, should be
• The existence of, or changes in the level of, any noted in the Report of Examination.
concentrations of credit.
Regulatory Reporting of the ALLL
Institutions are also encouraged to use ratio analysis as a
supplemental check for evaluating the overall An ALLL established in accordance with the guidelines
reasonableness of an ALLL. Ratio analysis can be useful in provided above should fall within a range of acceptable
identifying trends in the relationship of the ALLL to estimates. When an ALLL is not deemed at an appropriate
classified and nonclassified credits, to past due and level, management will be required to increase the provision
nonaccrual loans, to total loans and leases and binding for loan and lease loss expense sufficiently to restore the
commitments, and to historical charge-off levels. However, ALLL reported in its Call Report to an appropriate level.
while such comparisons can be helpful as a supplemental
check of the reasonableness of management’s assumptions Accounting and Reporting Treatment
and analysis, they are not, by themselves, a sufficient basis
for determining an appropriate ALLL. Such comparisons ASC Subtopic 450-20 provides the basic guidance for
do not eliminate the need for a comprehensive analysis and recognition of a loss from a contingency that should be
documentation of the loan and lease portfolio and the factors accrued through a charge to income (i.e., a provision
affecting its collectibility. expense) when available information indicates that it is
probable the asset has been impaired and the amount is
Examiner Responsibilities reasonably estimated. ASC Subtopic 310-10 provides
specific guidance about the measurement and disclosure for
Generally, following the quality assessment of the loan and loans individually evaluated and determined to be impaired.
lease portfolio, the loan review system, and the lending Loans are considered to be impaired when, based on current
policies, examiners are responsible for assessing the information and events, it is probable that the creditor will
appropriateness of the ALLL. Examiners should consider be unable to collect all interest and principal payments due
all significant factors that affect the collectibility of the according to the contractual terms of the loan agreement.
portfolio. Examination procedures for reviewing the This would generally include all loans restructured as a
appropriateness of the ALLL are included in the troubled debt and nonaccrual loans.
Examination Documentation (ED) Modules.
For individually impaired loans, ASC Subtopic 310-10
In assessing the overall appropriateness of an ALLL, it is provides guidance on the acceptable methods to measure
important to recognize that the related process, impairment. Specifically, this standard states that when a
methodology, and underlying assumptions require a loan is impaired, a creditor should measure impairment
substantial degree of judgement. Credit loss estimates will based on the present value of expected future cash flows
not be precise due to the wide range of factors that must be discounted at the loan’s effective interest rate, except that as
considered. Furthermore, the ability to estimate credit a practical expedient, a creditor may measure impairment
losses on specific loans and categories of loans should based on a loan’s observable market price. However, the
improve over time. Therefore, examiners will generally Call Report instructions require an institution to use the fair

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LOANS Section 3.2

value of the collateral in its determination of impairment for • Be well-documented, in writing, with clear
all impaired collateral dependent loans. When developing explanations of the supporting analyses and rationale;
the estimate of expected future cash flows for a loan, an and
institution should consider all available information • Include a systematic and logical method to consolidate
reflecting past events and current conditions, including the the loss estimates and ensure the ALLL balance is
effect of existing qualitative factors. recorded in accordance with U.S. GAAP.

Large groups of smaller-balance homogenous loans are not A systematic methodology that is properly designed and
included in the scope of ASC Subtopic 310-10, unless the implemented should result in an institution’s best estimate
loan is a troubled debt restructuring. Such groups of loans of the ALLL. Accordingly, institutions should adjust their
may include, but are not limited to, credit card, residential ALLL balance, either upward or downward, in each period
mortgage, and consumer installment loans. Examiners for differences between the results of the systematic
should refer to ASC Subtopic 450-20 for loans collectively determination process and the unadjusted ALLL balance in
evaluated for impairment, as well as individual loans that the general ledger.
are identified for evaluation on an individual basis and
determined not to be impaired. Examiners are encouraged, with the acknowledgement of
management, to communicate with an institution’s external
Institutions should not layer their loan loss allowances. auditors and request an explanation of their rationale and
Layering is the inappropriate practice of recording estimates findings, when differences in judgment concerning the
in the ALLL for the same loan under the different appropriateness of the institution's ALLL exist. In case of
accounting standards. Layering can happen when an controversy, an institution and its auditor may be reminded
institution measures impairment on an individually when an institution's supervisory agency's interpretation on
impaired loan and includes that same loan in its estimate of how U.S. GAAP should be applied to a specified event or
loan losses on a collective basis, thereby estimating the loan transaction (or series of related events or transactions)
loss for the same loan twice. differs from the institution's interpretation, the supervisory
agency may require the institution to reflect the event(s) or
While different institutions may use different methods, transaction(s) in its Call Report in accordance with the
there are certain common elements that should be included agency's interpretation and to amend previously submitted
in any ALLL methodology. Generally, an institution’s reports.
methodology should:
Additional information on the documentation of the ALLL,
• Include a detailed loan portfolio analysis, performed including its methodology, and the establishment of loan
regularly; review systems is provided in the Interagency Statement of
• Consider all loans (whether on an individual or group Policy on the Allowance for Loan and Lease Losses,
basis); (including frequently asked questions) dated December 13,
• Identify loans to be evaluated for impairment on an 2006, and the Interagency Policy Statement on Allowance
individual basis under ASC Subtopic 310-10; loans for Loan and Lease Losses Methodologies and
evaluated under ASC Subtopic 310-30; and segment Documentation for Banks and Savings Associations, dated
the remainder of the portfolio into groups of loans July 2, 2001.
with similar risk characteristics for evaluation and
analysis under ASC Subtopic 450-20; ←
• Consider all known relevant internal and external PORTFOLIO COMPOSITION
factors that may affect loan collectibility;
• Be applied consistently but, when appropriate, be Commercial Loans
modified for new factors affecting collectibility;
• Consider the particular risks inherent in different General
kinds of lending;
• Consider current collateral values (less costs to sell), Loans to business enterprises for commercial or industrial
where applicable; purposes, whether proprietorships, partnerships or
• Require that analyses, estimates, reviews and other corporations, are commonly described as commercial loans.
ALLL methodology functions be performed by In asset distribution, commercial or business loans
competent and well-trained personnel; frequently comprise one of the most important assets of an
• Be based on current and reliable data; institution. They may be secured or unsecured and have
short or long-term maturities. Such loans include working

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LOANS Section 3.2

capital advances, term loans and loans to individuals for finance an expanding operation because borrowing capacity
business purposes. expands as sales increase; it permits the borrower to take
advantage of purchase discounts because the company
Short-term working capital and seasonal loans provide receives immediate cash on its sales and is able to pay trade
temporary capital in excess of normal needs. They are used creditors on a satisfactory basis; it insures a revolving,
to finance seasonal requirements and are repaid at the end expanding line of credit; and actual interest paid may be no
of the cycle by converting inventory and accounts more than that for a fixed amount unsecured loan.
receivable into cash. Such loans may be unsecured;
however, many working capital loans are advanced with Advantages from the institution's viewpoint are: it generates
accounts receivable and/or inventory as collateral. Firms a relatively high yield loan, new business, and a depository
engaged in manufacturing, distribution, retailing and relationship; permits continuing banking relationships with
service-oriented businesses use short-term working capital long-standing customers whose financial conditions no
loans. longer warrant unsecured credit; and minimizes potential
loss when the loan is geared to a percentage of the accounts
Term business loans have assumed increasing importance. receivable collateral. Although accounts receivable loans
Such loans normally are granted for the purpose of are collateralized, it is important to analyze the borrower's
acquiring capital assets, such as plant and equipment. Term financial statements. Even if the collateral is of good quality
loans may involve a greater risk than do short-term and in excess of the loan, the borrower must demonstrate
advances, because of the length of time the credit is financial progress. Full repayment through collateral
outstanding. Because of the potential for greater risk, term liquidation is normally a solution of last resort.
loans are usually secured and generally require regular
amortization. Loan agreements on such credits may contain Institutions use two basic methods to make accounts
restrictive covenants during the life of the loan. In some receivable advances. First, blanket assignment, wherein the
instances, term loans may be used as a means of liquidating, borrower periodically informs the institution of the amount
over a period of time, the accumulated and unpaid balance of receivables outstanding on its books. Based on this
of credits originally advanced for seasonal needs. While information, the institution advances the agreed percentage
such loans may reflect a borrower's past operational of the outstanding receivables. The receivables are usually
problems, they may well prove to be the most viable means pledged on a non-notification basis and payments on
of salvaging a problem situation and effecting orderly debt receivables are made directly to the borrower who then
collection. remits them to the institution. The institution applies all or
a portion of such funds to the borrower's loan. Second,
Commercial lending policies generally address acquisition ledgering the accounts, wherein the lender receives
of credit information, such as property, operating and cash duplicate copies of the invoices together with the shipping
flow statements; factors that might determine the need for documents and/or delivery receipts. Upon receipt of
collateral acquisition; acceptable collateral margins; satisfactory information, the institution advances the agreed
perfecting liens on collateral; lending terms, and charge- percentage of the outstanding receivables. The receivables
offs. are usually pledged on a notification basis. Under this
method, the institution maintains complete control of the
Accounts Receivable Financing funds paid on all accounts pledged by requiring the
borrower's customer to remit directly to the institution.
Accounts receivable financing is a specialized area of
commercial lending in which borrowers assign their In the area of accounts receivable financing, an institution's
interests in accounts receivable to the lender as collateral. lending policy typically addresses the acquisition of credit
Typical characteristics of accounts receivable borrowers are information such as property, operating and cash flow
those businesses that are growing rapidly and need statements. It also typically addresses maintenance of an
year-round financing in amounts too large to justify accounts receivable loan agreement that establishes a
unsecured credit, those that are nonseasonal and need percentage advance against acceptable receivables, a
year-round financing because working capital and profits maximum dollar amount due from any one account debtor,
are insufficient to permit periodic cleanups, those whose financial strength of debtor accounts, insurance that
working capital is inadequate for the volume of sales and "acceptable receivables" are defined in light of the turnover
type of operation, and those whose previous unsecured of receivables pledged, aging of accounts receivable, and
borrowings are no longer warranted because of various concentrations of debtor accounts.
credit factors.

Several advantages of accounts receivable financing from

the borrower's viewpoint are: it is an efficient way to

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LOANS Section 3.2

Leveraged Lending • A borrower recognized in the debt markets as a highly

leveraged firm, which is characterized by a high debt-
The federal institution regulatory agencies initially issued to-net-worth ratio.
guidance on April 9, 2001, concerning sound risk • Transactions when the borrower’s post-financing
management practices for institutions engaged in leveraged leverage, as measured by its leverage ratios (for
financing. In light of the developments and experience example, debt-to-assets, debt-to-net-worth, debt-to-
gained since the initial guidance was issued, the federal cash flow, or other similar standards common to
institution regulatory agencies issued new Interagency particular industries or sectors), significantly exceeds
Guidance on Leveraged Lending on May 21, 2013, to industry norms or historical levels.
update and replace the 2001 guidance. Examiners should
also review the related Frequently Asked Questions (FAQ) A financial institution engaging in leveraged lending
issued on November 7, 2014. typically defines the activity within its policies and
procedures in a manner sufficiently detailed to ensure
Applicability consistent application across all business lines. An
appropriate definition describes clearly the purposes and
A financial institution’s risk management practices should financial characteristics common to these transactions, and
be consistent with the size and risk profile of its leveraged covers risk from both direct exposure and indirect exposure
activities relative to its assets, earnings, liquidity, and via limited recourse financing secured by leveraged loans,
capital. Institutions that originate or sponsor leveraged or financing extended to financial intermediaries (such as
transactions can refer to the guidance for suggestions about conduits and special purpose entities (SPEs)) that hold
sound risk management principles. leveraged loans.

The agencies do not intend for a financial institution that In general, sound risk management of leveraged lending
originates a small number of less complex, leveraged loans activities places importance on institutions developing and
to have policies and procedures commensurate with a larger, maintaining the following:
more complex leveraged loan origination business.
However, any financial institution that participates in • Transactions structured to reflect a sound business
leveraged lending transactions may refer to and consider premise, an appropriate capital structure, and
supervisory guidance provided in the “Participations reasonable cash flow and balance sheet leverage.
Purchased” section of the guidance. Combined with supportable performance projections,
these elements of a safe-and-sound loan structure
General should clearly support a borrower’s capacity to repay
and to de-lever to a sustainable level over a reasonable
Leveraged lending is an important type of financing for period, whether underwritten to hold or distribute;
national and global economies, and the U.S. financial • A definition of leveraged lending that facilitates
industry plays an integral role in making credit available and consistent application across all business lines;
syndicating that credit to investors. In particular, financial • Well-defined underwriting standards that, among
institutions should ensure they do not unnecessarily other things, define acceptable leverage levels and
heighten risks by originating poorly underwritten loans. For describe amortization expectations for senior and
example, a poorly underwritten leveraged loan that is subordinate debt;
pooled with other loans or is participated with other • A credit limit and concentration framework consistent
institutions may generate risks for the financial system. with the institution’s risk appetite;
• Sound Management Information Systems (MIS) that
Numerous definitions of leveraged lending exist throughout enable management to identify, aggregate, and
the financial services industry and commonly contain some monitor leveraged exposures and comply with policy
combination of the following: across all business lines;
• Strong pipeline management policies and procedures
• Proceeds used for buyouts, acquisitions, or capital that, among other things, provide for real-time
distributions. information on exposures and limits, and exceptions to
• Transactions where the borrower’s Total Debt divided the timing of expected distributions and approved hold
by EBITDA (earnings before interest, taxes, levels; and
depreciation, and amortization) or Senior Debt divided • Guidelines for conducting periodic portfolio and
by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA, pipeline stress tests to quantify the potential impact of
respectively, or other defined levels appropriate to the economic and market conditions on the institution’s
industry or sector. asset quality, earnings, liquidity, and capital.

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Risk Management Framework • Effective underwriting practices for primary loan

origination and secondary loan acquisition.
Given the high-risk profile of leveraged transactions,
prudent financial institutions engaged in leveraged lending Participations Purchased
adopt a risk management framework that has an intensive
and frequent review and monitoring process. The Well-managed financial institutions purchasing
framework has as its foundation written risk objectives, risk participations and assignments in leveraged lending
acceptance criteria, and risk controls. A lack of robust risk transactions make a thorough, independent evaluation of the
management processes and controls at a financial institution transaction and the risks involved before committing any
with significant leveraged lending activities could funds. They should apply the same standards of prudence,
contribute to supervisory findings that the financial credit assessment and approval criteria, and in-house limits
institution is engaged in unsafe-and-unsound banking that would be employed if the purchasing organization were
practices. originating the loan. Policies typically include requirements
for:
General Policies
• Obtaining and independently analyzing full credit
A financial institution’s credit policies and procedures for information both before the participation is purchased
leveraged lending generally address the following: and on a timely basis thereafter;
• Obtaining from the lead lender copies of all executed
• Identification of the financial institution’s risk appetite and proposed loan documents, legal opinions, title
including clearly defined amounts of leveraged insurance policies, Uniform Commercial Code (UCC)
lending that the institution is willing to underwrite (for searches, and other relevant documents;
example, pipeline limits) and is willing to retain (for • Carefully monitoring the borrower’s performance
example, transaction and aggregate hold levels). The throughout the life of the loan; and,
designated risk appetite is commonly supported by an • Establishing appropriate risk management guidelines
analysis of the potential effect on earnings, capital, as described in this document.
liquidity, and other risks that result from these
positions, and is approved by the board of directors; Underwriting Standards
• A limit framework that includes limits or guidelines
for single obligors and transactions, aggregate hold A financial institution’s underwriting standards should be
portfolio, aggregate pipeline exposure, and industry clear, written and measurable, and should accurately reflect
and geographic concentrations. This limit framework the institution’s risk appetite for leveraged lending
identifies the related management approval authorities transactions. Examiners should review whether a financial
and exception tracking provisions. In addition to institution has clear underwriting limits regarding leveraged
notional pipeline limits, financial institutions with transactions, including the size that the institution will
significant leveraged transactions implement arrange both individually and in the aggregate for
underwriting limit frameworks that assess stress distribution. Legal and other risks associated with poorly
losses, flex terms, economic capital usage, and underwritten transactions may find their way into a wide
earnings at risk or that otherwise provide a more variety of investment instruments and exacerbate systemic
nuanced view of potential risk; risks within the general economy. An institution’s
• Procedures for ensuring the risks of leveraged lending underwriting standards typically consider the following:
activities are appropriately reflected in an institution’s
allowance for loan and lease losses (ALLL) and • Whether the business premise for each transaction is
capital adequacy analyses; sound and the borrower’s capital structure is
• Credit and underwriting approval authorities, sustainable regardless of whether the transaction is
including the procedures for approving and underwritten for the institution’s own portfolio or with
documenting changes to approved transaction the intent to distribute.
structures and terms; • A borrower’s capacity to repay and ability to de-lever
• Guidelines for appropriate oversight by senior to a sustainable level over a reasonable period.
management, including adequate and timely reporting • Expectations for the depth and breadth of due
to the board of directors; diligence on leveraged transactions.
• Expected risk-adjusted returns for leveraged • Standards for evaluating expected risk-adjusted
transactions; returns.
• Minimum underwriting standards (see “Underwriting • The degree of reliance on enterprise value and other
Standards” section below); and intangible assets for loan repayment, along with

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acceptable valuation methodologies, and guidelines function, are timely, and consider potential value
for the frequency of periodic reviews of those values; erosion;
• Expectations for the degree of support provided by the • Collateral liquidation and asset sale estimates are
sponsor (if any), taking into consideration the based on current market conditions and trends;
sponsor’s financial capacity, the extent of its capital • Potential collateral shortfalls are identified and
contribution at inception, and other motivating factors. factored into risk rating and accrual decisions;
• Whether credit agreement terms allow for the material • Contingency plans anticipate changing conditions in
dilution, sale, or exchange of collateral or cash flow- debt or equity markets when exposures rely on
producing assets without lender approval; refinancing or the issuance of new equity; and
• Credit agreement covenant protections, including • The borrower is adequately protected from interest
financial performance (such as debt-to-cash flow, rate and foreign exchange risk.
interest coverage, or fixed charge coverage), reporting
requirements, and compliance monitoring. Valuation Standards
• Collateral requirements in credit agreements that
specify acceptable collateral and risk-appropriate Institutions often rely on enterprise value and other
measures and controls, including acceptable collateral intangibles when (1) evaluating the feasibility of a loan
types, loan-to-value guidelines, and appropriate request; (2) determining the debt reduction potential of
collateral valuation methodologies. Standards for planned asset sales; (3) assessing a borrower’s ability to
asset-based loans that are part of the entire debt access the capital markets; and, (4) estimating the strength
structure outline expectations for the use of collateral of a secondary source of repayment. Institutions may also
controls (for example, inspections, independent view enterprise value as a useful benchmark for assessing a
valuations, and payment lockbox), other types of sponsor’s economic incentive to provide financial support.
collateral and account maintenance agreements, and Given the specialized knowledge needed for the
periodic reporting requirements; and development of a credible enterprise valuation and the
• Whether loan agreements provide for distribution of importance of enterprise valuations in the underwriting and
ongoing financial and other relevant credit ongoing risk assessment processes, enterprise valuations
information to all participants and investors. should be performed by qualified persons independent of an
institution’s origination function.
Credit Analysis
There are several methods used for valuing businesses. The
Effective underwriting and management of leveraged most common valuation methods are assets, income, and
lending risk is highly dependent on the quality of analysis market. Asset valuation methods consider an enterprise’s
employed during the approval process as well as ongoing underlying assets in terms of its net going-concern or
monitoring. An institution’s analysis of leveraged lending liquidation value. Income valuation methods consider an
transactions typically ensures that: enterprise’s ongoing cash flows or earnings and apply
appropriate capitalization or discounting techniques.
• Cash flow analyses do not rely on overly optimistic or Market valuation methods derive value multiples from
unsubstantiated projections of sales, margins, and comparable company data or sales transactions. However,
merger and acquisition synergies; final value estimates should be based on the method or
• Liquidity analyses include performance metrics methods that give supportable and credible results. In many
appropriate for the borrower’s industry; predictability cases, the income method is generally considered the most
of the borrower’s cash flow; measurement of the reliable.
borrower’s operating cash needs; and ability to meet
debt maturities; There are two common approaches employed when using
• Projections exhibit an adequate margin for the income method. The “capitalized cash flow” method
unanticipated merger-related integration costs; determines the value of a company as the present value of
• Projections are stress tested for one or two downside all future cash flows the business can generate in perpetuity.
scenarios, including a covenant breach; An appropriate cash flow is determined and then divided by
• Transactions are reviewed at least quarterly to a risk-adjusted capitalization rate, most commonly the
determine variance from plan, the related risk weighted average cost of capital. This method is most
implications, and the accuracy of risk ratings and appropriate when cash flows are predictable and stable. The
accrual status; “discounted cash flow” method is a multiple-period
• Enterprise and collateral valuations are independently valuation model that converts a future series of cash flows
derived or validated outside of the origination into current value by discounting those cash flows at a rate
of return (referred to as the “discount rate”) that reflects the
risk inherent therein. This method is most appropriate when

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future cash flows are cyclical or variable over time. Both that the institution is not merely masking repayment
income methods involve numerous assumptions, and capacity problems by extending or restructuring the loan.
therefore, supporting documentation should fully explain
the evaluator’s reasoning and conclusions. If the primary source of repayment becomes inadequate, it
would generally be inappropriate for an institution to
When a borrower is experiencing a financial downturn or consider enterprise value as a secondary source of
facing adverse market conditions, a prudent lender will repayment unless that value is well supported. Evidence of
reflect those adverse conditions in its assumptions for key well-supported value may include binding purchase and sale
variables such as cash flow, earnings, and sales multiples agreements with qualified third parties or thorough asset
when assessing enterprise value as a potential source of valuations that fully consider the effect of the borrower’s
repayment. Changes in the value of a borrower’s assets are distressed circumstances and potential changes in business
typically tested under a range of stress scenarios, including and market conditions. For such borrowers, when a portion
business conditions more adverse than the base case of the loan may not be protected by pledged assets or a well-
scenario. Stress tests of enterprise values and their supported enterprise value, examiners generally will rate
underlying assumptions are generally conducted and that portion Doubtful or Loss and place the loan on
documented at origination of the transaction and nonaccrual status.
periodically thereafter, incorporating the actual
performance of the borrower and any adjustments to Risks in leveraged lending activities are considered in the
projections. Prudent institutions perform their own ALLL and capital adequacy analysis. For allowance
discounted cash flow analysis to validate the enterprise purposes, leverage exposures are typically taken into
value implied by proxy measures such as multiples of cash account either through analysis of the estimated credit
flow, earnings, or sales. losses from the discrete portfolio or as part of an overall
analysis of the portfolio utilizing the institution's internal
Enterprise value estimates derived from even the most risk grades or other factors. At the transaction level,
rigorous procedures are imprecise and ultimately may not exposures heavily reliant on enterprise value as a secondary
be realized. Therefore, institutions relying on enterprise source of repayment are typically scrutinized to determine
value or illiquid and hard-to-value collateral typically have the need for and adequacy of specific allocations.
policies that provide for appropriate loan-to-value ratios,
discount rates, and collateral margins. Based on the nature Problem Credit Management
of an institution’s leveraged lending activities, the prudent
institution establishes limits for the proportion of individual Individual action plans are typically formulated by
transactions and the total portfolio that are supported by management when working with borrowers experiencing
enterprise value. Regardless of the methodology used, the diminished operating cash flows, depreciated collateral
assumptions underlying enterprise-value estimates typically values, or other significant plan variances. Weak initial
are clearly documented, well supported, and understood by underwriting of transactions, coupled with poor structure
the institution’s appropriate decision-makers and risk and limited covenants, may make problem credit
oversight units. Further, an institution’s valuation methods discussions and eventual restructurings more difficult for an
are appropriate for the borrower’s industry and condition. institution as well as result in less favorable outcomes.

Risk Rating Leveraged Loans A financial institution generally formulates credit policies
that define expectations for the management of adversely
The risk rating of leveraged loans involves the use of rated and other high-risk borrowers whose performance
realistic repayment assumptions to determine a borrower’s departs significantly from planned cash flows, asset sales,
ability to de-lever to a sustainable level within a reasonable collateral values, or other important targets. These policies
period of time. For example, supervisors commonly assume typically stress the need for workout plans that contain
that the ability to fully amortize senior secured debt or the quantifiable objectives and measureable time frames.
ability to repay at least 50 percent of total debt over a five- Actions may include working with the borrower for an
to-seven year period provides evidence of adequate orderly resolution while preserving the institution’s
repayment capacity. If the projected capacity to pay down interests, sale of the credit in the secondary market, or
debt from cash flow is nominal with refinancing the only liquidation of collateral. Problem credits should be
viable option, the credit will usually be adversely rated even reviewed regularly for risk rating accuracy, accrual status,
if it has been recently underwritten. In cases when recognition of impairment through specific allocations, and
leveraged loan transactions have no reasonable or realistic charge-offs.
prospects to de-lever, a Substandard rating is likely.
Furthermore, when assessing debt service capacity,
extensions and restructures should be scrutinized to ensure

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LOANS Section 3.2

Reporting and Analytics accepted but not closed, and funded and unfunded
commitments that have closed but have not been
Diligent financial institutions regularly monitor higher risk distributed; and
credits, including leveraged loans. Monitoring includes • Total and segmented leveraged lending exposures,
management’s review of comprehensive reports about the including subordinated debt and equity holdings,
characteristics and trends in such exposures at least alongside established limits. Reports typically
quarterly, with summaries provided to the board of provide a detailed and comprehensive view of global
directors. Policies and procedures typically identify the exposures, including situations when an institution has
fields to be populated and captured by a financial indirect exposure to an obligor or is holding a
institution’s MIS, which then yields accurate and timely previously sold position as collateral or as a reference
reporting to management and the board of directors that may asset in a derivative.
include the following:
Borrower and counterparty leveraged lending reporting
• Individual and portfolio exposures within and across typically consider exposures booked in other business units
all business lines and legal vehicles, including the throughout the institution, including indirect exposures such
pipeline; as default swaps and total return swaps, naming the
• Risk rating distribution and migration analysis, distributed paper as a covered or referenced asset or
including maintenance of a list of those borrowers collateral exposure through repo transactions. Additionally,
who have been removed from the leveraged portfolio the positions in the held for sale or traded portfolios or
due to improvements in their financial characteristics through structured investment vehicles owned or sponsored
and overall risk profile; by the originating institution or its subsidiaries or affiliates
• Industry mix and maturity profile; are typically considered.
• Metrics derived from probabilities of default and loss
given default; Deal Sponsors
• Portfolio performance measures, including
noncompliance with covenants, restructurings, A financial institution that relies on sponsor support as a
delinquencies, non-performing amounts, and charge- secondary source of repayment typically develops
offs; guidelines for evaluating the qualifications of financial
• Amount of impaired assets and the nature of sponsors and implements processes to regularly monitor a
impairment, and the amount of the ALLL attributable sponsor’s financial condition. Deal sponsors may provide
to leveraged lending; valuable support to borrowers such as strategic planning,
• The aggregate level of policy exceptions and the management, and other tangible and intangible benefits.
performance of that portfolio; Sponsors may also provide sources of financial support for
• Exposures by collateral type, including unsecured borrowers that fail to achieve projections. Generally, a
transactions and those where enterprise value will be financial institution rates a borrower based on an analysis of
the source of repayment for leveraged loans. the borrower’s standalone financial condition. However, a
Reporting also typically considers the implications of financial institution may consider support from a sponsor in
defaults that trigger pari-passu treatment for all assigning internal risk ratings when the institution can
lenders and, thus, dilute the secondary support from document the sponsor’s history of demonstrated support as
the sale of collateral; well as the economic incentive, capacity, and stated intent
to continue to support the transaction. However, even with
• Secondary market pricing data and trading volume,
documented capacity and a history of support, the sponsor’s
when available;
potential contributions may not mitigate supervisory
• Exposures and performance by deal sponsors. Deals
concerns absent a documented commitment of continued
introduced by sponsors may, in some cases, be
support. An evaluation of a sponsor’s financial support
considered exposure to related borrowers. An
typically includes the following:
institution should identify, aggregate, and monitor
potential related exposures;
• The sponsor’s historical performance in supporting its
• Gross and net exposures, hedge counterparty
investments, financially and otherwise;
concentrations, and policy exceptions;
• The sponsor’s economic incentive to support,
• Actual versus projected distribution of the syndicated
including the nature and amount of capital contributed
pipeline, with regular reports of excess levels over the
at inception;
hold targets for the syndication inventory. Well-
• Documentation of degree of support (for example, a
designed pipeline definitions clearly identify the type
guarantee, comfort letter, or verbal assurance);
of exposure. This includes committed exposures that
have not been accepted by the borrower, commitments • Consideration of the sponsor’s contractual investment
limitations;

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• To the extent feasible, a periodic review of the the size, complexity, and risk characteristics of the
sponsor’s financial statements and trends, and an institution’s leveraged loan portfolio. To the extent a
analysis of its liquidity, including the ability to fund financial institution is required to conduct enterprise-wide
multiple deals; stress tests, the leveraged portfolio should be included in
• Consideration of the sponsor’s dividend and capital any such tests.
contribution practices;
• The likelihood of the sponsor supporting a particular Conflicts of Interest
borrower compared to other deals in the sponsor’s
portfolio; and A financial institution typically develops appropriate
• Guidelines for evaluating the qualifications of a policies and procedures to address and to prevent potential
sponsor and a process to regularly monitor the conflicts of interest when it has both equity and lending
sponsor’s performance. positions. For example, an institution may be reluctant to
use an aggressive collection strategy with a problem
Independent Credit Review borrower because of the potential impact on the value of an
institution’s equity interest. A financial institution may
A financial institution with a strong and independent credit encounter pressure to provide financial or other privileged
review function demonstrates the ability to identify client information that could benefit an affiliated equity
portfolio risks and documented authority to escalate investor. Such conflicts also may occur when the
inappropriate risks and other findings to their senior underwriting financial institution serves as financial advisor
management. Due to the elevated risks inherent in to the seller and simultaneously offers financing to multiple
leveraged lending, and depending on the relative size of a buyers (that is, stapled financing). Similarly, there may be
financial institution’s leveraged lending business, there is conflicting interests among the different lines of business
greater importance for the institution’s credit review within a financial institution or between the financial
function to assess the performance of the leveraged institution and its affiliates. When these situations occur,
portfolio more frequently and in greater depth than other potential conflicts of interest arise between the financial
segments in the loan portfolio. To be most effective, such institution and its customers. Effective policies and
assessments are performed by individuals with the expertise procedures clearly define potential conflicts of interest,
and experience for these types of loans and the borrower’s identify appropriate risk management controls and
industry. Portfolio reviews are generally conducted at least procedures, enable employees to report potential conflicts
annually. For many financial institutions, the risk of interest to management for action without fear of
characteristics of leveraged portfolios, such as high reliance retribution, and ensure compliance with applicable laws.
on enterprise value, concentrations, adverse risk rating Further, an established training program for employees on
trends, or portfolio performance, may dictate more frequent appropriate practices to follow to avoid conflicts of interest
reviews. is an effective risk management practice.

A financial institution that staffs its internal credit review Oil and Gas Lending
function appropriately and ensures that the function has
sufficient resources is most capable of providing timely, Industry Overview
independent, and accurate assessments of leveraged lending
transactions. Effective reviews evaluate the level of risk, Oil and gas (O&G) lending is complex and highly
risk rating integrity, valuation methodologies, and the specialized due to factors such as global supply and
quality of risk management. Such internal credit reviews demand, geopolitical uncertainty, weather-related
that review the institution’s leveraged lending practices, disruptions, fluctuations and volatility in currency markets
policies, and procedures provide management with a (i.e. the strength of the U.S. dollar compared to global
complete assessment of the leveraged lending program. currency markets), and changes in environmental and other
governmental policies. As such, companies and borrowers
Stress Testing that are directly or indirectly tied to the O&G industry
frequently experience expansion and contraction within key
A financial institution typically develops and implements operational areas of their businesses that will directly
guidelines for conducting periodic portfolio stress tests on impact their financial condition and repayment capacity.
loans originated to hold as well as loans originated to
distribute, and sensitivity analyses to quantify the potential The O&G industry has four interconnected segments:
impact of changing economic and market conditions on its
asset quality, earnings, liquidity, and capital. The • Upstream - exploration and production (E&P)
sophistication of stress-testing practices and sensitivity companies
analyses are most effective when they are consistent with

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LOANS Section 3.2

• Midstream - transporting, treating, processing, storing, Types of Reserves

and marketing to Upstream companies
• Downstream - refining and marketing Lenders should generally only consider proved reserves,
• Support/Services - equipment, services, or support defined as having at least a 90 percent probability that the
activities (e.g. drilling, workover units, and water quantities actually recovered will equal or exceed the
hauling services) estimate, in determining collateral value. Within the proved
reserves category, Proved Developed Producing (PDP),
O&G lending to Upstream companies for E&P activities is Proved Developed Non-Producing (PDNP), and Proved
a specialized form of lending, and is the primary focus of Undeveloped (PUD) reserves are collectively known as P1.
this section (see Reserve-Based Lending below). Loans to As described below, PDNP and PUD require capital
Midstream, Downstream and Support/Service companies expenditures (CAPEX) to bring the non-producing and
are generally structured similar to other commercial loans. undeveloped reserves online as PDP:
In addition, Midstream companies often raise capital
through Master Limited Partnerships that are publicly • PDP represents reserves that are recoverable from
traded. The highest credit risk is typically found in existing wells with existing equipment and operating
Support/Services and Upstream lending, which are more methods that are producing at the time of the
directly affected by changes in production and commodity engineering report estimate.
prices. • PDNP reserves include both shut-in (PDSI) and
behind the pipe (PDBP) reserves, and production can
Reserve-Based Lending be initiated or restored with relatively low
expenditures compared to the cost of drilling a new
Loans for E&P activities are typically secured by proved well.
reserves and governed by a borrowing base, an arrangement o PDSI reserves are completion intervals that are
known as reserve-based lending, or RBL. Effective credit open, but have not started producing; were shut-in
risk management in RBL requires conservative for market conditions or pipeline connections; or
underwriting, appropriate structuring, experienced and not capable of production for mechanical reasons.
knowledgeable lending staff, and sound loan administration o PDBP reserves are those expected to be recovered
practices. It is also important for the board and senior from existing wells that require additional
management to consider the unique risks associated with completion work or future completion prior to the
this type of lending when developing RBL policies and start of production.
approving and administering such loans. These risks • PUD reserves are expected to be recovered only after
include, but are not limited to, credit, concentration, market making future investment. These reserves have been
volatility/pricing, limited purpose collateral, production, proved by independent engineering reports, but do not
operational, legal, compliance/environmental, interest rate, have a well infrastructure in place.
liquidity, strategic, and third-party risk.
Other categories of reserves include “probable” (P2) and
RBL may appear similar to traditional asset based lending “possible” (P3). Probable reserves are relatively uncertain,
(ABL), but there are notable differences. The primary while possible reserves are considered speculative in nature.
source of repayment for ABL is the orderly liquidation of Probable and possible reserves should not receive any value
the collateral (receivables and inventory) into cash. Such when determining the borrowing base.
loans are typically structured with strong controls over the
collateral, such as a lock box arrangement. In contrast, the Reserve Engineering Reports
primary source of repayment for RBL is the cash flows
derived from the extraction of O&G reserves. An Reserve engineering reports are an estimate of the volumes
independent, third-party reserve engineering report serves of O&G reserves that are likely to be recovered based on
as the primary underwriting tool to estimate the future cash reasonable assumptions regarding physical characteristics
stream and establish a “borrowing base,” which is a of the reservoir, available technology, and operating
collateral base agreed to by the borrower and lender that is efficiencies. The significant reliance on engineering reports
used to limit the amount of funds the lender advances the in underwriting RBL facilities requires sound internal
borrower. The borrowing base is subject to periodic controls over the collateral evaluation process. Reserve
redeterminations, typically semiannually, that can result in reports must be objective; based on reasonable, well-
the reduction of the borrowing base commitment when documented assumptions; and completed independently of
commodity prices and reserves are declining. the loan origination and collection functions. It is important
for management to document the qualifications and
independence of the engineer, and to periodically evaluate

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LOANS Section 3.2

the production performance, which includes a comparison 25 to 35 percent of the total borrowing base. In addition,
of production projections to actual results. PDNP and PUD reserves should be risk-adjusted (65 to 75
percent for PDNP and 25 to 50 percent for PUD, for
RBL collateral value consists of a point-in-time estimate of example) prior to applying the advance rate. Lenders may
the present value (PV) of future net revenue (FNR) derived apply separate risk-adjusted advance rates for each proved
from the production and sale of existing O&G reserves, net reserve category in the borrowing base. During extended
of operating expenses, production taxes, royalties, and periods of low or declining commodity prices, it is not
CAPEX, discounted at an appropriate rate. The engineering uncommon for banks to increase the risk adjustment for
reports should contain sufficient information and PDNP and PUD reserves.
documentation to support the assumptions and the analysis
used to derive the forecasted cash flows and discounted PV. As part of the underwriting process, lending personnel
Well-managed banks provide clear guidance to the engineer typically prepare both base-case and sensitivity-case
at engagement regarding discount rates, pricing analyses that focus on the ability of converting the
assumptions, operating expense escalation rates, and risk- underlying collateral into cash to repay the loan, including
adjustment guidelines limiting higher risk reserves. The an estimate of the impact that sustained adverse changes in
engineer will conduct an analysis of production reports from market conditions would have on a company’s repayment
the subject properties, and project estimated reserve ability. A base-case analysis uses standard assumption
depletion. scenarios and generally includes a discount to current prices
against the forward curve (projected futures pricing
Borrowing Base estimates of the commodity). A sensitivity case analysis
subjects the O&G reserves to adverse external factors such
The collateral base securing each facility should be as lower market prices and/or higher operating expenses to
primarily comprised of PDP reserves. Inclusion of PDNP ascertain the effect on loan repayment. Full debt service
reserves in the collateral evaluation should be supported capacity (DSC) is typically analyzed using both the base-
with sufficient documentation to demonstrate that the case and sensitivity-case scenarios.
borrower has the financial capacity to convert PDNP
reserves to PDP reserves by making the necessary Discount Rates
investments to restore or initiate production within the near-
term. The Securities and Exchange Commission (SEC) requires
publicly traded companies to report the value of their
To include PUDs in the borrowing base calculation, the reserves using a standard discount rate of 10 percent in
borrower should have sufficient liquidity and positive Free accordance with ASC Topic 932, Extractive Activities - Oil
Cash Flow to meet operational needs, and debt service and Gas. In evaluating collateral valuations for RBL
requirements, as well as be able to fund (or obtain the facilities, banks often utilize alternative discount rates. For
funding for) the CAPEX that would be required to convert creditworthy borrowers and during more benign operating
these undeveloped reserves into production. Potential sale cycles, a 9 percent discount rate is commonly used. For
and/or marketability of the PUDs can also be considered higher-risk borrowers or during volatile or declining market
when evaluating collateral values, provided there is cycles for O&G, higher discount rates are typically used. If
adequate documentation of recent PUD sales. a discount rate is selected that significantly differs from
generally accepted discount rates, examiners should assess
Lenders use risk-adjustment factors to lower the value of management’s documentation supporting its rationale.
unseasoned producing and non-producing reserves before Some banks may use multiple discount rates under certain
applying borrowing base advance rates. It is important to circumstances. An example may include establishing a
consider policy limits on production vs. non-production standard discount rate for performing credits and a higher
reserves, the oil and gas mix, maximum production coming rate for higher risk facilities.
from one well (single well concentration risk), and other
risk-adjustment factors. Ideally, management achieves Price Decks
diversification in the geographic location of reserve fields,
and establishes limits on the lowest number of producing Prudent management regularly evaluates, and updates as
wells needed to establish an acceptable borrowing base. necessary, its pricing assumptions for RBL, commonly
referred to as the institution’s price deck. The price deck is
Typically, the advance rate for high-quality proved (P1) a forecast used to derive cash flow and collateral value
reserves rarely exceed 65 percent (a typical range is 50 to assumptions, and typically is approved by the board of
65 percent) of the PV of FNR. If the lender determines that directors or a specifically designated board committee.
PDNP or PUD reserves are to be considered in the Pricing assumptions typically represent the most significant
borrowing base, these reserves should generally not exceed

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LOANS Section 3.2

variable in driving the final estimate of value, and must be designed covenants limit cash distributions to
well-supported. owners/shareholders, and include standard performance and
financial reporting requirements. Examples of commonly
Each institution’s price deck typically reflects both base- used ratios/covenants for evaluating E&P companies
case and sensitivity-case pricing scenarios. Pricing include Free Cash Flow (FCF), Interest Coverage, Fixed
assumptions for the sensitivity case are generally Charge Coverage, Current Ratio, Quick Ratio, Senior
sufficiently conservative and used to determine whether the Debt/EBITDA(X), and Total Debt/EBITDA(X). The
borrower has the financial capacity to generate adequate calculation of earnings before interest, taxes, depreciation,
cash flow to repay the debt during a prolonged low and amortization (EBITDA) typically incorporates
commodity price environment. Price deck considerations maintenance CAPEX (X) due to its impact on the amount
include, for example, current commodity pricing, forward of projected FCF that is available after debt service to
curve projections (future price considerations), cost support operations.
assumptions, discount rates, and timing of the various
reports. Management also typically documents any risk- Hedging
based adjustments applied to each proved reserve category.
While the risk-adjusted base case projections will generally When used properly, hedging may be an effective tool to
be used to underwrite RBLs, consideration is also given to help protect the borrower and the lender from sharp
the ability to repay the debt using the risk-adjusted commodity price declines by providing a stable cash flow
sensitivity case to determine potential exposure due to stream. E&P companies frequently use hedging
adverse market price fluctuations. instruments such as futures contracts, swaps, collars, and
put options to reduce price risk exposure. Generally, hedges
Loan Structure should be limited to no more than 85 percent of projected
production volumes. Counterparties are typically limited to
RBL credit facilities are typically structured as a revolving reputable, financially sound companies that are approved in
line of credit (RLOC), a reducing revolving line of credit accordance with the institution’s O&G loan policy. If the
(RRLOC), or an amortizing term loan, governed by a well- hedges are taken as collateral or part of the borrowing base,
supported and fully documented borrowing base. These the advance rate and any limitations on the hedging position
credit facilities generally fully amortize within the half-life should be documented in the loan agreement. If hedges are
of the reserves (that is, the time in years required to produce sold or monetized, the proceeds of such are generally
one-half of the total estimated recoverable production) with applied to the respective debt.
repayment aligning with projected cash flows. In other
words, the term of the loans should be tied to the economic Borrower and Financial Analysis
life of the underlying asset. This is often represented as the
“reserve tail tests” that are based on the economic half-life Management should have a clear understanding of the
of the reserves or the cash flow remaining after projected overall financial health of the borrower that includes an
loan payout. assessment of the borrower’s ability to maintain operations
through adverse market conditions. E&P companies in
Loan durations should be fairly short-term and directly tied sound financial condition should have strong cash flow
to the economic life of the asset (generally 50 to 60 percent from reliable revenue sources and well-controlled operating
of the economic life of the proved reserves or the proved expenses. Companies should also have adequate sources of
reserves’ half-life). The terms generally depend on the liquidity and effective working capital management, sound
projected and actual reserve production (reserve run data), reserve development practices, well-defined criteria for
as well as the type and range of collateral (PDP, PDNP, or divestiture, adequate capital structure, manageable levels of
PUD). A reasonable portion of the estimated revenues debt, and appropriate financial reporting. As part of the
should remain after the debt has fully amortized (reserve overall financial analysis of the relationship, updated
tail). Borrowing bases should be re-determined at least engineering data should be well-documented and should
semiannually, subject to an updated reserve engineering enable the lender to determine the borrower’s capacity to
report. service the debt. Any over-advance situation should have a
reasonable plan and timeframe to cure the over-advance.
Covenants
The principals of successful E&P companies should be
Appropriate use of covenants is imperative in managing experienced and have a well-documented track record of
credit risk for O&G loans. Lenders typically require managing through all stages of the business cycle. In good
financial covenants to instill discipline in the lending times, company management should be able to identify,
relationship, including the borrower’s leverage position, acquire, and develop reserves profitably and in line with
repayment capacity, and liquidity. In addition, well- expectations. During declining price cycles, company

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LOANS Section 3.2

management should be able to demonstrate the ability to • Officer and committee lending limits;
streamline operations, maintain reasonable production, • Borrowing base calculations and risk-adjustments;
manage working capital, strategically reduce CAPEX, and • Price deck considerations and adjustments;
make sound divestitures to ensure repayment of debt. Bank • Advance rates, risk-adjusted values for PDP, PDNP,
management should evaluate the borrower’s cost cycle, and PUD reserves, and requirement to risk adjust the
which reflects not only the ability to generate cash flow discount value of nonproducing reserves before
from production, but also the CAPEX necessary to replace applying advance rates;
depleted reserves. Working capital management is • Frequency and required details of borrowing base
critically important, as delinquent payments to vendors can redeterminations and price deck revaluations;
result in a negative working capital position (due to • Requirements for independent engineering reports and
accounts payable increasing) and an increased leverage analysis thereof;
ratio.
• Well concentration guidelines and maximum per
single well limits;
Financial analysis typically includes the following:
• Financial covenants, minimum ratio and other
financial information requirements, and review
• Adequacy of operating cash flows to service existing
requirements (e.g. current ratio, fixed charge
total debt;
coverage, cash flow coverage, leverage ratios);
• Overall compliance with financial covenants,
• Collateral valuation requirements, including required
including borrowing base limitations as detailed in the
remaining collateral at payout;
loan agreement;
• Renewal and restructuring guidelines, including
• Reasonableness of the company’s budget assumptions
nonaccrual and troubled debt restructuring
and projections;
implications;
• Comparison of borrower provided production
• Remedies for declining collateral or over-advanced
projections with actual results;
situations, such as Monthly Commitment Reductions,
• Working capital, tangible net worth, and leverage pledge of additional reserves as collateral, and sale of
positions; and non-productive reserves;
• Impact of capital expenses and recent acquisitions. • Minimum required insurance (including property,
liability, and environmental);
O&G Loan Policy Guidelines
• Defined loan safety or coverage factors and/or loan
value policies, including other debt that is “pari-
The O&G loan policy should provide sufficient guidance to
passu” (i.e. all debts sharing equally in the production
loan officers, clearly convey appropriate policy limitations
cash flows available to amortize debt);
and monitoring procedures, and detail appropriate
• Typical amortization, payout, and loan repayment
underwriting standards and practices. The O&G policy
terms, including maximum terms for production
should clearly indicate those industry segments (Upstream,
revolvers and term loans;
Midstream, Downstream, and Support/Services) the board
• Guarantor requirements;
chooses to lend to and include guidance on each of those
segments. • Hedging requirements, policies, and limitations;
• Stress-testing and sensitivity analysis and
For institutions engaged in RBL, appropriate policies requirements thereof; and
address reserve measurement and valuation analysis, • Monitoring requirements for the risks inherent in
borrowing base determinations, production history analysis, loans dependent on royalty interests in production
financial statement and ratio analysis, commitment revenues for repayment.
advances, discount rates, price deck formulation, financial
covenants, steps to cure an over-advance situation, and Credit Risk Rating Assessment and Classification
ALLL considerations. Specific guidelines typically cover Guidelines
the following areas:
An appropriate O&G loan policy also addresses specific
• Lending objectives, risk appetite, portfolio limits, credit risk review procedures for the O&G portfolio and
target market, and concentration limits; O&G loan grading criteria. Risk rating definitions should
• Methodology and requirements for monitoring O&G be clearly defined. RBL that are adequately protected by
markets, including pricing, supply and demand trends, the current sound worth and debt service capacity of the
overall market trends, and industry analysis; borrower, guarantor, or underlying collateral generally will
not be adversely classified for supervisory purposes.
• Board and committee oversight over the O&G lending
However, if any of the following circumstances are present,
and engineering departments;
a more in-depth and comprehensive analysis of the credit is

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LOANS Section 3.2

needed to determine whether the loan has potential or well- The following tables illustrate an example of the rating
defined weaknesses: methodology for a classified borrower. Actual pricing,
discount rates, and risk adjustment factors applied by the
• The loan balance exceeds 65 percent of the PV of institution may vary according to current market conditions
FNR of PDP, or the cash flow analysis indicates that and the nature of the reserves. Examiners should closely
the loan will not amortize within the reserve half-life; review the key assumptions made by the institution in
• The credit is not performing in accordance with arriving at the current collateral valuation.
contractual terms (repayment of interest and
principal); Example: Collateral Valuation ($ Million)
Discounted NPV at 9% and using NYMEX Strip Pricing
• Advance rates exceed the institution’s limits or
industry standards for proved reserves; Valuation Hedges PDP PDNP PUD Total
• Frequent over-advances occur at subsequent Basis Proved
borrowing base redeterminations; Unrisked $10 $50 $20 $40 $120
• Excessive operating leverage; NPV
• Covenant defaults; Risk 100% 100% 75% 50%
• Delinquent payables, or other evidence of poor adjustment
working capital management; factors
• Significant current or likely future disruptions in
production; Risked & $10 $50 $15 $20 $95
• Frequent financial statement revisions or changes in Adjusted
chosen accounting method; NPV
• Maintenance or capital expenditures significantly Total collateral value: $95
exceed budgeted forecasts; or
• The credit is identified by the institution as a Example: Classification ($ Million)
Borrowing base commitment on RBL is $125 million
“distressed” credit.
TC Pass SM II III IV
Examiners are to consider all information relevant to RBL $125 $95 $25 $5
evaluating the prospects that the loan will be repaid, Total $125 $95 $25 $5
including the borrower’s creditworthiness, the cash flow TC: Total Commitment SM: Special Mention
provided by the borrower’s operation, the collateral II: Substandard III: Doubtful IV: Loss
supporting the loan, integrity and reliability of the
engineering data, borrowing base considerations, primary Note: The $25 million of Doubtful represents the difference
source of repayment, and any support provided by between the unrisked NPV and the risked NPV. If the
financially responsible guarantors and co-borrowers. If the borrower's prospects for further developing PDNP and PUD
borrower’s circumstances reveal well-defined weaknesses, reserves to producing status are unlikely or not supported by
adverse classification of the loan relationship is likely a pending event, this amount should be reflected as Loss.
warranted. The level and severity of classification of
distressed, collateral-dependent RBLs will depend on the Institutions should follow accounting principles when
quality of the underlying collateral, based on the most recent determining whether a loan should be placed on nonaccrual.
re-determined and risk-adjusted borrowing base that is Each extension should be independently evaluated to
contractually obligated to be funded. determine whether it should be on nonaccrual; that is,
nonaccrual status should not be automatically applied to
The portion of the loan commitment(s) secured by the NPV multiple loans or extensions of credit to a single borrower if
of total risk-adjusted proved reserves should be classified only one loan meets the criteria for nonaccrual status.
Substandard. When the potential for loss may be mitigated However, multiple loans to one borrower that are structured
by the outcome of certain pending events, or when loss is as pari-passu to principal and interest and supported by the
expected but the amount of the loss cannot be reasonably same repayment source should not be treated differently for
determined, the remaining balance secured by the NPV of nonaccrual or troubled debt restructuring purposes,
total unrisked proved reserves should be classified regardless of collateral lien position.
Doubtful. The portion of the loan commitment(s) that
exceeds 100 percent of the NPV of total unrisked proved
reserves, and is uncollectible, should be classified Loss.
These guidelines may be adjusted depending on the
borrower’s specific situation and should not replace
examiner judgment.

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LOANS Section 3.2

Real Estate Loans Real Estate Lending Standards

General Section 18(o) of the FDI Act requires the federal banking
agencies to adopt uniform regulations prescribing standards
Real estate loans are part of the loan portfolios of almost all for loans secured by liens on real estate or made for the
commercial banks. Real estate loans include credits purpose of financing permanent improvements to real
advanced for the purchase of real property. However, the estate. For FDIC-supervised institutions, Part 365 of the
term may also encompass extensions granted for other FDIC Rules and Regulations requires each institution to
purposes, but for which primary collateral protection is real adopt and maintain written real estate lending policies that
property. are consistent with sound lending principles, appropriate for
the size of the institution and the nature and scope of its
The degree of risk in a real estate loan depends primarily on operations. These policies generally enable management to
the loan amount in relation to collateral value, the interest effectively identify, measure, monitor, and control the risks
rate, and most importantly, the borrower's ability to repay in associated with real estate lending. The level and
an orderly fashion. It is extremely important that an complexity of risk-monitoring techniques for real estate
institution's real estate loan policy ensure that loans are lending typically is commensurate with the level of real
granted with the reasonable probability the debtor will be estate activity and the nature and complexity of the
able and willing to meet the payment terms. Placing undue institution’s market. Within these general parameters, the
reliance upon a property's appraised value in lieu of an regulation specifically requires an institution to establish
adequate initial assessment of a debtor's repayment ability policies that include:
is a potentially dangerous mistake.
• Portfolio diversification standards;
Historically, many banks have jeopardized their capital • Prudent underwriting standards including loan-to-
structure by granting ill-considered real estate mortgage value limits;
loans. Apart from unusual, localized, adverse economic • Loan administration procedures;
conditions which could not have been foreseen, resulting in • Documentation, approval and reporting requirements;
a temporary or permanent decline in realty values, the and
principal errors made in granting real estate loans include • Procedures for monitoring real estate markets within
inadequate regard to normal or even depressed realty values the institution's lending area.
during periods when it is in great demand thus inflating the
price structure, mortgage loan amortization, the maximum These policies also should consider the Interagency
debt load and repayment capacity of the borrower, and Guidelines for Real Estate Lending Policies and must be
failure to reasonably restrict mortgage loans on properties reviewed and approved at least annually by the institution's
for which there is limited demand. board of directors.

A principal indication of a troublesome real estate loan is an The interagency guidelines, which are an appendix to Part
improper relationship between the amount of the loan, the 365, are intended to help institutions satisfy the regulatory
potential sale price of the property, and the availability of a requirements by outlining the general factors to consider
market. The potential sale price of a property may or may when developing real estate lending standards. The
not be the same as its appraised value. The current potential guidelines suggest maximum supervisory loan-to-value
sale price or liquidating value of the property is of primary (LTV) limits for various categories of real estate loans and
importance and the appraised value is of secondary explain how the agencies will monitor their use.
importance. There may be little or no current demand for
the property at its appraised value and it may have to be The Interagency Guidelines for Real Estate Lending
disposed of at a sacrifice value. Policies indicate that institutions should establish their own
internal LTV limits consistent with their needs. These
Examiners must appraise not only individual mortgage internal limits should not exceed the following
loans, but also the overall mortgage lending and recommended supervisory limits:
administration policies to ascertain the soundness of its
mortgage loan operations as well as the liquidity contained • 65 percent for raw land;
in the account. Institutions generally establish policies that • 75 percent for land development;
address the following factors: the maximum amount that • 80 percent for commercial, multi-family, and other
may be loaned on a given property, in a given category, and non-residential construction;
on all real estate loans; the need for appraisals (professional • 85 percent for construction of a 1-to-4 family
judgments of the present and/or future value of the real residence;
property) and for amortization on certain loans.

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LOANS Section 3.2

• 85 percent for improved property; and • The nature and scope of the institution's real estate
• Owner-occupied 1-to-4 family home loans have no lending activities;
suggested supervisory LTV limits. However, for any • The quality of management and internal controls;
such loan with an LTV ratio that equals or exceeds 90 • The size and expertise of the lending and
percent at origination, an institution should require administrative staff; and
appropriate credit enhancement in the form of either • Market conditions.
mortgage insurance or readily marketable collateral.
The institution should not be considered in nonconformance
Certain real estate loans are exempt from the supervisory of the standards as a result of minor exceptions or
LTV limits because of other factors that significantly reduce inconsistencies. Rather, examiners are to assess
risk. These include loans guaranteed or insured by the management’s overall practices and performance when
federal, state or local government as well as loans to be sold assessing conformance with the standards.
promptly in the secondary market without recourse. A
complete list of excluded transactions is included in the Examination procedures for various real estate loan
guidelines. categories are included in the ED Modules.

Because there are a number of credit factors besides LTV Commercial Real Estate Loans
limits that influence credit quality, loans that meet the
supervisory LTV limits should not automatically be These loans comprise a major portion of many banks' loan
considered sound, nor should loans that exceed the portfolios. When problems exist in the real estate markets
supervisory LTV limits automatically be considered high that the institution is servicing, it is necessary for examiners
risk. However, loans that exceed the supervisory LTV limit to devote additional time to the review and evaluation of
should be identified in the institution's records and the loans in these markets.
aggregate amount of these loans reported to the institution's
board of directors at least quarterly. The guidelines further There are several warning signs that real estate markets or
state that the aggregate amount of loans in excess of the projects are experiencing problems that may result in real
supervisory LTV limits should not exceed the institution's estate values decreasing from original appraisals or
total capital. Moreover, within that aggregate limit, the total projections. Adverse economic developments and/or an
loans for all commercial, agricultural and multi-family overbuilt market can cause real estate projects and loans to
residential properties (excluding 1-to-4 family home loans) become troubled. Signs of troubled real estate markets or
should not exceed 30 percent of total capital. projects include, but are not limited to:

Management and the board at each institution typically • Rent concessions or sales discounts resulting in cash
establish an appropriate internal process for the review and flow below the level projected in the original
approval of loans that do not conform to internal policy appraisal.
standards. The approval of any loan that is an exception to • Changes in concept or plan: for example, a
policy typically is supported by a written justification that condominium project converting to an apartment
clearly details all of the relevant credit factors supporting project.
the underwriting decision. Exception loans of a significant • Construction delays resulting in cost overruns, which
size often are individually reported to the board. may require renegotiation of loan terms.
• Slow leasing or lack of sustained sales activity and/or
Prudent management and boards monitor compliance with increasing cancellations, which may result in
internal policies and maintain reports of all exceptions to protracted repayment or default.
policy. Examiners should review loan policy exception
• Lack of any sound feasibility study or analysis.
reports to determine whether exceptions are adequately
• Periodic construction draws that exceed the amount
documented and appropriate in light of all the relevant credit
needed to cover construction costs and related
considerations.
overhead expenses.
Institutions should develop policies that are clear, concise, • Identified problem credits, past due and non-accrual
consistent with sound real estate lending practices, and meet loans.
their needs. Policies should not be so complex that they
place excessive paperwork burden on the institution. Real Estate Construction Loans
Therefore, when evaluating compliance with Part 365,
examiners should carefully consider the following: A well-underwritten construction loan is used to construct a
particular project within a specified period of time and
should be controlled by supervised disbursement of a
• The size and financial condition of the institution;

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predetermined sum of money. It is generally secured by a cost (including origination fees, interest payments,
first mortgage or deed of trust and backed by a purchase or construction costs, and even profit draws by the developer),
takeout agreement from a financially responsible permanent and lack of any substantive financial support from the
lender. Construction loans are vulnerable to a wide variety borrower or other guarantors. Acquisition, Development,
of risks. The major risk arises from the necessity to and Construction (ADC) arrangements that are in substance
complete projects within specified cost and time limits. The real estate investments of the institution should be reported
risk inherent in construction lending can be limited by accordingly.
establishing policies which specify type and extent of
institution involvement. Such policies generally define The following are the basic types of construction lending:
procedures for controlling disbursements and collateral
margins and assuring timely completion of the projects and • Unsecured Front Money - Unsecured front money
repayment of the institution's loans. loans are working capital advances to a borrower who
may be engaged in a new and unproven venture.
Before entering a construction loan agreement, it is Many bankers believe that unsecured front money
appropriate for the institution to investigate the character, lending is not prudent unless the institution is involved
expertise, and financial standing of all related parties. in the latter stages of construction financing. A
Documentation files would then include background builder planning to start a project before construction
information concerning reputation, work and credit funding is obtained often uses front money loans. The
experience, and financial statements. Such documentation funds may be used to acquire or develop a building
indicates that the developer, contractor, and subcontractors site, eliminate title impediments, pay architect or
have demonstrated the capacity to successfully complete the standby fees, and/or meet minimum working capital
type of project to be undertaken. The appraisal techniques requirements established by construction lenders.
used to value a proposed construction project are essentially Repayment often comes from the first draw against
the same as those used for other types of real estate. The construction financing. Unsecured front money loans
institution should realize that appraised collateral values are used for a developer's equity investment in a project or
not usually met until funds are advanced and improvements to cover initial costs overruns are symptomatic of an
made. undercapitalized, inexperienced or inept builder.

The institution, the builder, and the property owner typically • Land Development Loans - Land development loans
join in a written building loan agreement that specifies the are generally secured purchase or development loans
performance of each party during the entire course of or unsecured advances to investors and speculators.
construction. Loan funds are generally disbursed based Secured purchase or development loans are usually a
upon either a standard payment plan or a progress payment form of financing involving the purchase of land and
plan. The standard payment plan is normally used for lot development in anticipation of further construction
residential and smaller commercial construction loans and or sale of the property. A land development loan
utilizes a pre-established schedule for fixed payments at the should be predicated upon a proper title search and/or
end of each specified stage of construction. The progress mortgage insurance. The loan amount should be
payment plan is normally used for larger, more complex, based on appraisals on an "as is" and "as completed"
building projects. The plan is generally based upon monthly basis. Projections should be accompanied by a study
disbursements totaling 90 percent of the value with 10 explaining the effect of property improvements on the
percent held back until the project is completed. market value of the land. There should be a sufficient
spread between the amount of the development loan
Although many credits advanced for real estate acquisition, and the estimated market value to allow for
development or construction are properly considered loans unforeseen expenses. Appropriate repayment
secured by real estate, other such credits are, in economic programs typically are structured to follow the sales or
substance, "investments in real estate ventures.” A key development program. In the case of an unsecured
feature of these transactions is that the institution as lender land development loan to investors or speculators, it is
plans to share in the expected residual profit from the prudent for institution management to analyze the
ultimate sale or other use of the development. These profit borrower's financial statements for sources of
sharing arrangements may take the form of equity kickers, repayment other than the expected return on the
unusually high interest rates, a percentage of the gross rents property development.
or net cash flow generated by the project, or some other
form of profit participation over and above a reasonable • Commercial Construction Loans - Loans financing
amount for interest and related loan fees. These extensions commercial construction projects are usually
of credit may also include such other characteristics as collateralized, and such collateral is generally
nonrecourse debt, 100 percent financing of the development identical to that for commercial real estate loans.

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Supporting documentation should include a recorded The exposure in any type of construction lending is that the
mortgage or deed of trust, title insurance policy and/or full value of the collateral does not exist at the time the loan
title opinions, appropriate liability insurance and other is granted. Therefore, it is important for management to
coverages, land appraisals, and evidence that taxes ensure funds are used properly to complete construction or
have been paid to date. Additional documents relating development of the property serving as collateral. If default
to commercial construction loans include loan occurs, the institution must be in a position to either
agreements, takeout commitments, tri-party (buy/sell) complete the project or to salvage its construction advances.
agreements, completion or corporate bonds, and The various mechanic's and materialmen's liens, tax liens,
inspection or progress reports. and other judgments that arise in such cases are distressing
to even the most seasoned lender. Every precaution should
• Residential Construction Loans - Residential be taken by the lender to minimize any outside attack on the
construction loans may be made on a speculative basis collateral. The construction lender may not be in the
or as prearranged permanent financing. Smaller banks preferred position indicated by documents in the file. Laws
often engage in this type of financing and the of some states favor the subcontractors (materialmen's liens,
aggregate total of individual construction loans may etc.), although those of other states protect the construction
equal a significant portion of their capital funds. lender to the point of first default, provided certain legal
Prudence dictates that permanent financing be assured requirements have been met. Depending on the type and
in advance because the cost of such financing can size of project being funded, construction lending can be a
have a substantial effect on sales. Proposals to finance complex and fairly high-risk venture. For this reason,
speculative housing should be evaluated in accordance institution management should ensure that it has enacted
with predetermined policy standards compatible with policies and retained sufficiently trained personnel before
the institution's size, technical competence of its engaging in this type of lending.
management, and housing needs of its service area.
The prospective borrower's reputation, experience, Home Equity Loans
and financial condition should be reviewed. The
finished project's realistic marketability in favorable A home equity loan is a loan secured by the equity in a
and unfavorable market conditions is also an borrower's residence. It is generally structured in one of two
important consideration. ways. First, it can be structured as a traditional second
mortgage loan, wherein the borrower obtains the funds for
In addition to normal safeguards such as a recorded the full amount of the loan immediately and repays the debt
first mortgage, acceptable appraisal, construction with a fixed repayment schedule. Second, the home equity
agreement, draws based on progress payment plans borrowing can be structured as a line of credit, with a check,
and inspection reports, an institution dealing with credit card, or other access to the line over its life.
speculative contractors should institute control
procedures tailored to the individual circumstances. A The home equity line of credit has evolved into the
predetermined limit on the number of unsold units to dominant form of home equity lending. This credit
be financed at any one time is typically included in the instrument generally offers variable interest rates and
loan agreement to avoid overextending the contractor's flexible repayment terms. Additional characteristics of this
capacity. Loans on larger residential construction product line include relatively low interest rates as
projects are usually negotiated with prearranged compared to other forms of consumer credit, absorption by
permanent financing. Documentation of tract loans some banks of certain fees (origination, title search,
frequently includes a master note allocated for the appraisal, recordation cost, etc.) associated with
entire project and a master deed of trust or mortgage establishing a real estate-related loan. The changes imposed
covering all land involved in the project. Payment of by the Tax Reform Act of 1986 relating to the income tax
the loan will depend largely upon the sale of the deductibility of interest paid on consumer debt led to the
finished homes. As each sale is completed, the increased popularity of home equity lines of credit.
institution makes a partial release of the property
covered by its master collateral document. In addition Home equity lending is widely considered to be a low-risk
to making periodic inspections during the course of lending activity. These loans are secured by housing assets,
construction, periodic progress reports (summary of the value of which historically has performed well.
inventory lists maintained for each tract project) Nevertheless, the possibility exists that local housing values
typically are made on the entire project. A or household purchasing power may decline, stimulating
comprehensive inventory list shows each lot number, abandonment of the property and default on the debt secured
type of structure, release price, sales price, and loan by the housing. Certain features of home equity loans make
balance. them particularly susceptible to such risks. First, while the
variable rate feature of the debt reduces the interest rate risk

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of the lender, the variable payment size exposes the Agricultural Loans
borrower to greater cash flow risks than would a fixed-rate
loan, everything else being equal. This, in turn, exposes the Introduction
lender to greater credit risk. Another risk is introduced by
the very nature of the home equity loan. Such loans are Agricultural loans are an important component of many
generally secured by a junior lien. Thus, there is less community institution loan portfolios. Agricultural banks
effective equity protection than in a first lien instrument. represent a material segment of commercial banks and
Consequently, a decline in the value of the underlying constitute an important portion of the group of banks over
housing results in a much greater than proportional decline which the FDIC has the primary federal supervisory
in the coverage of a home equity loan. This added leverage responsibility.
makes them correspondingly riskier than first mortgages.
Agricultural loans are used to fund the production of crops,
Institutions that make these kinds of loans typically adopt fruits, vegetables, and livestock, or to fund the purchase or
specific policies and procedures for dealing with this refinance of capital assets such as farmland, machinery and
product line. Management expertise in mortgage lending equipment, breeder livestock, and farm real estate
and open-end credit procedures is critical to the appropriate improvements (for example, facilities for the storage,
administration of the portfolio. Another major concern is housing, and handling of grain or livestock). The
that borrowers will become overextended and the institution production of crops and livestock is especially vulnerable to
will have to initiate foreclosure proceedings. Therefore, two risk factors that are largely outside the control of
underwriting standards should emphasize the borrower's individual lenders and borrowers: commodity prices and
ability to service the line from cash flow rather than the sale weather conditions. While examiners must be alert to, and
of the collateral, especially if the home equity line is written critical of, operational and managerial weaknesses in
on a variable rate basis. If the institution has offered a low agricultural lending activities, they must also recognize
introductory interest rate, repayment capacity should be when the institution is taking reasonable steps to deal with
analyzed at the rate that could be in effect at the conclusion these external risk factors. Accordingly, loan restructurings
of the initial term. or extended repayment terms, or other constructive steps to
deal with financial difficulties faced by agricultural
Other important considerations include acceptable loan-to- borrowers because of adverse weather or commodity
value and debt-to-income ratios, and proper credit and conditions, will not be criticized if done in a prudent manner
collateral documentation, including adequate appraisals and and with proper risk controls and management oversight.
written evidence of prior lien status. Another significant Examiners should recognize these constructive steps and
risk concerns the continued lien priority for subsequent fairly portray them in oral and written communications
advances under a home equity line of credit. State law regarding examination findings. This does not imply,
governs the status of these subsequent advances. It is also however, that analytical or classification standards should
important that the institution's program include periodic be compromised. Rather, it means that the institution’s
reviews of the borrower's financial condition and continuing response to these challenges will be considered in
ability to repay the indebtedness. supervisory decisions.

The variation in contract characteristics of home equity debt Agricultural Loan Types and Maturities
affects the liquidity of this form of lending. For debt to be
easily pooled and sold in the secondary market, it needs to Production or Operating Loans - Short-term (one year or
be fairly consistent in its credit and interest rate less) credits to finance seed, fuel, chemicals, land and
characteristics. The complexity of the collateral structures, machinery rent, labor, and other costs associated with the
coupled with the uncertain maturity of revolving credit, production of crops. Family living expenses are also
makes home equity loans considerably less liquid than sometimes funded, at least in part, with these loans. The
straight first lien, fixed maturity mortgage loans. primary repayment source is sale of the crops at the end of
the production season when the harvest is completed.
While home equity lending is considered to be fairly low-
risk, subprime home equity loans and lending programs Feeder Livestock Loans - Short-term loans for the purchase
exist at some banks. These programs have a higher level of of, or production expenses associated with, cattle, hogs,
risk than traditional home equity lending programs. sheep, poultry or other livestock. When the animals attain
Individual or pooled home equity loans that have subprime market weight and are sold for slaughter, the proceeds are
characteristics should be analyzed using the information used to repay the debt.
provided in the subprime section of this Manual.
Breeder Stock Loans - Intermediate-term credits (generally
three to five years) used to fund the acquisition of breeding

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stock such as beef cows, sows, sheep, dairy cows, and collateral inspections, verifications, and valuations.
poultry. The primary repayment source is the proceeds Generally, financial information should be updated not less
from the sale of the offspring of these stock animals, or their than annually (loan officer files should be updated as needed
milk or egg production. and document all significant meetings and events). Credit
information should be analyzed by management so that
Machinery and Equipment Loans - Intermediate-term loans appropriate and timely actions are taken, as necessary, to
for the purchase of a wide array of equipment used in the administer the credit.
production and handling of crops and livestock. Cash flow
from farm earnings is the primary repayment source. Loans Institutions should be given some reasonable flexibility as
for grain handling and storage facilities are also sometimes to the level of sophistication or comprehensiveness of the
included in this category, especially if the facilities are not aforementioned financial information, and the frequency
permanently affixed to real estate. with which it is obtained, depending upon such factors as
the credit size, the type of loans involved, the financial
Farm Real Estate Acquisition Loans - Long-term credits for strength and trends of the borrower, and the economic,
the purchase of farm real estate, with cash flow from climatic or other external conditions which may affect loan
earnings representing the primary repayment source. repayment. It may therefore be inappropriate for the
Significant, permanent improvements to the real estate, such examiner to insist that all agricultural borrowers be
as for livestock housing or grain storage, may also be supported with the full complement of balance sheets,
included within this group. income statements, and other data discussed above,
regardless of the nature and amount of the credit or the
Carryover Loans - This term is used to describe two types debtor’s financial strength and payment record.
of agricultural credit. The first is production or feeder Nonetheless, while recognizing some leeway is appropriate,
livestock loans that are unable to be paid at their initial, most of the institution’s agricultural credit lines, and all of
short-term maturity, and which are rescheduled into an its larger or more significant ones, should be sufficiently
intermediate or long-term amortization. This situation supported by the financial information mentioned.
arises when weather conditions cause lower crop yields,
commodity prices are lower than anticipated, production Cash Flow Analysis - History clearly demonstrated that
costs are higher than expected, or other factors result in a significant problems can develop when banks fail to pay
shortfall in available funds for debt repayment. The second sufficient attention to cash flow adequacy in underwriting
type of carryover loan refers to already-existing term debt agricultural loans. While collateral coverage is important,
whose repayment terms or maturities need to be rescheduled the primary repayment source for intermediate and long-
because of inadequate cash flow to meet existing repayment term agricultural loans is not collateral but cash flow from
requirements. This need for restructuring can arise from the ordinary operations. This principle should be evident in the
same factors that lead to carryover production or feeder institution’s agricultural lending policies and implemented
livestock loans. Carryover loans are generally restructured in its actual practices. Cash flow analysis is therefore an
on an intermediate or long-term amortization, depending important aspect of the examiner’s review of agricultural
upon the type of collateral provided, the borrower’s debt loans. Assumptions in cash flow projections should be
service capacity from ongoing operations, the debtor’s reasonable and consider not only current conditions but also
overall financial condition and trends, or other variables. the historical performance of the farming operation.
The restructuring may also be accompanied by acquisition
of federal guarantees through the farm credit system to Collateral Support - Whether a loan or line of credit
lessen risk to the institution. warrants unsecured versus secured status in order to be
prudent and sound is a matter the examiner has to determine
Agricultural Loan Underwriting Guidelines based on the facts of the specific case. The decision should
generally consider such elements as the borrower’s overall
Many underwriting standards applicable to commercial financial strength and trends, profitability, financial
loans also apply to agricultural credits. The discussion of leverage, degree of liquidity in asset holdings, managerial
those shared standards is therefore not repeated. Some and financial expertise, and amount and type of credit.
items, however, are especially pertinent to agricultural Nonetheless, as a general rule, intermediate and long-term
credit and therefore warrant emphasis. agricultural credit is typically secured, and many times
production and feeder livestock advances will also be
Financial and Other Credit Information - As with any type collateralized. Often the security takes the form of an all-
of lending, sufficient information must be available so that inclusive lien on farm personal property, such as growing
the institution can make informed credit decisions. Basic crops, machinery and equipment, livestock, and harvested
information includes balance sheets, income statements, grain. A lien on real estate is customarily taken if the loan
cash flow projections, loan officer file comments, and was granted for the purchase of the property, or if the

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borrower’s debts are being restructured because of debt too-rapid amortization, on the other hand, can impose an
servicing problems. In some cases, the institution may undue burden on the cash flow capacity of the farming
perfect a lien on real estate as an abundance of caution. operation and thus lead to loan default or disruption of other
legitimate financing needs of the enterprise. It is also
Examiner review of agricultural related collateral valuations generally preferable that separate loans or lines of credit be
varies depending on the type of security involved. Real established for each loan purpose category financed by the
estate collateral should be reviewed using normal institution.
procedures. Feeder livestock and grain are highly liquid
commodities that are bought and sold daily in active, well- Administration of Agricultural Loans
established markets. Their prices are widely reported in the
daily media; so, obtaining their market values is generally Two aspects of prudent loan administration deserve
easy. The market for breeder livestock may be somewhat emphasis: collateral control and renewal practices for
less liquid than feeder livestock or grain, but values are production loans.
nonetheless reasonably well known and reported through
local or regional media or auction houses. If such Collateral Control - Production and feeder livestock loans
information on breeding livestock is unavailable or is are sometimes referred to as self-liquidating because sale of
considered unreliable, slaughter prices may be used as an the crops after harvest, and of the livestock when they reach
alternative (these slaughter prices comprise “liquidation” maturity, provides a ready repayment source for these
rather than “going concern” values). The extent of use and credits. These self-liquidating benefits may be lost,
level of maintenance received significantly affect however, if the institution does not monitor and exercise
machinery and equipment values. Determining collateral sufficient control over the disposition of the proceeds from
values can therefore be very difficult as maintenance and the sale. In agricultural lending, collateral control is mainly
usage levels vary significantly. Nonetheless, values for accomplished by periodic on-site inspections and
certain pre-owned machinery and equipment, especially verifications of the security pledged, with the results of
tractors, combines, and other harvesting or crop tillage those inspections documented, and by implementing
equipment, are published in specialized guides and are procedures to ensure sales proceeds are applied to the
based on prices paid at farm equipment dealerships or associated debt before those proceeds are released for other
auctions. These used machinery guides may be used as a purposes. The recommended frequency of collateral
reasonableness check on the valuations presented on inspections varies depending upon such things as the nature
financial statements or in management’s internal collateral of the farming operation, the overall credit soundness, and
analyses. the turnover rate of grain and livestock inventories.

Prudent agricultural loan underwriting also includes Renewal of Production Loans - After completion of the
systems and procedures to ensure that the institution has a harvest, some farm borrowers may wish to defer repayment
valid note receivable from the borrower and an enforceable of some or all of that season’s production loans, in
security interest in the collateral, should judicial collection anticipation of higher market prices at a later point
measures be necessary. Among other things, such systems (typically, crop prices are lower at harvest time when the
and procedures will confirm that promissory notes, loan supply is greater). Such delayed crop marketing will
agreements, collateral assignments, and lien perfection generally require production loan extensions or renewals.
documents are signed by the appropriate parties and are In these situations, the institution must strike an appropriate
filed, as needed, with the appropriate state, county, and/or balance of, on the one hand, not interfering with the debtor’s
municipal authorities. Flaws in the legal enforceability of legitimate managerial decisions and marketing plans while,
loan instruments or collateral documents will generally be at the same time, taking prudent steps to ensure its
unable to be corrected if they are discovered only when the production loans are adequately protected and repaid on an
credit is distressed and the borrower relationship strained. appropriate basis. Examiners should generally not take
exception to reasonable renewals or extensions of
Structuring - Orderly liquidation of agricultural debt, based production loans when the following factors are favorably
on an appropriate repayment schedule and a clear resolved:
understanding by the borrower of repayment expectations,
helps prevent collection problems from developing. • The borrower has sufficient financial strength to
Amortization periods for term indebtedness should correlate absorb market price fluctuations. Leverage and
with the useful economic life of the underlying collateral liquidity in the balance sheet, financial statement
and with the operation’s debt service capacity. A too- trends, profitability of the operation, and past
lengthy amortization period can leave the institution under repayment performance are relevant indices.
secured in the latter part of the life of the loan, when the • The borrower has sufficient financial capacity to
borrower’s financial circumstances may have changed. A support both old and new production loans. That is, in

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a few months subsequent to harvest, the farmer will livestock and grain collateral, and not more than six
typically be incurring additional production debt for months prior to the examination start date for breeder
the upcoming crop season. stock collateral. Copies of invoices or bills of sale are
• The institution has adequately satisfied itself of the acceptable substitutes for inspection reports prepared
amount and condition of grain in inventory, so that the by institution management, in the case of loans for the
renewed or extended production loans are adequately purchase of livestock.
supported. Generally, this means that a current • Loans secured by grain warehouse receipts are
inspection report will be available. generally excluded from adverse classification, up to
the market value of the grain represented by the
Classification Guidelines for Agricultural Credit receipts.
• The amount of credit to be given for the livestock or
When determining the level of risk in a specific lending grain collateral should be based on the daily,
relationship, the relevant factual circumstances must be published, market value as of the examination start
reviewed in total. This means, among other things, that date, less marketing and transportation costs, feed and
when an agricultural loan’s primary repayment source is veterinary expenses (to the extent determinable), and,
jeopardized or unavailable, adverse classification is not if material in amount, the accrued interest associated
automatic. Rather, such factors as the borrower’s historical with the loan(s). Current market values for breeder
performance and financial strength, overall financial stock may be derived from local or regional
condition and trends, the value of any collateral, and other newspapers, area auction barns, or other sources
sources of repayment must be considered. In considering considered reliable. If such valuations for breeding
whether a given agricultural loan or line of credit should be livestock cannot be obtained, the animals’ slaughter
adversely classified, collateral margin is an important, values may be used.
though not necessarily the determinative, factor. If that • The institution must have satisfactory practices for
margin is so overwhelming as to remove all reasonable controlling sales proceeds when the borrower sells
prospect of the institution sustaining some loss, it is livestock and feed and grain.
generally inappropriate to adversely classify such a loan. • The institution must have a properly perfected and
Note, however, that if there is reasonable uncertainty as to enforceable security interest in the assets in question.
the value of that security, because of an illiquid market or
other reasons, that uncertainty can, when taken in Examiners should exercise great caution in granting the
conjunction with other weaknesses, justify an adverse grain and livestock exclusion from adverse classification in
classification of the credit, or, at minimum, may mean that those instances where the borrower is highly leveraged, or
the margin in the collateral needs to be greater to offset this where the debtor’s basic operational viability is seriously in
uncertainty. Moreover, when assessing the adequacy of the question, or if the institution is in an under-secured position.
collateral margin, it must be remembered that deteriorating The issue of control over proceeds becomes extremely
financial trends will, if not arrested, typically result in a critical in such highly distressed credit situations. If the
shrinking of that margin. Such deterioration can also reduce livestock and grain exclusion from adverse classification is
the amount of cash available for debt service needs. not given in a particular case, institution management
should be informed of the reasons why.
That portion of an agricultural loan(s) or line of credit,
which is secured by grain, feeder livestock, and/or breeder With the above principles, requirements, and standards in
livestock, will generally be withheld from adverse mind, the general guidelines for determining adverse
classification. The basis for this approach is that grain and classification for agricultural loans are as follows, listed by
livestock are highly marketable and provide good protection loan type.
from credit loss. However, that high marketability also
poses potential risks that must be recognized and controlled. Feeder Livestock Loans - The self-liquidating nature of
The following conditions must therefore be met in order for these credits means that they are generally not subject to
this provision to apply: adverse classification. However, declines in livestock
prices, increases in production costs, or other unanticipated
• The institution must take reasonable steps to verify the developments may result in the revenues from the sale of
existence and value of the grain and livestock. This the livestock not being adequate to fully repay the loans.
generally means that on-site inspections must be made Adverse classification may then be appropriate, depending
and documented. Although the circumstances of each upon the support of secondary repayment sources and
case must be taken into account, the general policy is collateral, and the borrower’s overall financial condition
that, for the classification exclusion to apply, and trends.
inspections should have been performed not more than
90 days prior to the examination start date for feeder

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Production Loans - These loans are generally not subject to financial, operational or other managerial weaknesses; from
adverse classification if the debtor has good liquidity and/or inappropriate credit administration on the institution’s part,
significant fixed asset equities, or if the cash flow such as over lending or improper debt structuring; from
information suggests that current year’s operations should external events such as adverse weather conditions that
be sufficient to repay the advances. The examiner should affected crop yields; or from other causes? In many
also take into account any governmental support programs instances, it will be in the long-term best interests of both
or federal crop insurance benefits from which the borrower the institution and the debtor to restructure the obligations.
may benefit. If cash flow from ongoing operations appears The restructured obligation should generally be rescheduled
insufficient to repay production loans, adverse classification on a term basis and require clearly identified collateral,
may be in order, depending upon the secondary repayment amortization period, and payment amounts. The
sources and collateral, and the borrower’s overall financial amortization period may be intermediate or long term
condition and trends. depending upon the useful economic life of the available
collateral, and on realistic projections of the operation’s
Breeder Stock Loans - These loans are generally not payment capacity.
adversely classified if they are adequately secured by the
livestock and if the term debt payments are being met There are no hard and fast rules on whether carryover debt
through the sale of offspring (or milk and eggs in the case should be adversely classified, but the decision should
of dairy and poultry operations). If one or both of these generally consider the following: borrower’s overall
conditions is not met, adverse classification may be in order, financial condition and trends, especially financial leverage
depending upon the support of secondary repayment (often measured in farm debtors with the debt-to-assets
sources and collateral, and the borrower’s overall financial ratio); profitability levels, trends, and prospects; historical
condition and trends. repayment performance; the amount of carryover debt
relative to the operation’s size; realistic projections of debt
Machinery and Equipment Loans - Loans for the acquisition service capacity; and the support provided by secondary
of machinery and equipment will generally not be subject to collateral. Accordingly, carryover loans to borrowers who
adverse classification if they are adequately secured, are moderately to highly leveraged, who have a history of
structured on an appropriate amortization program (see weak or no profitability and barely sufficient cash flow
above), and are paying as agreed. Farm machinery and projections, as well as an adequate but slim collateral
equipment is often the second largest class of agricultural margin, will generally be adversely classified, at least until
collateral, hence its existence, general state of repair, and it is demonstrated through actual repayment performance
valuation are generally verified and documented during the that there is adequate capacity to service the rescheduled
institution’s periodic on-site inspections of the borrower’s obligation. The classification severity will normally depend
operation. Funding for the payments on machinery and upon the collateral position. At the other extreme are cases
equipment loans sometimes comes, at least in part, from where the customer remains fundamentally healthy
other loans provided by the institution, especially financially, generates good profitability and ample cash
production loans. When this is the case, the question arises flow, and who provides a comfortable margin in the security
whether the payments are truly being “made as agreed.” For pledged. Carryover loans to this group of borrowers will
examination purposes, such loans will be considered to be not ordinarily be adversely classified.
paying as agreed if cash flow projections, payment history,
or other available information, suggests there is sufficient Installment Loans
capacity to fully repay the production loans when they
mature at the end of the current production cycle. If the An installment loan portfolio is usually comprised of a large
machinery and equipment loan is not adequately secured, or number of small loans scheduled to be amortized over a
if the payments are not being made as agreed, adverse specific period. Most installment loans are made directly
classification should be considered. for consumer purchases, but business loans granted for the
purchase of heavy equipment or industrial vehicles may also
Carryover Debt - Carryover debt results from the debtor’s be included. In addition, the department may grant indirect
inability to generate sufficient cash flow to service the loans for the purchase of consumer goods.
obligation as it is currently structured. It therefore tends to
contain a greater degree of credit risk and must receive close The examiner's emphasis in reviewing the installment loan
analysis by the examiner. When carryover debt arises, the department should be on the overall procedures, policies
institution should determine the basic viability of the and credit qualities. The goal should not be limited to
borrower’s operation, so that an informed decision can be identifying current portfolio problems, but should include
made on whether debt restructuring is appropriate. It will potential future problems that may result from ineffective
thus be useful for institution management to know how the policies, unfavorable trends, potentially dangerous
carryover debt came about: Did it result from the obligor’s concentrations, or nonadherence to established policies.

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Direct installment lending policies typically address the lease contract is generally signed simultaneously with the
following factors: loan applications and credit checks; terms signing of the order to purchase and the agreement to lease.
in relation to collateral; collateral margins; perfection of
liens; extensions, renewals and rewrites; delinquency Lessor Accounting under ASC Topic 840
notification and follow-up; and charge-offs and collections.
For indirect lending, the policy typically addresses direct The types of assets that may be leased are numerous, and
payment to the institution versus payment to the dealer, the accounting for direct leasing is a complex subject which
acquisition of dealer financial information, possible upper is discussed in detail in ASC Topic 840, Leases. Familiarity
limits for any one dealer's paper, other standards governing with ASC Topic 840 is a prerequisite for the management
acceptance of dealer paper, and dealer reserves and charge- of any institution engaging in or planning to engage in direct
backs. lease financing. The following terms are commonly
encountered in direct lease financing:
Lease Accounting
• Net Lease, one in which the institution is not directly
ASC Topic 840, Leases, is the current lease accounting or indirectly obligated to assume the expenses of
standard for non-public business entities and entities that maintaining the equipment. This restriction does not
have not adopted ASC Topic 842, Leases. ASC Topic 842 prohibit the institution from paying delivery and set up
is effective for public business entities (as defined in U.S. charges on the property.
GAAP) and will become effective for banks that are not • Full Payout Lease, one for which the institution
public business entities, for fiscal years beginning after expects to realize both the return of its full investment
December 15, 2021, and interim reporting periods within and the cost of financing the property over the term of
fiscal years beginning after December 15, 2022. As such, a the lease. This payout can come from rentals,
calendar year end non-public business entity’s first reporting estimated tax benefits, and estimated residual value of
period will be December 31, 2022. Early adoption is the property.
permitted. • Leveraged Lease, in which the institution as lessor
purchases and becomes the equipment owner by
Direct Lease Financing providing a relatively small percentage (20-40%) of
the capital needed. Balance of the funds is borrowed
Leasing is a recognized form of term debt financing for by the lessor from long-term lenders who hold a first
fixed assets. While leases differ from loans in some lien on the equipment and assignments of the lease
respects, they are similar from a credit viewpoint because and lease rental payments. This specialized and
the basic considerations are cash flow, repayment capacity, complex form of leasing is prompted mainly by a
credit history, management and projections of future desire on the part of the lessor to shelter income from
operations. Additional considerations for a lease taxation. Creditworthiness of the lessee is paramount
transaction are the property type and its marketability in the and the general rule is an institution should not enter
event of default or lease termination. Those latter into a leveraged lease transaction with any party to
considerations do not radically alter the manner in which an whom it would not normally extend unsecured credit.
examiner evaluates collateral for a lease. The assumption is • Rentals, which include only those payments
that the lessee/borrower will generate sufficient funds to reasonably anticipated by the institution at the time the
liquidate the lease/debt. Sale of leased property/collateral lease is executed.
remains a secondary repayment source and, except for the
estimated residual value at the expiration of the lease, will Lessor Accounting under ASC Topic 842
not, in most cases, become a factor in liquidating the
advance. When the institution is requested to purchase ASC Topic 842, Leases does not fundamentally change
property of significant value for lease, it may issue a lessor accounting; however, it aligns terminology between
commitment to lease, describing the property, indicating lessee and lessor accounting and brings key aspects of lessor
cost, and generally outlining the lease terms. After all terms accounting into alignment with the FASB’s new revenue
in the lease transaction are resolved by negotiation between recognition guidance in ASC Topic 606. As a result, the
the institution and its customer, an order is usually written classification difference between direct financing leases and
requesting the institution to purchase the property. Upon sales-type leases for lessors moves from a risk-and-rewards
receipt of that order, the institution purchases the property principle to a transfer of control principle. As such, an
requested and arranges for delivery and, if necessary, institution as lessor is required to classify a lease as a sales-
installation. A lease contract is drawn incorporating all the type, direct financing, or operating leases. Additionally,
points covered in the commitment letter, as well as the rights there is no longer a distinction in the treatment of real estate
of the institution and lessee in the event of default. The and non-real estate leases by lessors.

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Leases classified as leveraged leases prior to the adoption of invoices, manufacturer's statement of origin, etc.) is
ASC Topic 842 may continue to be accounted for under provided. The method facilitates inventory purchases by, in
ASC Topic 840 unless subsequently modified. ASC Topic effect, guaranteeing payment to the manufacturer for
842 eliminates leveraged lease accounting for leases that merchandise supplied. Floor plan loans involve all the basic
commence after an institution adopts the new accounting risks inherent in any form of inventory financing. However,
standard. because of the banker's inability to exercise full control over
the floored items, the exposure to loss may be greater than
For more information refer to the Call Report Glossary for in other similar types of financing. Most dealers have
the accounting for leases or ASC Topic 842. minimal capital bases relative to debt. As a result, close and
frequent review of the dealer's financial information is
Examiner Consideration necessary. As with all inventory financing, collateral value
is of prime importance. Control requires the institution to
Examiners should determine whether bank management determine the collateral value at the time the loan is placed
carefully evaluates all lease variables, including the on the books, frequently inspect the collateral to determine
estimate of the residual value. Institutions may be able to its condition, and impose a curtailment requirement
realize unwarranted lease income in the early years of a sufficient to keep collateral value in line with loan balances.
contract by manipulating the lease variables. In addition, an
institution can offer the lessee a lower payment by assuming Handling procedures for floor plan lines will vary greatly
an artificially high residual value during the initial depending on institution size and location, dealer size and
structuring of the lease. But this technique may present the the type of merchandise being financed. In many cases, the
institution with serious long-term problems because of the term "trust receipt" is used to describe the debt instrument
reliance on speculative or nonexistent residual values. existing between the institution and the dealer. Trust
receipts may result from drafting agreements between an
Often, lease contracts contain an option permitting the institution and a manufacturer for the benefit of a dealer. In
lessee to continue use of the property at the end of the other instances, the dealer may order inventory, bring titles
original term, working capital restrictions and other or invoices to the institution, and then obtain a loan secured
restrictions or requirements similar to debt agreements and or to be secured by the inventory. Some banks may use
lease termination penalties. Each lease is an individual master debt instruments, and others may use a trust receipt
contract written to fulfill the lessee's needs. Consequently, or note for each piece of inventory. The method of
there may be many variations of each of the above perfecting a security interest also varies from state to state.
provisions. However, the underlying factors remain the The important point is that an institution enacts realistic
same: there is a definite contractual understanding of the handling policies and ensures that its collateral position is
positive right to use the property for a specific period of properly protected.
time, and required payments are irrevocable.
Examination procedures and examiner considerations for
Examination procedures for reviewing lease financing reviewing floor plan lending activities are included in the
activities are included in the ED Modules in the Loan ED Modules in the Loan References section.
References section.
Check Credit and Credit Card Loans
Floor Plan Loans
Check credit is defined as the granting of unsecured
Floor plan (wholesale) lending is a form of retail goods revolving lines of credit to individuals or businesses. Check
inventory financing in which each loan advance is made credit services are provided by the overdraft system, cash
against a specific piece of collateral. As each piece of reserve system, and special draft system. The most common
collateral is sold by the dealer, the loan advance against that is the overdraft system. In that method, a transfer is made
piece of collateral is repaid. Items commonly subject to from a pre-established line of credit to a customer's demand
floor plan debt are automobiles, home appliances, furniture, deposit account when a check which would cause an
television and stereophonic equipment, boats, mobile overdraft position is presented. Transfers normally are
homes and other types of merchandise usually sold under a made in stated increments, up to the maximum line of credit
sales finance contract. Drafting agreements are a relatively approved by the institution, and the customer is notified that
common approach utilized in conjunction with floor plan the funds have been transferred. In a cash reserve system,
financing. Under this arrangement, the institution customers must request that the institution transfer funds
establishes a line of credit for the borrower and authorizes from their pre-established line of credit to their demand
the good’s manufacturer to draw drafts on the institution in deposit account before negotiating a check against them. A
payment for goods shipped. The institution agrees to honor special draft system involves the customer negotiating a
these drafts, assuming proper documentation (such as special check drawn directly against a pre-established line

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of credit. In that method, demand deposit accounts are not accounts from delinquent status (curing) through
affected. In all three systems, the institution periodically performance not requiring a catch-up of delinquent
provides its check credit customers with a statement of principal; and provisions that preclude automatic reissuance
account activity. Required minimum payments are of expired cards to obligors with charged-off balances or an
computed as a fraction of the balance of the account on the otherwise unsatisfactory credit history with the institution.
cycle date and may be made by automatic charges to a
demand deposit account. Examination procedures for reviewing these activities are
included in the ED Modules. Also, the FDIC has separate
Most institution credit card plans are similar. The manuals on Credit Card Specialty Bank Examination
institution solicits retail merchants, service organizations Guidelines and Credit Card Securitization Activities.
and others who agree to accept a credit card in lieu of cash
for sales or services rendered. The parties also agree to a Credit Card-related Merchant Activities
discount percentage of each sales draft and a maximum
dollar amount per transaction. Amounts exceeding that Merchant credit card activities basically involve the
limit require prior approval by the institution. Merchants acceptance of credit card sales drafts for clearing by a
also may be assessed a fee for imprinters or promotional financial institution (clearing institution). For the clearing
materials. The merchant deposits the institution credit card institution, these activities are generally characterized by
sales draft at the institution and receives immediate credit thin profit margins amidst high transactional and sales
for the discounted amount. The institution assumes the volumes. Typically, a merchant's customer will charge an
credit risk and charges the nonrecourse sales draft to the item on a credit card, and the clearing institution will give
individual customer's credit card account. Monthly credit to the merchant's account. Should the customer
statements are rendered by the institution to the customer dispute a charge transaction, the clearing institution is
who may elect to remit the entire amount, generally without obligated to honor the customer's legitimate request to
service charge, or pay in monthly installments, with an reverse the transaction. The Clearing Institution must then
additional percentage charged on the outstanding balance seek reimbursement from the merchant. Problems arise
each month. A cardholder also may obtain cash advances when the merchant is not creditworthy and is unable, or
from the institution or dispensing machines. Those unwilling, to reimburse the clearing institution. In these
advances accrue interest from the transaction date. An instances, the clearing institution will incur a loss.
institution may be involved in a credit card plan in three Examiners should review for the existence of any such
ways: contingent liabilities.

• Agent Bank, which receives credit card applications To avoid losses and to ensure the safe and profitable
from customers and sales drafts from merchants and operation of a clearing institution's credit card activities, the
forwards such documents to banks described below, merchants with whom it contracts for clearing services
and is accountable for such documents during the should be financially sound and honestly operated. To this
process of receiving and forwarding. end, safe and sound merchant credit card activities include
• Sublicensee Bank, which maintains accountability for clear and detailed acceptance standards for merchants, such
credit card loans and merchant's accounts; may as the following:
maintain its own center for processing payments and
drafts; and may maintain facilities for embossing • Scrutinizing prospective merchants using the same
credit cards. care and diligence used in evaluating prospective
• Licensee Bank, which is the same as sublicensee borrowers.
institution, but in addition may perform transaction • Closely monitoring merchants with controls to ensure
processing and credit card embossing services for that early warning signs are recognized so that
sublicensee banks, and also acts as a regional or problem merchants can be removed from a clearing
national clearinghouse for sublicensee banks. institution's program promptly to minimize loss
exposure.
Check credit and credit card loan policies typically address • Establishing an account administration program that
procedures for careful screening of account applicants; incorporates periodic reviews of merchants' financial
establishment of internal controls to prevent interception of statements and business activities in cases of
cards before delivery, merchants from obtaining control of merchants clearing large dollar volumes.
cards, or customers from making fraudulent use of lost or • Establishing an internal periodic reporting system of
stolen card; frequent review of delinquent accounts, merchant account activities regardless of the amount
accounts where payments are made by drawing on reserves, or number of transactions cleared, with these reports
and accounts with steady usage; delinquency notification
procedures; guidelines for realistic charge-offs; removal of

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reviewed for irregularities so problematic merchant • Cost Approach - In this approach, the appraiser
activity is identified quickly. estimates the reproduction cost of the building and
• Developing policies that follow the guidelines improvements, deducts estimated depreciation, and
established by the card issuing networks. adds the value of the land. The cost approach is
particularly helpful when reviewing draws on
Another possible problem with merchant activities involves construction loans. However, as the property
clearing institutions that sometimes engage the services of increases in age, both reproduction cost and
agents, such as an independent sales organization (ISO). depreciation become more difficult to estimate.
ISOs solicit merchants' credit card transactions for a Except for special purpose facilities, the cost approach
clearing institution. In some cases, the ISOs actually is usually inappropriate in a troubled real estate
contract with merchants on behalf of clearing institutions. market because construction costs for a new facility
Some of these contracts are entered into by the ISOs without normally exceed the market value of existing
the review and approval of the clearing institutions. At comparable properties.
times, clearing institutions unfortunately rely too much on • Market Data or Direct Sales Comparison
the ISOs to oversee account activity. In some cases, Approach - This approach examines the price of
clearing institutions have permitted ISOs to contract with similar properties that have sold recently in the local
disreputable merchants. Because of the poor condition of market, estimating the value of the subject property
the merchant, or ISO, or both, these clearing institutions can based on the comparable properties' selling prices. It
ultimately incur heavy losses. is very important that the characteristics of the
observed transactions be similar in terms of market
A financial institution with credit card clearing activities location, financing terms, property condition and use,
typically develops its own internal controls and procedures timing, and transaction costs. The market approach
to ensure sound agent selection standards before engaging generally is used in valuing owner-occupied
an ISO. ISOs that seek to be compensated solely on the residential property because comparable sales data is
basis of the volume of signed-up merchants should be typically available. When adequate sales data is
carefully scrutinized. A clearing institution should available, an analyst generally will give the most
adequately supervise the ISO's activities, just as the weight to this type of estimate. Often, however, the
institution would supervise any third party engaged to available sales data for commercial properties is not
perform services for any aspect of the institution's sufficient to justify a conclusion.
operations. Also, institutions typically and appropriately • The Income Approach - The economic value of an
reserve the right to ratify or reject any merchant contract that income-producing property is the discounted value of
is initiated by an ISO. the future net operating income stream, including any
"reversion" value of property when sold. If
Examination procedures for reviewing credit card related competitive markets are working perfectly, the
merchant activities are included in the ED Modules in the observed sales price should be equal to this value. For
Supplemental Modules Section and in the Credit Card unique properties or in depressed markets, value based
Activities Manual. on a comparable sales approach may be either
unavailable or distorted. In such cases, the income
← approach is usually the appropriate method for valuing
OTHER CREDIT ISSUES the property. The income approach converts all
expected future net operating income into present
Appraisals value terms. When market conditions are stable and
no unusual patterns of future rents and occupancy
Appraisals are professional judgments of the market value rates are expected, the direct capitalization method is
of real property. Three basic valuation approaches are used often used to estimate the present value of future
by professional appraisers in estimating the market value of income streams. For troubled properties, however, the
real property; the cost approach, the market data or direct more explicit discounted cash flow (net present value)
sales comparison approach, and the income approach. The method is more typically utilized for analytical
principles governing the three approaches are widely known purposes. In the rent method, a time frame for
in the appraisal field and are referenced in parallel achieving a "stabilized", or normal, occupancy and
regulations issued by each of the federal banking agencies. rent level is projected. Each year's net operating
When evaluating collateral, the three valuation approaches income during that period is discounted to arrive at
are not equally appropriate. present value of expected future cash flows. The
property's anticipated sales value at the end of the
period until stabilization (its terminal or reversion
value) is then estimated. The reversion value

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represents the capitalization of all future income Subcommittee is to monitor the state certification and
streams of the property after the projected occupancy licensing of appraisers. It has the authority to disapprove a
level is achieved. The terminal or reversion value is state appraiser regulatory program, thereby disqualifying
then discounted to its present value and added to the the state's licensed and certified appraisers from conducting
discounted income stream to arrive at the total present appraisals for federally related transactions. The Appraisal
market value of the property. Subcommittee also has the authority to temporarily waive
the credential requirement if certain criteria are met. The
Valuation of Troubled Income-Producing Properties Appraisal Subcommittee gets its funding by charging state
certified and licensed appraisers an annual registration fee.
When an income property is experiencing financial The fee income is used to cover Appraisal Subcommittee
difficulties due to general market conditions or due to its administrative expenses and to provide grants to the
own characteristics, data on comparable property sales is Appraisal Foundation.
often difficult to obtain. Troubled properties may be hard
to market, and normal financing arrangements may not be Formed in 1987, the Appraisal Foundation was established
available. Moreover, forced and liquidation sales can as a private not for profit corporation bringing together
dominate market activity. When the use of comparables is interested parties within the appraisal industry, as well as
not feasible (which is often the case for commercial users of appraiser services, to promote professional
properties), the net present value of the most reasonable standards within the appraisal industry. The Foundation
expectation of the property's income-producing capacity - sponsors two independent boards referred to in Title XI, The
not just in today's market but over time - offers the most Appraiser Qualifications Board (AQB) and The Appraisal
appropriate method of valuation in the supervisory process. Standards Board (ASB). Title XI specifies that the
minimum standards for state appraiser certification are to be
Estimates of the property's value should be based upon the criteria for certification issued by the AQB. Title XI
reasonable and supportable projections of the determinants does not set specific criteria for the licensed classification.
of future net operating income: rents (or sales), expenses, These are individually determined by each state.
and rates of occupancy. The primary considerations for Additionally, Title XI requires that the appraisal standards
these projections include historical levels and trends, the prescribed by the federal agencies, at a minimum, must be
current market performance achieved by the subject and the appraisal standards promulgated by the ASB. The ASB
similar properties, and economically feasible and defensible has issued The Uniform Standards of Professional Appraisal
projections of future demand and supply conditions. If Practice (USPAP) which set the appraisal industry standards
current market activity is dominated by a limited number of for conducting an appraisal of real estate. To the appraisal
transactions or liquidation sales, high capitalization and industry, USPAP is analogous to generally accepted
discount rates implied by such transactions should not be accounting principles for the accounting profession.
used. Rather, analysts should use rates that reflect market
conditions that are neither highly speculative nor depressed. In conformance with Title XI, Part 323 of the FDIC
regulations identifies which real estate related transactions
Appraisal Regulation require an appraisal by a certified or licensed appraiser and
establishes minimum standards for performing appraisals.
Title XI of the Financial Institutions Reform, Recovery, and Substantially similar regulations have been adopted by each
Enforcement Act of 1989 requires that appraisals prepared of the federal financial institutions regulatory agencies.
by certified or licensed appraisers be obtained in support of
real estate lending and mandates that the federal financial Real estate-related transactions include real estate loans,
institutions regulatory agencies adopt regulations regarding mortgage-backed securities, institution premises, real estate
the preparation and use of appraisals in certain real estate investments, and other real estate owned. All real estate-
related transactions by financial institutions under their related transactions by FDIC-insured institutions not
jurisdiction. In addition, Title XI created the Appraisal specifically exempt are, by definition, "federally related
Subcommittee of the Federal Financial Institutions transactions" subject to the requirements of the regulation.
Examination Council (FFIEC) to provide oversight of the Exempt real estate-related transactions include:
real estate appraisal process as it relates to federally related
real estate transactions. The Appraisal Subcommittee is (1) The transaction is a residential real estate
composed of six members, each of whom is designated by transaction that has a transaction value of $400,000
the head of their respective agencies. Each of the five or less;
financial institution regulatory agencies which comprise the (2) A lien on real estate has been taken as collateral in an
FFIEC and the U.S. Department of Housing and Urban abundance of caution;
Development are represented on the Appraisal (3) The transaction is not secured by real estate;
Subcommittee. A responsibility of the Appraisal

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(4) A lien on real estate has been taken for purposes other certified or licensed appraiser per exemption (1), (5), (7),
than the real estate’s value; (13), or (14).
(5) The transaction is a business loan that: (i) has a
transaction value of $1 million or less; and (ii) is not Section 323.4 establishes minimum standards for all
dependent on the sale of, or rental income derived appraisals in connection with federally related transactions.
from, real estate as the primary source of repayment; Appraisals performed in conformance with the regulation
(6) A lease of real estate is entered into, unless the lease is must conform to the requirements of the USPAP and certain
the economic equivalent of a purchase or sale of the other listed standards. The applicable sections of USPAP
leased real estate; are the Preamble (ethics and competency), Standard 1
(7) The transaction involves an existing extension of (appraisal techniques), Standard 2 (report content), and
credit at the lending institution, provided that: (i) Standard 3 (review procedures). USPAP Standards 4
There has been no obvious and material change in the through 10 concerning appraisal services and appraising
market conditions or physical aspects of the property personal property do not apply to federally related
that threatens the adequacy of the institution’s real transactions. An appraisal satisfies the regulation if it is
estate collateral protection after the transaction, even performed in accordance with all of its provisions and it is
with the advancement of new monies; or (ii) There is still current and meaningful. The regulation also requires
no advancement of new monies, other than funds that the appraisal report contain the appraiser's certification
necessary to cover reasonable closing costs; that the appraisal was prepared in conformance with
(8) The transaction involves the purchase, sale, USPAP.
investment in, exchange of, or extension of credit
secured by, a loan or interest in a loan, pooled loans, In addition, the regulation requires appraisals for federally
or interests in real property, including mortgage- related transactions to be subject to appropriate review for
backed securities, and each loan or interest in a loan, compliance with USPAP. Specific review procedures in an
pooled loan, or real property interest met FDIC institution's written appraisal program that produce some
regulatory requirements for appraisals at the time of form of documented evidence would facilitate meeting this
origination; regulatory requirement. Procedures for maintaining some
(9) The transaction is wholly or partially insured or form of documented evidence of the review of other
guaranteed by a United States government agency or appraisals help ensure those appraisals facilitate making
United States government sponsored agency; informed lending decisions. Examiners should note that
(10) The transaction either; (i) Qualifies for sale to a such evidence could take the form of an appraisal checklist
United States government agency or United States that includes the signature of an appropriately trained
government sponsored agency; or (ii) Involves a external person or an internal staff member, indicates the
residential real estate transaction in which the appraisal was reviewed, and finds that all USPAP standards
appraisal conforms to the Federal National Mortgage were met. An effective appraisal program’s review
Association or Federal Home Loan Mortgage escalation procedures will facilitate internal staff’s ability to
Corporation appraisal standards applicable to that take appropriate action to address appraisals that do not
category of real estate; comply with USPAP.
(11) The regulated institution is acting in a fiduciary
capacity and is not required to obtain an appraisal Adherence to the appraisal regulations should be part of the
under other law; examiner's overall review of the lending function. When
(12) The FDIC determines that the services of an appraiser analyzing individual transactions, examiners should review
are not necessary in order to protect federal financial appraisal reports to determine the institution's conformity to
and public policy interests in real estate-related its own internal appraisal policies and for compliance with
financial transaction or to protect the safety and the regulation. Examiners may need to conduct a more
soundness of the institution; detailed review if the appraisal does not have sufficient
(13) The transaction is a commercial real estate transaction information, does not explain assumptions, is not logical, or
that has a transaction value of $500,000 or less; or has other major deficiencies that cast doubt as to the validity
(14) The transaction is exempted from the appraisal of its opinion of value. Examination procedures regarding
requirement pursuant to the rural residential appraisal reviews are included in the Examination
exemption under 12 U.S.C. 3356. Documentation Modules.

The regulation also requires an institution to obtain an Loans in a pool such as an investment in mortgage- backed
appropriate evaluation of the real property collateral that securities or collateralized mortgage obligations should
is consistent with safe and sound banking practices for a have some documented assurance that each loan in the pool
transaction that does not require the services of a state has an appraisal in accordance with the regulation.

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Appropriate evidence could include an issuer's certification • Provide for the receipt of the appraisal or evaluation
of compliance. report in a timely manner to facilitate the underwriting
decision;
All apparent violations of Part 323 should be listed in the • Assess the validity of existing appraisals or
examination report in the usual manner. Significant evaluations to support subsequent transactions;
systemic failures to meet standards and procedures could • Establish criteria for obtaining appraisals or
call for formal corrective measures. evaluations for transactions that are otherwise exempt
from the agencies' appraisal regulations; and
Interagency Appraisal and Evaluation Guidelines • Establish internal controls that promote compliance
with these program standards.
The Interagency Appraisal and Evaluation Guidelines dated
December 2, 2010 address supervisory matters relating to Selection of Individuals Who May Perform Appraisals and
real estate-related financial transactions and provide Evaluations - An institution's program establishes criteria to
guidance to examining personnel and federally regulated select, evaluate, and monitor the performance of the
institutions about prudent appraisal and evaluation policies, individual(s) who performs a real estate appraisal or
procedures, practices, and standards that are consistent with evaluation. Appropriate criteria ensure that:
the appraisal regulation.
• The selection process is non-preferential and
An institution's real estate appraisal and evaluation policies unbiased;
and procedures will be reviewed as part of the examination • The individual selected possesses the requisite
of the institution's overall real estate-related activities. An education, expertise and competence to complete the
institution's policies and procedures typically are assignment;
incorporated into an effective appraisal and evaluation • The individual selected is capable of rendering an
program. Examiners will consider the institution's size and unbiased opinion; and
the nature of its real estate-related activities when assessing
• The individual selected is independent and has no
the appropriateness of its program.
direct or indirect interest, financial or otherwise, in the
property or the transaction.
When analyzing individual transactions, examiners should
review an appraisal or evaluation to determine whether the
Under the agencies’ appraisal regulations, the appraiser
methods, assumptions, and findings are reasonable and
must be selected and engaged directly by the institution or
comply with the agencies' appraisal regulations and the
its agent. The appraiser's client is the institution, not the
institution’s internal policies. Examiners also will review
borrower. Also, an institution may not use an appraisal that
the steps taken by an institution to ensure that the
has been “readdressed” – appraisal reports that are altered
individuals who perform its appraisals and evaluations are
by the appraiser to replace any references to the original
qualified and are not subject to conflicts of interest.
client with the institution’s name. An institution may use
Institutions that fail to maintain a sound appraisal or
an appraisal that was prepared by an appraiser engaged
evaluation program or to comply with the agencies'
directly by another financial services institution, as long as
appraisal regulations will be cited in examination reports
the institution determines that the appraisal conforms to the
and may be criticized for unsafe and unsound banking
agencies' appraisal regulations and is otherwise acceptable.
practices. Deficiencies will require corrective action.
Independence of the Appraisal and Evaluation Function -
Appraisal and Evaluation Program - An institution's board
Because the appraisal and evaluation process is an integral
of directors is responsible for reviewing and adopting
component of the credit underwriting process, it should be
policies and procedures that establish an effective real estate
isolated from influence by the institution's loan production
appraisal and evaluation program. Effective programs:
process. An appraiser and an individual providing
evaluation services should be independent of the loan and
• Establish selection criteria and procedures to evaluate collection functions of the institution and have no interest,
and monitor the ongoing performance of individuals financial or otherwise, in the property or the transaction. In
who perform appraisals or evaluations; addition, individuals independent from the loan production
• Provide for the independence of the person area should oversee the selection of appraisers and
performing appraisals or evaluations; individuals providing evaluation services. If absolute lines
• Identify the appropriate appraisal for various lending of independence cannot be achieved, an institution must be
transactions; able to clearly demonstrate that it has prudent safeguards to
• Establish criteria for contents of an evaluation; isolate its collateral evaluation process from influence or
interference from the loan production process. That is, no

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single person should have sole authority to render credit partially leased buildings, non-market lease terms, and
decisions on loans which they ordered or reviewed tract developments with unsold units. This standard is
appraisals or evaluations. designed to avoid having appraisals prepared using
unrealistic assumptions and inappropriate methods.
The agencies recognize, however, that it is not always For federally related transactions, an appraisal is to
possible or practical to separate the loan and collection include the current market value of the property in its
functions from the appraisal or evaluation process. In some actual physical condition and subject to the zoning in
cases, such as in a small or rural institution or branch, the effect as of the date of the appraisal. For properties
only individual qualified to analyze the real estate collateral where improvements are to be constructed or
may also be a loan officer, other officer, or director of the rehabilitated, the regulated institution may also
institution. To ensure their independence, such lending request a prospective market value based on stabilized
officials, officers, or directors abstain from any vote or occupancy or a value based on the sum of retail sales.
approval involving loans on which they performed an However, the sum of retail sales for a proposed
appraisal or evaluation. development is not the market value of the
development for the purpose of the agencies' appraisal
Transactions That Require Appraisals - Although the regulations. For proposed developments that involve
agencies' appraisal regulations exempt certain categories of the sale of individual houses, units, or lots, the
real estate-related financial transactions from the appraisal appraiser must analyze and report appropriate
requirements, most real estate transactions over $400,000 deductions and discounts for holding costs, marketing
($500,000 for commercial real estate transactions) are costs and entrepreneurial profit. For proposed and
considered federally related transactions and thus require rehabilitated rental developments, the appraiser must
appraisals. A "federally related transaction" means any real make appropriate deductions and discounts for items
estate-related financial transaction, in which the agencies such as leasing commission, rent losses, and tenant
engage, contract for, or regulate and that requires the improvements from an estimate based on stabilized
services of an appraiser. An agency also may impose more occupancy;
stringent appraisal requirements than the appraisal • Be based upon the definition of market value set forth
regulations require, such as when an institution's troubled in the regulation. Each appraisal must contain an
condition is attributable to real estate loan underwriting estimate of market value, as defined by the agencies'
problems. appraisal regulations; and
• Be performed by state licensed or certified appraisers
Minimum Appraisal Standards - The agencies' appraisal in accordance with requirements set forth in the
regulations include five minimum standards for the regulation.
preparation of an appraisal. The appraisal must:
Appraisal Options - An appraiser typically uses three
• Conform to generally accepted appraisal standards as market value approaches to analyze the value of a property
evidenced by the Uniform Standards of Professional cost, income, and sales market. The appraiser reconciles the
Appraisal Practice (USPAP) promulgated by the results of each approach to estimate market value. An
Appraisal Standards Board (ASB) of the Appraisal appraisal will discuss the property's recent sales history and
Foundation unless principles of safe and sound contain an opinion as to the highest and best use of the
banking require compliance with stricter standards. property. An appraiser must certify that he/she has
Although allowed by USPAP, the agencies' appraisal complied with USPAP and is independent. Also, the
regulations do not permit an appraiser to appraise any appraiser must disclose whether the subject property was
property in which the appraiser has an interest, direct inspected and whether anyone provided significant
or indirect, financial or otherwise; assistance to the person signing the appraisal report.
• Be written and contain sufficient information and
analysis to support the institution's decision to engage An institution may engage an appraiser to perform either a
in the transaction. As discussed below, appraisers Complete or Limited Appraisal. When performing a
have available various appraisal development and Complete Appraisal assignment, an appraiser must comply
report options; however, not all options may be with all USPAP standards - without departing from any
appropriate for all transactions. A report option is binding requirements - and specific guidelines when
acceptable under the agencies' appraisal regulations estimating market value. When performing a Limited
only if the appraisal report contains sufficient Appraisal, the appraiser elects to invoke the Departure
information and analysis to support an institution's Provision which allows the appraiser to depart, under
decision to engage in the transaction. limited conditions, from standards identified as specific
• Analyze and report appropriate deductions and guidelines. For example, in a Limited Appraisal, the
discounts for proposed construction or renovation, appraiser might not utilize all three approaches to value;

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however, departure from standards designated as binding appraiser is not always necessary. Instead, less formal
requirements is not permitted. There are numerous binding evaluations of the real estate may suffice for transactions
requirements which are detailed in the USPAP. Use of the that are exempt from the agencies' appraisal requirements.
USPAP Standards publication as a reference is Additionally, prudent institutions establish criteria for
recommended. The book provides details on each appraisal obtaining appraisals or evaluations for safety and soundness
standard and advisory opinions issued by the Appraisal reasons for transactions that are otherwise exempt from the
Standards Board. agencies' appraisal regulations.

An institution and appraiser must concur that use of the Evaluation Content - Prudent standards for preparing
Departure Provision is appropriate for the transaction before evaluations typically require that evaluations:
the appraiser commences the appraisal assignment. The
appraiser must ensure that the resulting appraisal report will • Be written;
not mislead the institution or other intended users of the • Include the preparer's name, address, and signature,
appraisal report. The agencies do not prohibit the use of a and the effective date of the evaluation;
Limited Appraisal for a federally related transaction, but the • Describe the real estate collateral, its condition, its
agencies believe that institutions should be cautious in their current and projected use;
use of a Limited Appraisal because it will be less thorough • Describe the source(s) of information used in the
than a Complete Appraisal. analysis;
• Describe the analysis and supporting information; and
Complete and Limited Appraisal assignments may be • Provide an estimate of the real estate's market value,
reported in three different report formats: a Self-Contained with any limiting conditions.
Report, a Summary Report, or a Restricted Report. The
major difference among these three reports relates to the An appropriate evaluation report includes calculations,
degree of detail presented in the report by the appraiser. The supporting assumptions, and, if utilized, a discussion of
Self-Contained Appraisal Report provides the most detail, comparable sales. Documentation should be sufficient to
while the Summary Appraisal Report presents the allow an institution to understand the analysis, assumptions,
information in a condensed manner. The Restricted Report and conclusions. An institution's own real estate loan
provides a capsulated report with the supporting details portfolio experience and value estimates prepared for recent
maintained in the appraiser's files. loans on comparable properties might provide a basis for
evaluations.
The agencies believe that the Restricted Report format will
not be appropriate to underwrite a significant number of An appropriate evaluation provides an estimate of value to
federally related transactions due to the lack of sufficient assist the institution in assessing the soundness of the
supporting information and analysis in the appraisal report. transaction. Prudent practices may include more detailed
However, it might be appropriate to use this type of evaluations as an institution engages in more complex real
appraisal report for ongoing collateral monitoring of an estate-related financial transactions, or as its overall
institution's real estate transactions and under other exposure increases. For example, an evaluation for a home
circumstances when an institution's program requires an equity loan might be based primarily on information derived
evaluation. from a sales data services organization or current tax
assessment information, while an evaluation for an income-
Moreover, since the institution is responsible for selecting producing real estate property describes the current and
the appropriate appraisal report to support its underwriting expected use of the property and includes an analysis of the
decisions, its program should identify the type of appraisal property's rental income and expenses.
report that will be appropriate for various lending
transactions. The institution's program should consider the Qualifications of Evaluation Providers - Individuals who
risk, size, and complexity of the individual loan and the prepare evaluations should have real estate-related training
supporting collateral when determining the level of or experience and knowledge of the market relevant to the
appraisal development and the type of report format that subject property. Based upon their experience and training,
will be ordered. When ordering an appraisal report, professionals from several fields may be qualified to
institutions may want to consider the benefits of a written prepare evaluations of certain types of real estate collateral.
engagement letter that outlines the institution's expectations Examples include individuals with appraisal experience,
and delineates each party's responsibilities, especially for real estate lenders, consultants or sales persons, agricultural
large, complex, or out-of-area properties. extension agents, or foresters. Well-managed institutions
document the qualifications and experience level of
Transactions That Require Evaluations - A formal opinion individuals whom the institution deems acceptable to
of market value prepared by a state licensed or certified

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perform evaluations. An institution might also augment its to repair damaged property, because these funds would be
in-house expertise and hire an outside party familiar with a used to restore the damaged property to its original
certain market or a particular type of property. Although condition. If a loan workout involves modification of the
not required, an institution may use state licensed or terms and conditions of an existing credit, including
certified appraisers to prepare evaluations. As such, acceptance of new or additional real estate collateral, which
Limited Appraisals reported in a Summary or Restricted facilitates the orderly collection of the credit or reduces the
format may be appropriate for evaluations of real estate- institution's risk of loss, a reappraisal or reevaluation may
related financial transactions exempt from the agencies' be prudent, even if it is obtained after the modification
appraisal requirements. occurs.

Valid Appraisals and Evaluations - The institution may use An institution may engage in a subsequent transaction based
an existing appraisal or evaluation to support a subsequent on documented equity from a valid appraisal or evaluation,
transaction, if the institution documents that the existing if the planned future use of the property is consistent with
estimate of value remains valid. Therefore, a prudent the use identified in the appraisal or evaluation. If a
appraisal and evaluation program includes criteria to property, however, has reportedly appreciated because of a
determine whether an existing appraisal or evaluation planned change in use of the property, such as rezoning, an
remains valid to support a subsequent transaction. Criteria appraisal would be required for a federally related
for determining whether an existing appraisal or evaluation transaction, unless another exemption applied.
remains valid will vary depending upon the condition of the
property and the marketplace, and the nature of any Program Compliance - Appropriate appraisal and
subsequent transaction. Factors that could cause changes to evaluation programs establish effective internal controls
originally reported values include: the passage of time; the that promote compliance with the program's standards. An
volatility of the local market; the availability of financing; individual familiar with the appraisal regulations should
the inventory of competing properties; improvements to, or ensure that the institution's appraisals and evaluations
lack of maintenance of, the subject property or competing comply with the appraisal regulations and the institution's
surrounding properties; changes in zoning; or program. Typically, loan administration files document this
environmental contamination. The institution must compliance review, although a detailed analysis or
document the information sources and analyses used to comprehensive analytical procedures are not required for
conclude that an existing appraisal or evaluation remains every appraisal or evaluation. For some loans, the
valid for subsequent transactions. compliance review may be part of the loan officer's overall
credit analysis and may take the form of either a narrative
Renewals, Refinancings, and Other Subsequent or a checklist. Examiners should determine whether
Transactions - The agencies' appraisal regulations generally corrective action for noted deficiencies was undertaken by
allow appropriate evaluations of real estate collateral in lieu the individual who prepared the appraisal or evaluation.
of an appraisal for loan renewals and refinancings; however,
in certain situations an appraisal is required. If new funds Effective appraisal and evaluation programs have
are advanced in excess of reasonable closing costs, an comprehensive analytical procedures that focus on certain
institution is expected to obtain a new appraisal for the types of loans, such as large-dollar credits, loans secured by
renewal of an existing transaction when there is a material complex or specialized properties, non-residential real
change in market conditions or in the physical aspects of the estate construction loans, or out-of-area real estate. These
property that threatens the institution's real estate collateral comprehensive analytical procedures are typically designed
protection. to verify that the methods, assumptions, and conclusions are
reasonable and appropriate for the transaction and the
The decision to reappraise or reevaluate the real estate property. These procedures provide for a more detailed
collateral should be guided by the regulatory exemption for review of selected appraisals and evaluations prior to the
renewals, refinancings, and other subsequent transactions. final credit decision. The individual(s) performing these
Loan workouts, debt restructurings, loan assumptions, and reviews should have the appropriate training or experience,
similar transactions involving the addition or substitution of and be independent of the transaction.
borrowers may qualify for the exemption for renewals,
refinancings, and other subsequent transactions. Use of this Appraisers and persons performing evaluations are
exemption depends on the condition and quality of the loan, responsible for any deficiencies in their reports. Deficient
the soundness of the underlying collateral and the validity reports should be returned to them for correction.
of the existing appraisal or evaluation. Unreliable appraisals or evaluations should be replaced
prior to the final credit decision. Examiners should be
A reappraisal would not be required when an institution mindful that changes to an appraisal's estimate of value are
advances funds to protect its interest in a property, such as permitted only as a result of a review conducted by an

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appropriately qualified state licensed or certified appraiser to accommodate large loan requests which would otherwise
in accordance with Standard III of USPAP. exceed lending limits, diversify risk, and improve liquidity.
Participating banks are able to compensate for low local
Portfolio Monitoring - The institution also typically loan demand or invest in large loans without servicing
develops criteria for obtaining reappraisals or reevaluations burdens and origination costs. If not appropriately
as part of a program of prudent portfolio review and structured and documented, a participation loan can present
monitoring techniques, even when additional financing is unwarranted risks to both the seller and purchaser of the
not being contemplated. Examples of such types of loan. Examiners should determine the nature and adequacy
situations include large credit exposures and out-of-area of the participation arrangement as well as analyze the credit
loans. quality of the loan.

Referrals - Financial institutions are encouraged to make Accounting

referrals directly to state appraiser regulatory authorities
when a state licensed or certified appraiser violates USPAP, The proper accounting treatment for loan participations is
applicable state law, or engages in other unethical or governed by ASC Topic 860, Transfers and Servicing, that
unprofessional conduct. Examiners finding evidence of applies to the transferor (seller) of assets and the transferee
unethical or unprofessional conduct by appraisers will (purchaser).
forward their findings and recommendations to their
supervisory office for appropriate disposition and referral to Before considering whether the conditions for a sale have
the state, as necessary. been met, the transfer of a portion of an entire financial asset
must first meet the definition of a participating interest.
Examination Treatment
A participating interest in an entire financial asset, as
All apparent violations of the appraisal regulation should be defined in ASC Topic 860, has all of the following
described in the schedule of violations of laws and characteristics:
regulations. Management's comments and any
commitments for correcting the practices that led to the • From the date of transfer, it must represent a
apparent violation should be included. Violations that are proportionate (pro-rata) ownership interest in the
technical in nature and do not impact the value conclusion entire financial asset;
generally should not require a new appraisal. (These • From the date of the transfer, all cash flows received
technical violations should not be relisted in subsequent from the entire financial asset, except any cash flows
examinations.) Since the point of an appraisal is to help allocated as compensation for servicing or other
make sound loan underwriting decisions, getting an services performed (which must not be subordinated
appraisal on a loan already made simply to fulfill the and must not significantly exceed an amount that
requirements of the appraisal regulation, would be of little would fairly compensate a substitute service provider
benefit. However, an institution should be expected to should one be required), must be divided
obtain a new appraisal on a loan in violation of the appraisal proportionately among the participating interest
regulation when there is a safety and soundness reason for holders in an amount equal to their share of
such action. For example, construction loans and lines of ownership;
credit need to have the value of the real estate reviewed • The rights of each participating interest holder
frequently in order for the institution to properly manage the (including the lead lender) must have the same
credit relationship. A new appraisal might also be needed priority, no interest is subordinated to another interest,
to determine the proper classification for examination and no participating interest holder has recourse to the
purposes of a collateral dependent loan. lead lender or another participating interest holder
other than standard representations and warranties and
Loan Participations ongoing contractual servicing and administration
obligations; and
A loan participation is a sharing or selling of ownership • No party has the right to pledge or exchange the entire
interests in a loan between two or more financial financial asset unless all participating interest holders
institutions. Normally, a lead institution originates the loan agree to do so.
and sells ownership interests to one or more participating
banks at the time the loan is closed. The lead (originating) If the financial asset meets the definition of a participating
institution retains a partial interest in the loan, holds all loan interest, the institution must then determine if the
documentation in its own name, services the loan, and deals participating interest qualifies for sale treatment. The sale
directly with the customer for the benefit of all participants. criteria focus on whether or not control is effectively
Properly structured, loan participations allow selling banks transferred to the purchaser.

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A transfer of an entire financial asset, a group of financial may affect the accounting treatment of a participation
assets, or a participating interest in an entire financial asset depending upon the date that the participation is transferred
in which the transferor surrenders control over those to another institution. Implicit recourse provisions would
financial assets shall be accounted for as a sale if and only not affect the financial reporting treatment of a participation
if all of the following conditions are met: because the accounting standards look to the contractual
terms of asset transfers in determining whether or not the
• The transferred financial assets have been isolated criteria necessary for sales accounting treatment have been
from the seller, meaning that the purchaser's interest in met. Although implicit recourse provisions would not affect
the loan is presumptively beyond the reach of the the accounting treatment of a loan participation, they may
seller and its creditors, even in bankruptcy or other affect the risk-based capital treatment of a participation.
receivership;
• Each purchaser has the right to pledge or exchange its If an originating selling institution has transferred a loan
interest in the loan, and there are no conditions that participation to a participating institution with recourse on
both constrain the purchaser from taking advantage of or before December 31, 2001, the existence of the recourse
that right to pledge or exchange and provide more obligation in and of itself does not preclude sale accounting
than a trivial benefit to the seller; and for the transfer. If a loan participation transferred with
• The seller or their agents do not maintain effective recourse on or before December 31, 2001, meets the three
control over the transferred financial assets. Examples conditions then in effect for the transferor to have
of a seller maintaining effective control include an surrendered control over the transferred assets, the transfer
agreement that both entitles and obligates the seller to should be accounted for as a sale for financial reporting
repurchase or redeem the purchaser's interest in the purposes. However, a loan participation sold with recourse
loan prior to the loan's maturity, an agreement that is subject to the banking agencies’ risk-based capital
provides the seller with the unilateral ability to cause requirements.
the purchaser to return its interest in the loan to the
seller (other than through a cleanup call), or an If an originating selling institution transfers a loan
agreement that permits the purchaser to require the participation with recourse on or after January 1, 2002, the
seller to repurchase its interest in the loan at a price so participation generally will not be considered isolated from
favorable to the purchaser that it is probable that the the originating lender in an FDIC receivership. Section
purchaser will require the seller to repurchase. 360.6 of the FDIC Rules and Regulations limits the FDIC's
ability to reclaim loan participations transferred without
Right to Repurchase recourse as defined in the regulations, but does not limit the
FDIC's ability to reclaim loan participations transferred
Some loan participation agreements may give the seller a with recourse. Under Section 360.6, a participation subject
contractual right to repurchase the participated interest in to an agreement that requires the originating lender to
the loan at any time. In this case, the seller's right to repurchase the participation or to otherwise compensate the
repurchase the participation effectively provides the seller participating institution due to a default on the underlying
with a call option on a specific asset that would preclude loan is considered a participation with recourse. As a result,
sale accounting if the asset is not readily obtainable in the a loan participation transferred with recourse on or after
marketplace. If a loan participation agreement contains January 1, 2002, generally should be accounted for as a
such a provision, freestanding or attached, it constrains the secured borrowing and not as a sale for financial reporting
purchaser from pledging or exchanging its participating purposes. This means that the originating lender should not
interest, and results in the seller maintaining effective remove the participation from its loan assets on the balance
control over the participating interest. In such cases, the sheet, but should report the loan participation as a secured
transfer would be accounted for as a secured borrowing. borrowing.

For additional information on the transfer of loan Call Report Treatment

participations refer to the Call Report Glossary entry:
“Transfers of Financial Assets”. When a loan participation meets the definition of a
participating interest and the conditions for sale treatment
Recourse Arrangements are met, the seller removes the participated interest in the
loan from the balance sheet. The purchaser reports the
Recourse arrangements may, or may not, preclude loan participating interest in “Loans” in the Report of Condition,
participations from being accounted for as sales for and in Call Report Schedule RC-C - Loans and Lease
financial reporting purposes. The date of the participation Financing Receivables, based upon collateral, borrower, or
and the formality of the recourse provision affect the purpose. When a loan participation does not meet the
accounting for the transaction. Formal recourse provisions definition of a participating interest, or if a transfer of a

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participating interest does not meet all of the conditions for transaction, comprehensive participation agreements
sale accounting, the transfer must be reported as a secured specifically include the following considerations:
borrowing with a pledge of collateral. In these situations,
because the transferred loan participation does not qualify • The obligation of the lead institution to furnish timely
for sale accounting, the transferring institution must credit information and to provide notification of
continue to report the transferred participation (as well as material changes in the borrower's status;
the retained portion of the loan) in “Loans” in the Report of • Requirements that the lead institution consult with
Condition, based upon collateral, borrower, and purpose. participants prior to modifying any loan, guaranty, or
As a consequence, the transferred loan participation should security agreements and before taking any action on
be included in the originating lender’s loans and leases for defaulted loans;
purposes of determining the appropriate level for the • The specific rights and remedies available to the lead
institution’s allowance for loan and lease losses. The and participating banks upon default of the borrower;
transferring institution should also report the transferred • Resolution procedures when the lead and participating
loan participation as a secured borrowing in “Other banks cannot agree on the handling of a defaulted
Borrowed Money” in the Report of Condition. loan;
• Resolution of any potential conflicts between the lead
Independent Credit Analysis institution and participants in the event that more than
one loan to the borrower defaults; and
An institution purchasing a participation loan is expected to • Provisions for terminating the agency relationship
perform the same degree of independent credit analysis on between the lead and participating banks upon such
the loan as if it were the originator. To determine if a events as insolvency, breach of duty, negligence, or
participation loan meets its credit standards, a participating misappropriation by one of the parties.
institution must obtain all relevant credit information and
details on collateral values, lien status, loan agreements and Participations Between Affiliated Institutions
participation agreements before a commitment is made to
purchase. The absence of such information may be Examiners should ascertain that banks do not relax their
evidence that the participating institution has not been credit standards when dealing with affiliated institutions and
prudent in its credit decision. that participation loans between affiliated institutions
comply with Section 23A of the Federal Reserve Act. The
During the life of the participation, the participant should Federal Reserve Board’s staff has interpreted that the
monitor the servicing and the status of the loan. In order to purchase of a participation loan from an affiliate is exempt
exercise control of its ownership interest, a purchasing from Section 23A provided that the commitment to
institution must ascertain that the selling institution will purchase is obtained by the affiliate before the loan is
provide complete and timely credit information on a consummated by the affiliate, and the decision to participate
continuing basis. is based upon the institution's independent evaluation of the
creditworthiness of the loan. If these criteria are not strictly
The procedures for purchasing loan participations should be met, the loan participation could be subject to the qualitative
provided for in the institution's formal lending policy. The and/or quantitative restrictions of Section 23A. Refer to the
criteria for participation loans should be consistent with that Related Organizations Section of this Manual which
for similar direct loans. The policy would normally require describes transactions with affiliates.
the complete analysis of the credit quality of obligations to
be purchased, determination of value and lien status of Sales of 100 Percent Loan Participations
collateral, and the maintenance of full credit information for
the life of the participation. In some cases, depository institutions structure loan
originations and participations with the intention of selling
Participation Agreements 100 percent of the underlying loan amount. Certain 100
percent loan participation programs raise unique safety and
A participation loan can present unique problems if the soundness issues that should be addressed by an
borrower defaults, the lead institution becomes insolvent, or institution’s policies, procedures, and practices.
a party to the participation arrangement does not perform as
expected. These contingencies should be considered in a If not appropriately structured, these 100 percent
written participation agreement. The agreement should participation programs can present unwarranted risks to the
clearly state the limitations the originating and participating originating institution including legal, and compliance risks.
banks impose on each other and the rights all parties retain. Therefore, agreements to mitigate these risks clearly state
In addition to the general terms of the participation the limitations the originating and participating institutions

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impose on each other and the rights all parties retain. This Thus, examiners should verify that institutions maintain an
typically includes the originating institution stating that loan environmental risk program to evaluate the potential
participants are participating in loans and are not investing adverse effect of environmental contamination on the value
in a business enterprise. The policies of an institution of real property and the potential environmental liability
engaged in these originations typically address safety and associated with the real property. An effective
soundness concerns and include criteria to address: environmental risk program aids management’s decision-
making process by establishing procedures for identifying
• The program’s objectives – these should be of a and evaluating potential environmental concerns associated
commercial nature (structured as commercial with lending practices and other actions relating to real
undertakings and not as investments in securities). property.
• The plan of distribution – participants should be
limited to sophisticated financial and commercial Examiners should determine whether the board of directors
entities and sophisticated persons and the reviews and approves the program periodically and
participations should not be sold directly to the public. designates a senior officer knowledgeable in environmental
• The credit requirements applicable to the borrower - matters to be responsible for program implementation.
the originating institution should structure 100% loan Examiners should assess whether the environmental risk
participation programs only for borrowers who meet program is commensurate with the institution’s operations.
the originating institution’s credit requirements. That is, institutions that have a heavier concentration of
• Access afforded program participants to financial loans to higher risk industries or localities of known
information on the borrower - the originating contamination may require a more elaborate and
institution should allow potential loan participants to sophisticated environmental risk program than institutions
obtain and review appropriate credit and other that lend more to lower risk industries or localities. For
information to enable the participants to make an example, loans collateralized by 1- to 4-family residences
informed credit decision. normally have less exposure to environmental liability than
loans to finance industrial properties.
Environmental Risk Program
Elements of an Effective Environmental Risk Program
The potential adverse effect of environmental
The environmental risk program typically provides for staff
contamination on the value of real property and the potential
training, sets environmental policy guidelines and
for liability under various environmental laws are important
procedures, requires an environmental review or analysis
factors for institution management to consider in evaluating
during the application or due diligence process, includes
real estate transactions and making loans secured by real
loan documentation standards, and establishes appropriate
estate. Institutions that establish appropriate environmental
environmental risk assessment safeguards in loan workout
risk programs lower their potential liability for certain types
situations and foreclosures.
of environmental risks and penalties per the Comprehensive
Environmental Response, Compensation and Liability Act
Training
of 1980 (CERCLA). 1
The environmental risk program generally incorporates
An appropriate environmental risk program is consistent
training sufficient to ensure that the environmental risk
with the safety and soundness standards prescribed in
program is implemented and followed, and that the
Appendix A to Part 364 of the FDIC Rules and Regulations.
appropriate personnel have the knowledge and experience
The environmental risk program enables institution
to identify and evaluate potential environmental concerns
management to make an informed lending decision and to
that might affect the institution, including its interests in real
assess risk, as necessary, and helps provide for
property. Such training programs typically address
consideration of the nature and value of any underlying
circumstances where the complexity of the environmental
collateral. Such a program also is consistent with the real
issue is beyond the expertise of the institution’s staff to
estate lending standards prescribed in Part 365 of the
adequately assess by instructing staff to consult legal
FDIC’s Rules and Regulations relating to compliance with
counsel, environmental consultants, or other qualified
all real estate related laws and regulations, which include
experts.
the CERCLA.

1
See CERCLA, as amended by the Superfund Amendments and et seq., and the Asset Conservation, Lender Liability, and Deposit
Reauthorization Act of 1986, 42 U.S.C. §§ 9601 et seq., the Resource Insurance Protection Act of 1996 (Asset Conservation Act).
Conservation and Recovery Act of 1976, as amended, 42 U.S.C. §§ 6901

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Policies EPA All Appropriate Inquiry Rule – In January 2002,

Congress amended the CERCLA to establish, among
Loan policies and written procedures typically address other things, additional protections from cleanup
environmental issues pertinent to the institution’s specific liability for a new owner of a property. The bona fide
lending activities. For example, the lending policy may prospective purchaser provision establishes that a
identify the types of environmental risks associated with person may purchase property with the knowledge that
industries and real estate in the institution’s trade area, the property is contaminated without being held
provide guidelines for conducting an analysis of potential potentially liable for the cleanup of contamination at
environmental liability, and describe procedures for the the property.
resolution of potential environmental concerns. Procedures
for the resolution of environmental concerns might also be The new owner must meet certain statutory
developed for credit monitoring, loan workout situations, requirements to qualify as a bona fide prospective
and foreclosures. purchaser and, prior to the date of acquiring the
property, undertake “all appropriate inquiries” into the
Environmental Risk Analysis prior ownership and uses of the property.

Examiners should determine whether management In November 2005, the EPA promulgated its
conducts an initial environmental risk analysis during the “Standards and Practices for All Appropriate Inquiries”
application process prior to making a loan. An appropriate final rule (EPA All Appropriate Inquiry Rule) which
analysis helps management to minimize potential establishes the standards and practices that are
environmental liability and facilitates implementation of necessary to meet the requirements for an “all
appropriate mitigation strategies prior to closing a loan. appropriate inquiry” into the prior ownership and uses
Much of the needed information may be gathered by the of a property. The All Appropriate Inquiry Rule
account officer when interviewing the loan applicant became effective on November 1, 2006.
concerning his or her business activities. Some institutions
use the loan application to request relevant environmental An environmental evaluation of the property that meets
information, such as the present and past uses of the the standards and practices of the EPA All Appropriate
property and the occurrence of any contacts by federal, state Inquiry Rule will provide the borrower with added
or local governmental agencies about environmental protection from CERCLA cleanup liability, provided
matters. For some transactions, the loan officer or other the borrower meets the requirements to be a bona fide
representative of an institution may visit the site to evaluate purchaser and other statutory requirements. This
whether there is obvious visual evidence of environmental protection, however, is limited to CERCLA and does
concerns; such visits are usually documented in the loan not apply to the Resource Compensation and Recovery
file. Act (RCRA), including liability associated with
underground storage tanks, and other federal
Structured Environmental Risk Assessment environmental statutes, and, depending on state law,
state environmental statutes. In addition, such an
Whenever the application, interview, or visitation indicates environmental evaluation may provide a more detailed
a possible environmental concern, examiners should assessment of the property than an evaluation that does
determine whether a more detailed structured investigation not conform to the EPA All Appropriate Inquiry Rule.
was conducted by a qualified individual. This investigation
may include surveying prior owners of the property, Examiner’s should determine whether, as part of its
researching past uses of the property, inspecting the site and environmental risk analysis of any particular extension
contiguous parcels, and reviewing company records for past of credit, a lender evaluates whether it is appropriate or
use or disposal of hazardous materials. A review of public necessary to require the borrower to perform an
records and contact with federal and state environmental environmental evaluation that meets the standards and
protection agencies often helps institution management practices of the EPA All Appropriate Inquiry Rule.
determine whether the borrower has been cited for This decision involves judgment and is made on a case-
violations concerning environmental laws or if the property by-case basis considering the risk characteristics of the
has been identified on federal and state lists of real property transaction, the type of property, and the environmental
with significant environmental contamination. Examiners information gained during an initial environmental risk
should also determine whether the institution’s policies and analysis. If indications of environmental concern are
procedures consider the Environmental Protection known or discovered during the loan application
Agency’s (EPA) “All Appropriate Inquiry Rule.” process, an institution may decide to require the
borrower to perform an environmental evaluation that

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LOANS Section 3.2

meets the requirements of the EPA All Appropriate and guarantors for environmental liability associated with
Inquiry Rule. the real property collateral.

The decision to require the borrower to perform a Involvement in the Borrower’s Operations
property assessment that meets the requirements of the
EPA All Appropriate Inquiry Rule is generally made in Under CERCLA and many state environmental cleanup
the context of the institution’s environmental risk statutes, an institution may have an exemption from
program. An effective environmental risk program is environmental liability as the holder of a security interest in
generally designed to ensure management makes an real property collateral. Examiners should determine
informed judgment about potential environmental risk whether institution management, in monitoring a loan, takes
and considers such risks in its overall consideration of action to resolve environmental situations and evaluates
risks associated with the extension of credit. In whether its actions may constitute “participating in the
addition, an institution’s environmental risk program management” of the business located on the real property
may be tailored to its lending practices. Thus, a lender collateral within the meaning of CERCLA. If its actions are
makes its decision concerning when and under what considered participation in the management, the institution
circumstances to require the borrower to perform an may lose its exemption from liability under CERCLA or
environmental property assessment based on its similar state statutes.
environmental risk program. Individuals who
administer an institution’s environmental risk program Foreclosure
are typically familiar with these statutory elements.
More information concerning the EPA All Appropriate A lender’s exposure to environmental liability may increase
Rule can be found on the EPA website at significantly if it takes title to real property held as
http://www.epa.gov/brownfields/regneg.htm. collateral. Examiners should determine whether
management evaluates the potential costs and liability for
Monitoring environmental contamination in conjunction with an
assessment of the value of the collateral in reaching a
Examiners should assess whether the environmental risk decision to take title to the property by foreclosure or other
assessment continues during the life of the loan, including means. Based on the type of property involved, a lender
monitoring the borrower and the real property collateral for often includes as part of this evaluation of potential
potential environmental concerns. Examiners should assess environmental liability, an assessment of the property that
whether loan officers are aware of changes in the business meets the requirements of the EPA All Appropriate Inquiry
activities of a borrower that may result in a significant Rule.
increase in risk of environmental liability associated with
real property collateral. When there is a potential for Examination Procedures
environmental contamination to adversely affect the value
of the collateral, management might exercise its rights under Examiners should review an institution’s environmental
the loan covenants to require the borrower to resolve the risk program as part of the examination of lending and
environmental condition and to take actions to protect the investment activities. When analyzing individual credits,
value of the real property. examiners should review the institution’s compliance with
its environmental risk program. Failure to establish or
Loan Documentation comply with an appropriate environmental program is to be
criticized.
Loan documents typically include language to safeguard the
institution against potential environmental losses and ←
liabilities. Such language might require that the borrower LOAN PROBLEMS
comply with environmental laws, disclose information
about the environmental status of the real property It would be impossible to list all sources and causes of
collateral, and grant the institution the right to acquire problem loans. They cover a multitude of mistakes an
additional information about potential hazardous institution may permit a borrower to make, as well as
contamination by inspecting the collateral property for mistakes directly attributable to weaknesses in the
environmental concerns. The loan documents might also institution's credit administration and management. Some
provide the institution the right to call the loan, refuse to well-constructed loans may develop problems due to
extend funds under a line of credit, or foreclose if hazardous unforeseen circumstances on the part of the borrower;
contamination is discovered. The loan documents might however, institution management must endeavor to protect
also call for an indemnity of the institution by the borrower a loan by every means possible. One or more of the items

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LOANS Section 3.2

in the following list is often basic to the development of loan Overlending

problems.
It is almost as serious, from the standpoint of ultimate
Many of these items may also be indicative of potential losses, to lend a sound financial risk too much money as it
institution fraud and/or insider abuse. Additional is to lend to an unsound risk. Loans beyond the reasonable
information on the warning signs and suggested areas for capacity of the borrower to repay invariably lead to the
investigation are included in the Bank Fraud and Insider development of problem loans.
Abuse Section of this Manual.
Failure to Establish or Enforce Liquidation
Poor Selection of Risks Agreements
Problems in this area may reflect the absence of sound Loans granted without a well-defined repayment program
lending policies, and/or management's lack of sound credit violate a fundamental principle of sound lending.
judgment in advancing certain loans. The following are Regardless of what appears to be adequate collateral
general types of loans which may fall within the category of protection, failure to establish at inception or thereafter
poor risk selection. It should be kept in mind that these enforce a program of repayment almost invariably leads to
examples are generalizations, and the examiner must weigh troublesome and awkward servicing problems, and in many
all relevant factors in determining whether a given loan is instances is responsible for serious loan problems including
indeed a poor risk. eventual losses. This axiom of sound lending is important
not only from the lender's standpoint, but also the
• Loans to finance new and untried business ventures borrower’s.
which are inadequately capitalized.
• Loans based more upon the expectation of
Incomplete Credit Information
successfully completing a business transaction than on
sound worth or collateral.
Lending errors frequently result because of management's
• Loans for the speculative purchase of securities or failure to obtain and properly evaluate credit information.
goods. Adequate comparative financial statements, income
• Collateral loans made without adequate margin of statements, cash flow statements and other pertinent
security. statistical support should be available. Other essential
• Loans made because of other benefits, such as the information, such as the purpose of the borrowing and
control of large deposit balances, and not based upon intended plan or sources of repayment, progress reports,
sound worth or collateral. inspections, memoranda of outside information and loan
• Loans made without adequate owner equity in conferences, correspondence, etc., should be contained in
underlying real estate security. the institution's credit files. Failure of an institution's
• Loans predicated on collateral which has questionable management to give proper attention to credit files makes
liquidation value. sound credit judgment difficult if not impossible.
• Loans predicated on the unmarketable stock of a local
corporation when the institution is at the same time Overemphasis on Loan Income
lending directly to the corporation. Action which may
be beneficial to the institution from the standpoint of Misplaced emphasis upon loan income, rather than
the one loan may be detrimental from the standpoint soundness, almost always leads to the granting of loans
of the other loan. possessing undue risk. In the long run, unsound loans
• Loans which appear to be adequately protected by usually are far more expensive than the amount of revenue
collateral or sound worth, but which involve a they may initially produce.
borrower of poor character risk and credit reputation.
• Loans which appear to be adequately protected by Self-Dealing
collateral, but which involve a borrower with limited
or unassessed repayment ability. Pronounced self-dealing practices are often present in
• An abnormal amount of loans involving serious problem institution situations and in banks which
out-of-territory borrowers (excluding large banks fail. Such practices with regard to loans are found in the
properly staffed to handle such loans). form of overextensions of unsound credit to insiders, or
• Loans involving brokered deposits or link financing. their interests, who have improperly used their positions to
obtain unjustified loans. Active officers, who serve at the
pleasure of the ownership interests, are at times subjected to
pressures which make it difficult to objectively evaluate

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LOANS Section 3.2

such loans. Loans made for the benefit of ownership the compromise of sound credit principles and acquisition
interests that are carried in the name of a seemingly of unsound loans. The ultimate cost of unsound loans
unrelated party are sometimes used to conceal self-dealing outweighs temporary gains in growth, income and
loans. influence.

Technical Incompetence Potential Problem Indicators by Document

Technical incompetence usually is manifested in The preceding discussions describe various practices or
management's inability to obtain and evaluate credit conditions which may serve as a source or cause of weak
information or put together a well-conceived loan package. loans. Weak loans resulting from these practices or
Management weaknesses in this area are almost certain to conditions may manifest themselves in a variety of ways.
lead to eventual loan losses. Problems can also develop While it is impossible to provide a complete detailing of
when management, technically sound in some forms of potential "trouble indicators", the following list, by
lending, becomes involved in specialized types of credit in document, may aid the examiner in identifying potential
which it lacks expertise and experience. problem loans during the examination process.

Lack of Supervision • Debt Instrument - Delinquency; irregular payments

or payments not in accordance with terms; unusual or
Loan problems encountered in this area normally arise for frequently modified terms; numerous renewals with
one of two reasons: little or no principal reduction; renewals that include
interest; and extremely high interest rate in relation to
• Absence of effective active management supervision comparable loans granted by the institution or the
of loans which possessed reasonable soundness at going rate for such loans in the institution's market
inception. Ineffective supervision almost invariably area.
results from lack of knowledge of a borrower's affairs • Liability Ledger - Depending on the type of debt,
over the life of the loan. It may well be coupled with failure to amortize in a regular fashion over a
one or more of the causes and sources of loan reasonable period of time, e.g., on an annual basis,
problems previously mentioned. seasonally, etc.; and a large number of out-of-territory
• Failure of the board and/or senior management to borrowers, particularly in cases where these types of
properly oversee subordinates to determine that sound loans have increased substantially since the previous
policies are being carried out. examination.
• Financial and Operating Statements - Inadequate or
Lack of Attention to Changing Economic declining working capital position; excessive volume
or negative trend in receivables; unfavorable level or
Conditions negative trend in inventory; no recent aging of
receivables, or a marked slowing in receivables;
Economic conditions, both national and local, are
drastic increase in volume of payables; repeated and
continuously changing, management must be responsive to
increasing renewals of carry-over operating debt;
these changes. This is not to suggest that lending policies
unfavorable trends in sales and profits; rapidly
should be in a constant state of flux, nor does it suggest that
expanding expenses; heavy debt-to-worth level and/or
management should be able to forecast totally the results of
deterioration in this relationship; large dividend or
economic changes. It does mean, however, that bankers
other payments without adequate or reasonable
should realistically evaluate lending policies and individual
earnings retention; and net worth enhancements
loans in light of changing conditions. Economic downturns
resulting solely from reappraisal in the value of fixed
can adversely affect borrowers' repayment potential and can
assets.
lessen an institution's collateral protection. Reliance on
• Cash Flow Documentation - Absence of cash flow
previously existing conditions as well as optimistic hopes
statements or projections, particularly as related to
for economic improvement can, particularly when coupled
newly established term borrowers; projections
with one or more of the causes and sources of loan problems
indicating an inability to meet required interest and
previously mentioned, lead to serious loan portfolio
principal payments; and statements reflecting that cash
deterioration.
flow is being provided by the sale of fixed assets or
nonrecurring situations.
Competition • Correspondence and Credit Files - Missing and/or
inadequate collateral or loan documentation, such as
Competition among financial institutions for growth, financial statements, security agreements, guarantees,
profitability, and community influence sometimes results in

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LOANS Section 3.2

assignments, hypothecation agreements, mortgages, whether activities conducted by a branch, subsidiary,

appraisals, legal opinions and title insurance, property affiliate, or third party partner warrant particular attention.
insurance, loan applications; evidence of borrower
credit checks; corporate or partnership borrowing Examiners are to consider the historical adequacy of the
authorizations; letters indicating that a borrower has institution’s policies and practices relative to credit
suffered financial difficulties or has been unable to underwriting, administration, and loan grading for each
meet established repayment programs; and documents significant loan type. Examiners should review recent
that reveal other unfavorable factors relative to a line management reports and Board or committee packages
of credit. before selecting a targeted sample to determine whether the
• Collateral - Collateral evidencing a speculative loan Board of Directors and officers are receiving sufficient
purpose or collateral with inferior marketability information to remain abreast of emerging trends and
characteristics (single purpose real estate, restricted changes in the loan portfolio’s risk profile.
stock, etc.) which has not been compensated for by
other reliable repayment sources; and collateral of Selecting the Sample
questionable value acquired subsequent to the
extension of the credit. The size and composition of the loan sample should be
commensurate with the quantity of credit risk, the adequacy
← of risk management practices, and the institution’s financial
SELECTING A LOAN REVIEW SAMPLE condition and business model. There are no established or
IN A RISK-FOCUSED EXAMINATION expected levels of minimum or maximum coverage, or
penetration, ratios for loan review samples. Rather,
Examiners are expected to select a sample of loans that is of examiners should use judgment when determining the focus
sufficient size, scope, and variety to enable them to reach and extent of loan sampling. Ensuring that the appropriate
reliable conclusions about the aforementioned aspects of an types of loans are in the sample is more meaningful than
institution’s overall lending function, and tailor the loan how much of the overall portfolio is reviewed.
review sample based on an institution’s business model,
complexity, risk profile, and lending activities. The review Examiners must make the most efficient use of resources,
may include all sources of credit exposure arising from and should sample loans of sufficient size, scope and variety
loans and leases, including guarantees, letters of credit, and to enable them to form reliable conclusions about overall
other commitments. credit quality and the adequacy of credit risk management
and governance. Examiners’ understanding of the
institution’s business model, risk profile, complexity,
Assessing the Risk Profile external and internal reports, as well as discussions with
management, will be highly instrumental in identifying
Prior to developing the loan review sample, examiners are
loans to be included in a judgmental sample. Examiners
to assess the risk profile of the loan portfolio by reviewing
may also leverage the institution’s external and internal loan
the institution’s management reports and policies as well as
reviews when determining the loan sample. For example,
agency available information. This includes evaluating
examiners may want to exclude loans already covered in
concerns detailed in prior Reports of Examination (ROEs),
institution loan reviews or follow-up on loans identified as
issues detailed in the institution’s loan exception reports and
problems in the loan reviews.
internal loan reviews, and the historical accuracy of
independent credit rating or grading systems. The Uniform
If information gathered indicates weaknesses in
Bank Performance Report provides information relative to
underwriting or credit administration practices, or if the
loan mix and recent trends, such as concentrations of credit,
institution is engaging in lending activities with significant
rapid growth, and loan yields higher or lower than peer in
or increasing risk, the examiner should select a robust
different portfolio segments. Examiners are also to consider
sample to fully assess the risk areas. Conversely,
changes in local economic or market conditions that could
institutions with stable, well-managed loan functions
affect the portfolio’s risk profile. Numerous economic tools
exhibiting few signs of change should have more
and resources are available to examiners to assist in
streamlined reviews, focusing more on newer originations
planning the loan review.
and less on loans that were deemed of satisfactory quality at
previous examinations that continue to perform as agreed.
As part of the examination planning activities, examiners
However, in all instances, examiners should sample enough
are to consider whether management has implemented any
credits, including new and various-sized credits, to assess
material changes in the institution’s business lines, loan
the adequacy of asset quality, underwriting practices, and
products, lending policies, markets, or personnel since the
credit risk management, in order to support ROE findings
prior examination. Additionally, examiners should consider
and assigned ratings.

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LOANS Section 3.2

Nonhomogeneous Loan Sample more appropriate for Discuss Only or not included at all,
which would allow more resources to be focused on new
Nonhomogeneous loans include acquisition, development originations or other loans not previously reviewed that
and construction, commercial real estate, commercial and would help evaluate areas of significant or growing risk.
industrial, and agricultural credits. The nonhomogeneous
loan sample generally should include a sufficient number of Homogeneous Pool Sample
loans to transaction test various segments of the loan
portfolio, but it is unnecessary to review all loans in a Assessing the quality of homogeneous retail consumer
particular segment. Rather, the loan review should credit on a loan-by-loan basis is burdensome for both
encompass enough loans in each portfolio segment to institutions and examiners due to portfolios generally
support examination conclusions about credit quality and consisting of a large number of loans with relatively low
credit management practices relative to underwriting balances. Instead, examiners should assess the quality of
standards and credit administration. retail consumer loans based on the borrowers’ repayment
performance. Examiners generally should review and
In general, a sampling of loans in the following segments classify retail consumer loans in accordance with the
should be included in the overall loan review sample, as procedures discussed later in this section under the
applicable to a particular institution: Interagency Retail Credit Classification Policy subheading.

• Adversely classified or listed for Special Mention in The EIC may supplement the classification of retail loans
prior ROEs. with a direct review of larger consumer loans or by sampling
• Delinquent, nonaccrual, impaired, or various segments when the risk assessment supports doing
renegotiated/restructured (particularly loans with so. Such an expansion may be warranted when
multiple renewals). homogeneous lending is a major business line of the
• Internally adversely classified by the institution. institution or when examiners note rapid growth, new
• Rated by the institution as a marginally acceptable products, weaknesses in the loan review or audit program,
credit. weaknesses in management information systems, or other
• Subject to prior supervisory criticism or corrective factors that raise concerns. The EIC also may conduct
actions. limited transaction testing to focus on specific risk
• Upgraded or removed from internal adverse characteristics, such as the underwriting standards for new
classification since the prior examination, to ensure loans or the revised terms granted in workouts or
that procedures for managing the watch list are modifications.
appropriate.
• Insider loans (directors, officers, employees, principal Sampling for Trading and Derivatives Activities. At
shareholders, or related interests at any insured institutions that are active in such markets, examiners
depository institution). should include an assessment of credit exposures arising
from matching loans with derivatives (generally swaps or
• Originated since the prior examination, including
forwards) to hedge a particular type of risk. For example,
those in new or expanding product lines.
an institution can use a swap to contractually exchange a
• Participations.
stream of floating-rate payments for a stream of fixed-rate
• Out of territory. payments to hedge interest rate risk. Such activities create
• Part of a significant credit concentration or growth a credit exposure relative to both the loan and the derivative.
area. When warranted, examiners should review a sufficient
• Flagged for potential fraud. number of loan relationships with these exposures to assess
• Contain outlier characteristics (e.g. higher risk loans, the institution’s overall exposure and management’s ability
credits with policy exceptions). to prudently manage derivatives activities. Examiners also
• Originated by specific loan officers, particularly those should review a sample of credit relationships established
with known concerns or weaknesses. solely for the purpose of facilitating derivatives activities.
• In geographic areas exposed to changes in market
conditions. Determining the Depth of the Review
• Various sized loans (larger, mid-sized, and smaller
loan amounts). Examiners should assign loans to be reviewed into one of
three groupings, “In Scope” (full review), “Discuss Only”
As part of a risk-focused and forward-looking approach to (limited review), and, when applicable, “Group” (pooled
loan review, loans that had been reviewed at previous loans).
examinations that had sufficient performance, collateral and
documentation, and continue to amortize as agreed, may be

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LOANS Section 3.2

In Scope. This sample consists of loans that warrant the Adjusting Loan Review
most comprehensive level of review. Examiners are to
review loan files to the extent needed to assess the risk in The EIC has the flexibility, after communicating with the
the credit, conformance to lending risk management case manager and receiving concurrence of field
policies and procedures, and compliance with applicable management, to adjust the loan review sample at any point
laws and regulations. Examiners should document the during the examination based on findings. The rationale for
assessment of the borrower’s repayment capacity, collateral significant changes in the examination plan will be clearly
protection, and overall risk to the institution on individual communicated to institution management, along with any
linesheets. Documentation should also note underwriting adjustments to the breadth or depth of procedures,
exceptions, administrative weaknesses, and apparent personnel, and examination schedule.
violations.
Accepting an Institution’s Internal Ratings
For institutions with stable, well-managed loan functions, In
Scope loans should generally focus on newer originations If the institution’s internal grading system (watch list) is
and insider loans. In these situations, if certain loans from determined to be accurate and reliable, examiners can use
previous examinations are included In Scope, examiners the institution’s data for preparing the applicable
have the ability to leverage documentation from previous examination report pages and schedules, for determining the
reviews and focus on updates to the essential credit overall level of classifications, and for providing supporting
information. comments regarding the quality of the loan portfolio.
Discuss Only. This sample is to consist of loans subject to
a limited level of review, and examiners are to discuss these Loan Penetration Ratio
credits with institution management. Such discussions can
be an effective method of confirming the adequacy of loan The FDIC has not established any minimum or maximum
grading systems and credit administration practices, loan penetration ratios.
particularly when the In Scope sample indicates the
institution has adequate risk management practices, and The objectives for loan review on an examination include
when the institution has a stable, well-managed loan an analysis of credit quality through transaction testing and
function and exhibits few signs of change. Examiners an assessment of credit administration practices. Achieving
should briefly document key issues raised during these a specific loan penetration ratio is not to be the driving
discussions, but examiners do not need to complete full factor in determining the loan review sample. Rather,
linesheets. When warranted, examiners may conduct a examiners should focus on reviewing a sufficient number of
limited file review or assessment of specific work-out plans loans in various segments of the portfolio to assess overall
and performance metrics for these loans. risk in the portfolio and to support examination findings,
and then calculate the resultant loan penetration ratio for
Credits should be reallocated from Discuss Only to In Scope informational purposes only and enter the ratio in the
if management disagrees with the classification, material Summary Analysis of Examination Report.
concerns with credit underwriting or administration
practices are identified, or the EIC or Asset Manager Large Bank Loan Review
determines a more comprehensive review is warranted.
In addition to point-in-time examinations conducted at most
Group. This sample could include loans with similar risk community banks, the FDIC utilizes targeted loan reviews
characteristics that merit review on a pooled conducted under a supervisory plan, guiding a continuous
basis. Examiners generally should discuss or classify the examination program for certain institutions. These
loans not on an individual basis but as a pool, and apply the targeted programs are generally warranted to ensure
findings and conclusions to the entire Group. Examiners effective monitoring and examination activity related to
may use multiple Groups to focus on the adequacy of credit larger and more complex institutions. While the
underwriting and administration practices or to address supervisory plan and continuous examination processes and
different risk attributes in stratified segments. The Group procedures may differ in some respects from the point in
sample may be appropriate for specific categories of time approach, the principles contained in the preceding
homogeneous retail consumer credit, such as automobile, loan review instructions are applicable to examination
credit card, or residential mortgage loans. activities for all institutions supervised by the FDIC.

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LOANS Section 3.2

← customer's deposit account or other related institution

LOAN EVALUATION AND records. The examiner should also determine the purpose
of the credit and the expected source of repayment.
CLASSIFICATION
Examination Procedures regarding loan portfolio analysis
Loan Evaluation are included in the ED Modules.
To properly analyze any credit, an examiner must acquire Additional Transaction Testing
certain fundamental information about a borrower's
financial condition, purpose and terms of the borrowing, Part of the assessment of loan administration practices
and prospects for its orderly repayment. The process includes transaction testing. Such testing can verify that the
involved in acquiring the foregoing information will institution’s written policies and practices are implemented
necessarily vary with the type and sophistication of records as intended. Testing can also be useful in detecting potential
utilized by the institution. fraudulent or irregular activity. In particular, examiners are
required to verify a sample of loans that paid off during or
Review of Files and Records just prior to the on-site portion of the examination. Such
verification would include reviewing the loan file, payoff
Commercial loan liability ledgers or comparable subsidiary tickets, and tracing the source of funds for the payoff.
records vary greatly in quality and detail. Generally, they
will provide the borrower's total commercial loan liability Loan Discussion
to the institution, and the postings thereto will depict a
history of the debt. Collateral records should be scrutinized The examiner must comprehensively review all data
to acquire the necessary descriptive information and to collected on the individual loans. In most banks, this review
ascertain that the collateral held to secure the notes is as should allow the majority of loans to be passed without
transcribed. criticism, eliminating the need for discussing these lines
with the appropriate institution officer(s). No matter how
Gathering credit information is an important process and thoroughly the supporting loan files have been reviewed,
should be done with care to obtain the essential information, there will invariably be a number of loans which will require
which will enable the examiner to appraise the loans additional information or discussion before an appropriate
accurately and fairly. Failure to obtain and record pertinent judgment can be made as to their credit quality, relationship
information contained in the credit files can reflect to other loans, proper documentation, or other
unfavorably on examiners, and a good deal of examiner and circumstances related to the overall examination of the loan
loan officer time can be saved by carefully analyzing the portfolio. Such loans require discussion with the
files. Ideally, credit files will also contain important appropriate institution officer(s) as do other loans for which
correspondence between the institution and the borrower. adequate information has been assembled to indicate that
However, this is not universally the case; in some instances, classification or Special Mention is warranted.
important correspondence is deliberately lodged in separate
files because of its sensitive character. Correspondence Proper preparation for the loan discussion is essential, and
between the institution and the borrower can be especially the following points should be given due consideration by
valuable to the examiner in developing added insight into the examiner. Loans which have been narrowed down for
the status of problem credits. discussion should be reviewed in depth to insure a
comprehensive grasp of all factual material. Careful
Verification of loan proceeds is one of the most valuable advance preparation can save time for all concerned.
and effective loan examining techniques available to the Particularly with regard to large, complicated lines, undue
examiner and often one of the most ignored. This reliance should not be placed on memory to cover important
verification process can disclose fraudulent or fictitious points in loan discussion. Important weaknesses and salient
notes, misapplication of funds, loans made for the benefit or points to be covered in discussion, questions to be asked,
accommodation of parties other than the borrower of record, and information to be sought should be noted. The loan
or utilization of loans for purposes other than those reflected discussion should not involve discussion of trivialities since
in the institution's files. Verification of the disbursement of the banker's time is valuable, and it is no place for
a selected group of large or unusual loans, particularly those antagonistic remarks and snide comments directed at loan
subject to classification or Special Mention and those officers. The examiner should listen carefully to what the
granted under circumstances which appear illogical or banker has to say, and concisely and accurately note this
incongruous is important. However, it is more important to information. Failure to do so can result in inaccuracies and
carry the verification process one step further to the make follow-up at the next examination more difficult.
apparent utilization of loan proceeds as reflected by the

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LOANS Section 3.2

Loan Analysis Loan classifications are expressions of different degrees of

a common factor, risk of nonpayment. All loans involve
In the evaluation of individual loans, the examiner should some risk, but the degree varies greatly. It is incumbent
weigh carefully the information obtained and arrive at a upon examiners to avoid classification of sound loans. The
judgment as to the credit quality of the loans under review. practice of lending to sound businesses or individuals for
Each loan is appraised on the basis of its own reasonable periods is a legitimate banking function.
characteristics. Consideration is given to the risk involved Adverse classifications should be confined to those loans
in the project being financed; the nature and degree of which are unsafe for the investment of depositors' funds.
collateral security; the character, capacity, financial
responsibility, and record of the borrower; and the If the internal grading system is determined to be accurate
feasibility and probability of its orderly liquidation in and reliable, examiners can use the institution’s data for
accordance with specified terms. The willingness and preparing the applicable examination report pages and
ability of a debtor to perform as agreed remains the primary schedules, for determining the overall level of
measure of a loan’s risk. This implies that the borrower classifications, and for providing supporting comments
must have earnings or liquid assets sufficient to meet regarding the quality of the loan portfolio. If the internal
interest payments and provide for reduction or liquidation classifications are overly conservative, examiners should
of principal as agreed at a reasonable and foreseeable date. make appropriate adjustments and include explanations in
However, it does not mean that borrowers must at all times the report’s comments.
be in a position to liquidate their loans, for that would defeat
the original purpose of extending credit. The Uniform Agreement on the Classification and
Appraisal of Securities Held by Depository Institutions was
Following analysis of specific credits, it is important that the issued on October 29, 2013, by the Office of the
examiner ascertain whether troublesome loans result from Comptroller of the Currency, the FDIC, and the Federal
inadequate lending and collection policies and practices or Reserve Board. The attachment to this interagency
merely reflect exceptions to basically sound credit policies statement provides definitions of Substandard, Doubtful,
and practices. In instances where troublesome loans exist and Loss categories used for adversely classifying
due to ineffective lending practices and/or inadequate institution assets. Amounts classified Loss should be
supervision, it is quite possible that existing problems will promptly eliminated from the institution's books.
go uncorrected and further loan quality deterioration may
occur. Therefore, the examiner should not only identify Uniform guidelines have been established by the FDIC
problem loans, but also ascertain the cause(s) of these regarding the Report of Exam treatment of assets classified
problems. Weaknesses in lending policies or practices Doubtful. The general policy is not to require charge-off or
should be stressed, along with possible corrective measures, similar action for Doubtful classifications. Examiners
in discussions with the institution's senior management should make a statement calling for an institution to
and/or the directorate and in the Report of Examination. charge-off a portion of loans classified Doubtful only when
state law or policy requires. Further, any such statement
Loan Classification should be clear as to the intended purpose of bringing the
institution into conformity with those state requirements.
To quantify and communicate the results of the loan review, An exception is made for formal actions under Section 8 of
the examiner must arrive at a decision as to which loans are the FDI Act.
to be subjected to criticism and/or comment in the
examination report. Adversely classified loans are allocated A statement addressing the chargeoff of loans classified
on the basis of risk to three categories: Substandard; Loss is a required comment Report of Examination when
Doubtful; and Loss. the amount is material. Amounts classified Loss should be
promptly eliminated from the institution's books.
Other loans of questionable quality, but involving
insufficient risk to warrant classification, are designated as Definitions
Special Mention loans. Loans lacking technical or legal
support, whether or not adversely classified, should be • Substandard - Substandard loans are inadequately
brought to the attention of the institution's management. If protected by the current sound worth and paying
the deficiencies in documentation are severe in scope or capacity of the obligor or of the collateral pledged, if
volume, a schedule of such loans should be included in the any. Loans so classified must have a well-defined
Report of Examination. weakness or weaknesses that jeopardize the
liquidation of the debt. They are characterized by the
distinct possibility that the institution will sustain
some loss if the deficiencies are not corrected.

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• Doubtful - Loans classified Doubtful have all the technical exceptions are a factor in scheduling loans for
weaknesses inherent in those classified Substandard Special Mention.
with the added characteristic that the weaknesses
make collection or liquidation in full, on the basis of Careful identification of loans which properly belong in this
currently known facts, conditions, and values, highly category is important in determining the extent of risk in the
questionable and improbable. loan portfolio and providing constructive criticism for
• Loss - Loans classified Loss are considered institution management. While Special Mention Assets
uncollectible and of such little value that their should not be combined with adversely classified assets,
continuance as bankable assets is not warranted. This their total should be considered in the analysis of asset
classification does not mean that the loan has quality and management, as appropriate.
absolutely no recovery or salvage value but rather it is
not practical or desirable to defer writing off this The nature of this category precludes inclusion of smaller
basically worthless asset even though partial recovery lines of credit unless those loans are part of a large grouping
may be effected in the future. listed for related reasons. Comments on loans listed for
Special Mention in the Report of Examination should be
There is a close relationship between classifications, and no drafted in a fashion similar to those for adversely classified
classification category should be viewed as more important loans. There is no less of a requirement upon the examiner
than the other. The uncollectibility aspect of Doubtful and to record clearly the reasons why the loan is listed. The
Loss classifications makes their segregation of obvious major thrust of the comments should be towards achieving
importance. The function of the Substandard classification correction of the deficiencies identified.
is to indicate those loans which are unduly risky and, if
unimproved, may be a future hazard. Troubled Commercial Real Estate Loan
Classification Guidelines
A complete list of adversely classified loans is to be
provided to management, either during or at the close of an
Additional classification guidelines have been developed to
examination.
aid the examiner in classifying troubled commercial real
estate loans. These guidelines are intended to supplement
Special Mention Assets the uniform guidelines discussed above. After performing
an analysis and evaluation of the project, the examiner must
Definition - A Special Mention asset has potential determine the classification of any exposure.
weaknesses that deserve management's close attention. If
left uncorrected, these potential weaknesses may result in The following guidelines are to be applied in instances
deterioration of the repayment prospects for the asset or in where the obligor is devoid of other reliable means of
the institution's credit position at some future date. Special repayment, with support of the debt provided solely by the
Mention assets are not adversely classified and do not project. If other types of collateral or other sources of
expose an institution to sufficient risk to warrant adverse repayment exist, the project should be evaluated in light of
classification. these mitigating factors.
Use of Special Mention - The Special Mention category is • Substandard - Any such troubled real estate loan or
not to be used as a means of avoiding a clear decision to portion thereof should be classified Substandard when
classify a loan or pass it without criticism. Neither should well-defined weaknesses are present which jeopardize
it include loans listed merely "for the record" when the orderly liquidation of the debt. Well-defined
uncertainties and complexities, perhaps coupled with large weaknesses include a project's lack of marketability,
size, create some reservations about the loan. If weaknesses inadequate cash flow or collateral support, failure to
or evidence of imprudent handling cannot be identified, complete construction on time or the project's failure
inclusion of such loans in Special Mention is not justified. to fulfill economic expectations. They are
characterized by the distinct possibility that the
Ordinarily, Special Mention credits have characteristics institution will sustain some loss if the deficiencies are
which corrective management action would remedy. Often not corrected.
weak origination and/or servicing policies are the cause for • Doubtful - Doubtful classifications have all the
the Special Mention designation. Examiners should not weaknesses inherent in those classified Substandard
misconstrue the fact that most Special Mention loans with the added characteristic that the weaknesses
contain management correctable deficiencies to mean that make collection or liquidation in full, on the basis of
loans involving merely technical exceptions belong in this currently known facts, conditions and values, highly
category. However, instances may be encountered where questionable and improbable. A Doubtful

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classification may be appropriate in cases where more past due. Nonaccrual loans may include both current
significant risk exposures are perceived, but Loss and past due loans. In the case of installment credit, a loan
cannot be determined because of specific reasonable will not be considered overdue until at least two monthly
pending factors which may strengthen the credit in the payments are delinquent. The same will apply to real estate
near term. Examiners should attempt to identify Loss mortgage loans, term loans or any other loans payable on
in the credit where possible thereby limiting the regular monthly installments of principal and interest.
excessive use of the Doubtful classification.
• Loss - Advances in excess of calculated current fair Some modification of the overdue criteria may be necessary
value which are considered uncollectible and do not because of applicable state law, joint examinations, or
warrant continuance as bankable assets. There is little unusual circumstances surrounding certain kinds of loans or
or no prospect for near term improvement and no in individual loan situations. It will always be necessary for
realistic strengthening action of significance pending. the examiner to ascertain the institution's renewal and
extension policies and procedures for collecting interest
Technical Exceptions prior to determining which loans are overdue, since such
practices often vary considerably from institution to
Deficiencies in documentation of loans should be brought institution. This is important not only to validate which
to the attention of management for remedial action. Failure loans are actually overdue, but also to evaluate the
of management to effect corrections may lead to the soundness of such policies. Standards for renewal should
development of greater credit risk in the future. Moreover, be aimed at achieving an orderly liquidation of loans and
an excessive number of technical exceptions may be a not at maintaining a low ratio of past due paper through
reflection on management's quality and ability. Inclusion of unwarranted extensions or renewals.
the schedule "Assets With Credit Data or Collateral
Documentation Exceptions" and various comments in the In larger departmentalized banks or banks with large branch
Report of Examination is appropriate in certain systems, it may be informative to analyze delinquencies by
circumstances. Refer to the Report of Examination determining the source of overdue loans by department or
Instructions for further guidance. branch. This is particularly true if a large volume of overdue
loans exist. The production of schedules delineating
Past Due and Nonaccrual overdue loans by department or branch is encouraged if it
will aid in pinpointing the source of a problem or be
otherwise informative.
Overdue loans are not necessarily subject to adverse
criticism. Nevertheless, a high volume of overdue loans
Continuing to accrue income on assets which are in default
almost always indicates liberal credit standards, weak
as to principal and interest overstates an institution's assets,
servicing practices, or both. Because loan renewal and
earnings, and capital. Call Report Instructions indicate that
extension policies vary among banks, comparison of their
where the period of default of principal or interest equals or
delinquency ratios may be misleading. A more significant
exceeds 90 days, the accruing of income should be
method of evaluating this factor lies in determination of the
discontinued unless the asset is well-secured and in process
trend within the institution under examination, keeping in
of collection. A debt is well-secured if collateralized by
mind the distortion resulting from seasonal influences,
liens on or pledges of real or personal property, including
economic conditions, or the timing of examinations. It is
securities that have a realizable value sufficient to discharge
important for the examiner to carefully consider the makeup
the debt in full; or by the guarantee of a financially
and reasons for the volume of overdue loans. Only then can
responsible party. A debt is in process of collection if
it be determined whether the volume of past due paper is a
collection is proceeding in due course either through legal
significant factor reflecting adversely on the quality or
action, including judgment enforcement procedures, or, in
soundness of the overall loan portfolio or the efficiency and
appropriate circumstances, through collection efforts not
quality of management. It is important that overdue loans
involving legal action which are reasonably expected to
be computed on a uniform basis. This allows for
result in repayment of the debt or its restoration to a current
comparison of overdue totals between examinations and/or
status. Institutions are strongly encouraged to follow this
with other banks.
guideline not only for reporting purposes but also
bookkeeping purposes. There are several exceptions,
The Report of Examination includes information on
modifications and clarifications to this general standard.
overdue and nonaccrual loans. Loans which are still
First, consumer loans and real estate loans secured by
accruing interest but are past their maturity or on which
one-to-four family residential properties are exempt from
either interest or principal is due and unpaid (including
the nonaccrual guidelines. Nonetheless, these exempt loans
unplanned overdrafts) are separated by loan type into two
should be subject to other alternative methods of evaluation
distinct groupings: 30 to 89 days past due and 90 days or
to assure the institution's net income is not materially

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overstated. Second, any state statute, regulation or rule that is payable only if certain conditions are met (e.g.,
which imposes more stringent standards for nonaccrual of sufficient cash flow from property). For other TDRs, the
interest should take precedence over these instructions. "B" note may be contingently forgiven (e.g., note "B" is
Third, reversal of previously accrued but uncollected forgiven if note "A" is paid in full). In other instances, an
interest applicable to any asset placed in a nonaccrual status, institution would have granted a concession (e.g., rate
and treatment of subsequent payments as either principal or reduction) to the troubled borrower, but the "B" note would
interest, should be handled in accordance with generally remain a contractual obligation of the borrower. Because
accepted accounting principles. Acceptable accounting the "B" note is not reflected as an asset on the institution's
treatment includes reversal of all previously accrued but books and is unlikely to be collected, for reporting purposes
uncollected interest against appropriate income and balance the "B" note could be viewed as a contingent receivable.
sheet accounts.
Institutions may return the "A" note to accrual status
Nonaccrual Loans That Have Demonstrated provided the following conditions are met:
Sustained Contractual Performance
• The restructuring qualifies as a TDR as defined by
The following information applies to borrowers who have ASC Subtopic 310-40, Receivables – Troubled Debt
resumed paying the full amount of scheduled contractual Restructurings by Creditors and there is economic
interest and principal payments on loans that are past due substance to the restructuring.
and in nonaccrual status. Although a prior arrearage may • The portion of the original loan represented by the "B"
not have been eliminated by payments from a borrower, the note has been charged-off. The charge-off must be
borrower may have demonstrated sustained performance supported by a current, well-documented credit
over a period of time in accordance with the contractual evaluation of the borrower's financial condition and
terms. Such loans to be returned to accrual status, even prospects for repayment under the revised terms. The
though the loans have not been brought fully current, charge-off must be recorded before or at the time of
provided two criteria are met: the restructuring.
• The "A" note is reasonably assured of repayment and
• All principal and interest amounts contractually due of performance in accordance with the modified
(including arrearage) are reasonably assured of terms.
repayment within a reasonable period, and • In general, the borrower must have demonstrated
• There is a sustained period of repayment performance sustained repayment performance (either immediately
(generally a minimum of six months) by the borrower, before or after the restructuring) in accordance with
in accordance with the contractual terms involving the modified terms for a reasonable period prior to the
payments of cash or cash equivalents. date on which the "A" note is returned to accrual
status. A sustained period of payment performance
When the regulatory reporting criteria for restoration to generally would be a minimum of six months and
accrual status are met, previous charge-offs taken would not involve payments in the form of cash or cash
have to be fully recovered before such loans are returned to equivalents.
accrual status. Loans that meet the above criteria would
continue to be disclosed as past due, as appropriate, until Under existing reporting requirements, the "A" note would
they have been brought fully current. be disclosed as a TDR. In accordance with these
requirements, if the "A" note yields a market rate of interest
Troubled Debt Restructuring - Multiple Note and performs in accordance with the restructured terms,
such disclosures could be eliminated in the year following
Structure restructuring. To be considered a market rate of interest, the
interest rate on the "A" note at the time of restructuring must
The basic example of a trouble debt restructuring (TDR) be equal to or greater than the rate that the institution is
multiple note structure is a troubled loan that is restructured willing to accept for a new receivable with comparable risk.
into two notes where the first or "A" note represents the
portion of the original loan principal amount which is
expected to be fully collected along with contractual
Interagency Retail Credit Classification
interest. The second part of the restructured loan, or "B" Policy
note, represents the portion of the original loan that has been
charged-off. The quality of consumer credit soundness is best indicated
by the repayment performance demonstrated by the
Such TDRs generally may take any of three forms. In borrower. Because retail credit generally is comprised of a
certain TDRs, the "B" note may be a contingent receivable large number of relatively small balance loans, evaluating

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the quality of the retail credit portfolio on a loan-by-loan • One-to-four family residential real estate loans and
basis is burdensome for the institution being examined and home equity loans that are delinquent 90 days or more
examiners. To promote an efficient and consistent credit with loan-to-value ratios greater than 60 percent,
risk evaluation, the FDIC, the Comptroller of Currency, the should be classified Substandard.
Federal Reserve and the former Office of Thrift Supervision
adopted the Uniform Retail Credit Classification and When an open- or closed-end residential or home equity
Account Management Policy (Retail Classification Policy.) loan is 180 days past due, a current assessment of value
should be made and any outstanding loan balance in excess
Retail credit includes open-end and closed-end credit of the fair value of the property, less cost to sell, should be
extended to individuals for household, family, and other classified Loss.
personal expenditures. It includes consumer loans and
credit cards. For purposes of the policy, retail credit also Properly secured residential real estate loans with loan-to-
includes loans to individuals secured by their personal value ratios equal to or less than 60 percent are generally not
residence, including home equity and home improvement classified based solely on delinquency status. Home equity
loans. loans to the same borrower at the same institution as the
senior mortgage loan with a combined loan-to-value ratio
In general, retail credit should be classified based on the equal to or less than 60 percent should not be classified.
following criteria: However, home equity loans where the institution does not
hold the senior mortgage, that are delinquent 90 days or
• Open-end and closed-end retail loans past due 90 more should be classified Substandard, even if the loan-to-
cumulative days from the contractual due date should value ratio is equal to, or less than, 60 percent.
be classified Substandard.
• Closed-end retail loans that become past due 120 If an institution can clearly document that the delinquent
cumulative days and open-end retail loans that loan is well secured and in the process of collection, such
become past due 180 cumulative days from the that collection will occur regardless of delinquency status,
contractual due date should be charged-off. The then the loan need not be classified. A well secured loan is
charge-off should be taken by the end of the month in collateralized by a perfected security interest in, or pledges
which the 120-or 180-day time period elapses. of, real or personal property, including securities, with an
• Unless the institution can clearly demonstrate and estimated fair value, less cost to sell, sufficient to recover
document that repayment on accounts in bankruptcy is the recorded investment in the loan, as well as a reasonable
likely to occur, accounts in bankruptcy should be return on that amount. In the process of collection means
charged off within 60 days of receipt of notification of that either a collection effort or legal action is proceeding
filing from the bankruptcy court or within the and is reasonably expected to result in recovery of the loan
delinquency time frames specified in this balance or its restoration to a current status, generally within
classification policy, whichever is shorter. The the next 90 days.
charge-off should be taken by the end of the month in
which the applicable time period elapses. Any loan This policy does not preclude an institution from adopting
balance not charged-off should be classified an internal classification policy more conservative than the
Substandard until the borrower re-establishes the one detailed above. It also does not preclude a regulatory
ability and willingness to repay (with demonstrated agency from using the Doubtful or Loss classification in
payment performance for six months at a minimum) certain situations if a rating more severe than Substandard
or there is a receipt of proceeds from liquidation of is justified. Loss in retail credit should be recognized when
collateral. the institution becomes aware of the loss, but in no case
• Fraudulent loans should be charged off within 90 days should the charge-off exceed the time frames stated in this
of discovery or within the delinquency time frames policy.
specified in this classification policy, whichever is
shorter. The charge-off should be taken by the end of Re-aging, Extensions, Deferrals, Renewals, or Rewrites
the month in which the applicable time period elapses.
• Loans of deceased persons should be charged off Re-aging is the practice of bringing a delinquent account
when the loss is determined or within the delinquency current after the borrower has demonstrated a renewed
time frames adopted in this classification policy, willingness and ability to repay the loan by making some,
whichever is shorter. The charge-off should be taken but not all, past due payments. Re-aging of open-end
by the end of the month in which the applicable time accounts, or extensions, deferrals, renewals, or rewrites of
period elapses. closed-end accounts should only be used to help borrowers
overcome temporary financial difficulties, such as loss of
job, medical emergency, or change in family circumstances

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like loss of a family member. A permissive policy on re- payments of only $150 per month for a six-month period,
agings, extensions, deferrals, renewals, or rewrites can the loan would be $900, or three full months delinquent. An
cloud the true performance and delinquency status of the institution may use either or both methods in its portfolio,
portfolio. However, prudent use of a policy is acceptable but may not use both methods simultaneously with a single
when it is based on recent, satisfactory performance and the loan.
true improvement in a borrower's other credit factors, and
when it is structured in accordance with internal policies. Examination Considerations

The decision to re-age a loan, like any other modification of Examiners should determine whether institutions’ policies
contractual terms, should be supported in the institution's and practices consider the Retail Classification Policy,
management information systems. Adequate management understanding that there may be instances that warrant
information systems usually identify and document any loan exceptions to the general classification policy. Loans need
that is extended, deferred, renewed, or rewritten, including not be classified if the institution can document clearly that
the number of times such action has been taken. repayment will occur regardless of delinquency status.
Documentation normally shows that institution personnel Examples might include loans well secured by marketable
communicated with the borrower, the borrower agreed to collateral and in the process of collection, loans for which
pay the loan in full, and the borrower shows the ability to claims are filed against solvent estates, and loans supported
repay the loan. by valid insurance claims. Conversely, the Retail
Classification Policy does not preclude examiners from
Institutions that re-age open-end accounts should establish reviewing and classifying individual large dollar retail
a reasonable written policy and adhere to it. An account credit loans that exhibit signs of credit weakness regardless
eligible for re-aging, extension, deferral, renewal, or rewrite of delinquency status.
should exhibit the following:
In addition to reviewing loan classifications, the examiner
• The borrower should show a renewed willingness and should review the ALLL to assess whether it is at an
ability to repay the loan. appropriate level. Sound risk and account management
• The account should exist for at least nine months systems typically include:
before allowing a re-aging, extension, renewal,
referral, or rewrite. • Prudent retail credit lending policies,
• The borrower should make at least three minimum • Measures to monitor adherence to policy,
consecutive monthly payments or the equivalent lump • Detailed operating procedures, and
sum payment before an account is re-aged. Funds • Appropriate internal controls.
may not be advanced by the institution for this
purpose. Institutions lacking sound policies or failing to implement
• No loan should be re-aged, extended, deferred, or effectively follow established policies will be subject to
renewed, or rewritten more than once within any criticism.
twelve-month period; that is, at least twelve months
must have elapsed since a prior re-aging. In addition, Examination Treatment
no loan should be re-aged, extended, deferred,
renewed, or rewritten more than two times within any Use of the formula classification approach can result in
five-year period. numerous small dollar adversely classified items. Although
• For open-end credit, an over limit account may be re- these classification details are not always included in the
aged at its outstanding balance (including the over Report of Examination, an itemized list is to be left with
limit balance, interest, and fees). No new credit may management. A copy of the listing should also be retained
be extended to the borrower until the balance falls in the examination work papers.
below the designated predelinquency credit limit.
Examiner support packages are available which have built
Partial Payments on Open-End and Closed-End Credit in parameters of the formula classification policy, and
which generate a listing of delinquent consumer loans to be
Institutions should use one of two methods to recognize classified in accordance with the policy. Use of this
partial payments. A payment equivalent to 90 percent or package may expedite the examination in certain cases,
more of the contractual payment may be considered a full especially in larger banks.
payment in computing delinquency. Alternatively, the
institution may aggregate payments and give credit for any Losses are one of the costs of doing business in consumer
partial payment received. For example, if a regular installment credit departments. It is important for the
installment payment is $300 and the borrower makes examiner to give consideration to the amount and severity

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of installment loan charge-offs when examining the When a loan is impaired under ASC Subtopic 310-10, the
department. Excessive loan losses are the product of weak amount of impairment should be measured based on the
lending and collection policies and therefore provide a good present value of expected future cash flows discounted at
indication of the soundness of the consumer installment the loan’s effective interest rate (i.e., the contractual interest
loan operation. The examiner should be alert also to the rate adjusted for any net deferred loan fees or costs and
absence of installment loan charge-offs, which may indicate premium or discount existing at the origination or
that losses are being deferred or concealed through acquisition of the loan). As a practical expedient,
unwarranted rewrites or extensions. impairment may also be measured based on a loan’s
observable market price. The fair value of the collateral
Dealer lines should be scheduled in the report under the must be used if the loan is collateral dependent. An
dealer's name regardless of whether the contracts are impaired loan is collateral dependent if repayment would be
accepted with or without recourse. Any classification or expected to be provided solely by the sale or continued
totaling of the nonrecourse line can be separately identified operation of the underlying collateral.
from the direct or indirect liability of the dealer. Comments
and format for scheduling the indirect contracts will be If the measure of a loan calculated in accordance with ASC
essentially the same as for direct paper. If there is direct Subtopic 310-10 is less than the recorded investment in the
debt, comments will necessarily have to be more extensive loan (typically the face amount of the loan, plus accrued
and probably will help form a basis for the indirect interest, adjusted for any premium or discount, deferred fee
classification. or cost, less any charge-offs), impairment on that loan
should be recognized as a part of the ALLL. In general,
No general rule can be established as to the proper when the amount of the recorded investment in the loan
application of dealers' reserves to the examiner's exceeds the amount calculated under ASC Subtopic 310-10
classifications. Such a rule would be impractical because of and that amount is determined to be uncollectible, this
the many methods used by banks in setting up such reserves excess amount should be promptly charged-off against the
and the various dealer agreements utilized. Generally, ALLL. In all cases, when an impaired loan is collateral
where the institution is handling a dealer who is not dependent and the repayment of the loan is expected from
financially responsible, weak contracts warrant the sale of the collateral, any portion of the recorded
classification irrespective of any balance in the dealer's investment in the loan in excess of the fair value less cost to
reserve. Fair and reasonable judgment on the part of the sell of the collateral should be charged-off.
examiner will determine application of dealer reserves.
Troubled Debt Restructuring - The accounting for TDRs
If the amount involved would have a material impact on is set forth in ASC Subtopic 310-40, Receivables-Troubled
capital, consumer loans should be classified net of unearned Debt Restructurings by Creditors. A restructuring
income. Large business-type loans placed in consumer constitutes a troubled debt restructuring if the institution for
installment loan departments should receive individual economic or legal reasons related to the borrower’s
review and, in all cases, the applicable unearned income financial difficulties grants a concession to the borrower
discount should be deducted when such loans are classified. that it would not otherwise consider. A troubled debt
restructuring takes place when an institution grants a
Impaired Loans, Troubled Debt concession to a debtor in financial difficulty. Examiners are
Restructurings, Foreclosures, and expected to reflect all TDRs in examination reports in
accordance with this accounting guidance and institutions
Repossessions are expected to follow these principles when filing the Call
Report.
Loan Impairment – The accounting standard for impaired
loans is ASC Subtopic 310-10. A loan is impaired when, TDRs may be divided into two broad groups: those where
based on current information and events, it is probable that the borrower transfers assets to the creditor in full or partial
an institution will be unable to collect all amounts due satisfaction of the debt, which would include foreclosures;
according to the contractual terms of the loan agreement and those in which the terms of a debtor’s obligation are
(i.e., principal and interest). Impaired loans encompass all modified, which may include reduction in the stated interest
loans that are restructured in a troubled debt restructuring, rate to an interest rate that is less than the current market
including smaller balance homogenous loans that are rate for new obligations with similar risk, extension of the
typically exempt from ASC Subtopic 310-10. However, the maturity date, or forgiveness of principal or interest. A third
standard does not include loans that are measured at fair type of restructuring combines a receipt of assets and a
value or the lower of cost or fair value. modification of loan terms. A loan extended or renewed at
an interest rate equal to the current market interest rate for

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new debt with similar risk is not reported as a restructured earned over the life of the new loan. The $22,000 discount
loan for examination purposes. is accreted into interest income over the life of the loan as
long as the loan remains in accrual status.
Transfer of Assets to the Creditor - An institution that
receives assets (except long-lived assets that will be sold) The basis for this accounting approach is the assumption
from a borrower in full satisfaction of the recorded that financing the resale of the property at a concessionary
investment in the loan should record those assets at fair rate exacts an opportunity cost which the institution must
value. If the fair value of the assets received is less than the recognize. That is, unearned discount represents the present
institution’s recorded investment in the loan, a loss is value of the "imputed" interest differential between the
charged to the ALLL. When property is received in full concessionary and market rates of interest. Present value
satisfaction of an asset other than a loan (e.g., a debt accounting also assumes that both the institution and the
security), the loss should be reflected in a manner consistent third party who purchased the property are indifferent to a
with the balance sheet classification of the asset satisfied. cash sales price at the "economic value" or a higher financed
When long-lived assets that will be sold, such as real estate, price repayable over time.
are received in full satisfaction of a loan, the real estate is
recorded at its fair value less cost to sell. This fair value Modification of Terms - When the terms of a TDR provide
(less cost to sell) becomes the “cost” of the foreclosed asset. for a reduction of interest or principal, the institution should
measure any loss on the restructuring in accordance with the
To illustrate, assume an institution forecloses on a defaulted guidance for impaired loans as set forth in ASC Subtopic
mortgage loan of $100,000 and takes title to the property. If 310-10 unless the loans are measured at fair value or the
the fair value of the property at the time of foreclosure is lower of cost or fair value. The amount of impairment of
$90,000 and costs to sell are estimated at $10,000, a $20,000 the restructured loan using the appropriate measurement
loss should be immediately recognized by a charge to the method in ASC Subtopic 310-10 is reported as a component
ALLL. The cost of the foreclosed asset becomes $80,000. in determining the overall ALLL. If any amount of the
If the institution is on an accrual basis of accounting, there calculated impairment is determined to be uncollectible,
may also be adjusting entries necessary to reduce both the that amount should be promptly charged-off against the
accrued interest receivable and loan interest income ALLL.
accounts. Assume further that in order to effect sale of the
realty to a third party, the institution is willing to offer a new For example, in lieu of foreclosure, an institution chooses to
mortgage loan (e.g., of $100,000) at a concessionary rate of restructure a $100,000 loan to a borrower which had
interest (e.g., 10 percent while the market interest rate for originally been granted with an interest rate of 10 percent
new loans with similar risk is 20 percent). Before booking for 10 years. The institution and the borrower have agreed
this new transaction, the institution must establish its to capitalize the accrued interest ($10,000) into the note
"economic value" or what would be the cash price paid. balance, but the restructured terms will permit the borrower
Pursuant to ASC Subtopic 835-30, Interest – Imputation of to repay the debt over 10 years at a six percent interest rate.
Interest, the value is represented by the sum of the present The institution does not believe the loan is collateral
value of the income stream to be received from the new dependent. In this situation, the institution would determine
loan, discounted at the current market interest rate for this the amount of impairment on the TDR as the difference
type of credit, and the present value of the principal to be between the present value of the expected cash flows
received, also discounted at the current market interest rate. discounted at the 10 percent rate specified in the original
This economic value (calculated by discounting the cash contract and the recorded investment in loan of $110,000.
flows at the current market interest rate) becomes the proper This amount of the calculated impairment becomes a
carrying value for the property at its sale date. Since the component of the overall ALLL.
sales price of $78,000 is less than the property’s carrying
amount of $80,000), an additional loss has been incurred Combination Approach - In some instances, the institution
and should be immediately recognized. This additional loss may receive assets in partial rather than full satisfaction of
should be reflected in the allowance if a relatively brief a loan or security and may also agree to alter the original
period has elapsed between foreclosure and subsequent repayment terms. In these cases, the recorded investment in
resale of the property. However, the loss should be treated the loan should be reduced by the fair value of the assets
as loss on the sale of real estate if the asset has been held for received (less cost to sell, if appropriate). The remaining
a longer period. The new loan would be placed on the books recorded investment in the loan is accounted for as a TDR.
at its face value ($100,000) and the difference between the
new loan amount and the "economic value" ($78,000) is Examination Report Treatment - Examiners should
treated as unearned discount ($22,000). For examination continue to classify TDRs, including any impaired collateral
and Call Report purposes, the asset would be shown net of dependent loans, based on the definitions of Loss, Doubtful,
the unearned discount which is reduced periodically as it is and Substandard. When an impaired loan is collateral

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dependent and the loan is expected to be satisfied by the sale earnings performance and assigning the earnings
of the collateral, any portion of the recorded investment in performance rating.
the loan which exceeds the fair value of the collateral, less
cost to sell is the amount of impairment included in the Examination procedures for reviewing TDRs are included
ALLL. This is the amount of Loss on that loan that should in the ED Modules.
be promptly charged-off. For other loans that are impaired
loans, the amount of the recorded investment in the loan Report of Examination Treatment of
over the amount of the calculated impairment is recognized Classified Loans
as a component of the ALLL. However, when available
information confirms that loans and leases (including any The Items Subject to Adverse Classification page allows an
recorded accrued interest, net deferred loan fees or costs, examiner to present pertinent and readily understandable
and unamortized premium or discount) other than impaired comments related to loans which are adversely classified.
collateral dependent loans (dependent on the sale of the In addition, the Analysis of Loans Subject to Adverse
collateral), or portions thereof, are uncollectible, these Classification page permits analysis of present and previous
amounts should be promptly charged-off against the ALLL. classifications from the standpoint of source and
disposition. These loan schedules should be prepared in
An examiner should not require an additional allowance for accordance with the Report of Examination Instructions.
credit losses of impaired loans over and above what is
calculated in accordance with these standards. An additional An examiner must present, in writing, relevant and readily
allowance on impaired loans may be supported based on understandable comments related to criticized loans.
consideration of institution-specific factors, such as Therefore, a thorough understanding of all factors
historical loss experience compared with estimates of such surrounding the loan is required and only those germane to
losses and concerns about the reliability of cash flow description, collectibility, and management plans should be
estimates, the quality of an institution’s loan review included in the comments. Comments should be concise,
function, and controls over its process for estimating its but brevity is not to be accomplished by omission of
ASC Subtopic 310-10 allowance. appropriate information. Comments should be informative
and factual data emphasized. The important weaknesses of
Other Considerations - Examiners may encounter the loan should not be overshadowed by extraneous
situations where impaired loans and TDRs are identified, information which might well have been omitted. An
but the institution has not properly accounted for the ineffective presentation of a classified loan weakens the
transactions. Where incorrect accounting treatment resulted value of a Report of Examination and frequently casts doubt
in an overstatement of earnings, capital and assets, it will be on the accuracy of the classifications. The essential test of
necessary to determine the proper carrying values for these loan comments is whether they justify the classification.
assets, utilizing the best available information developed by
the examiner after consultation with institution Careful organization is an important ingredient of good loan
management. Nonetheless, proper accounting for impaired comments. Generally, loan comments should include the
loans and TDRs is the responsibility of institution following items:
management. Examiners should not spend a
disproportionate amount of time developing the appropriate
• Identification - Indicate the name and occupation or
accounting entries, but instead discuss with and require
type of business of the borrower. Cosigners,
corrective action by institution management when the
endorsers and guarantors should be identified and in
institution’s treatment is not in accordance with accepted
the case of business loans, it should be clear whether
accounting guidelines. It must also be emphasized that
the borrower is a corporation, partnership, or sole
collectibility and proper accounting and reporting are
proprietorship.
separate matters; restructuring a borrower’s debt does not
• Description - The make-up of the debt should be
ensure collection of the loan or security. As with all other
concisely described as to type of loan, amount, origin
assets, adverse classification should be assigned if analysis
and terms. The history, purpose, and source of
indicates there is risk of loss present. Examiners should take
repayment should also be indicated.
care, however, not to discourage or be critical of institution
management’s legitimate and reasonable attempts to • Collateral - Describe and evaluate any collateral,
achieve debt settlements through concessionary terms. In indicating the marketability and/or condition thereof.
many cases, restructurings offer the only realistic means for If values are estimated, note the source.
an institution to bring about collection of weak or • Financial Data - Current balance sheet information
nonearning assets. Finally, the volume of impaired loans along with operating figures should be presented, if
and restructured debts having concessionary interest rates such data are considered necessary. The examiner
should be considered when evaluating the institution’s must exercise judgment as to whether a statement

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should be detailed in its entirety. When the statement the institution as Loss assets under applicable regulatory
is relevant to the classification, it is generally more standards are conclusively presumed to have become
effective to summarize weaknesses with the entire worthless in the taxable year of the charge-offs.
statement presented. On the other hand, if the To be eligible for this accounting method for tax purposes,
statement does not significantly support or detract an institution must file a conformity election with its federal
from the loan, a very brief summarization of the income tax return. The tax regulations also require the
statement is in order. institution's primary federal supervisory authority to
• Summarize the Problem - The examiner's comments expressly determine that the institution maintains and
should explicitly point out reasons for the applies loan loss classification standards that are consistent
classification. Where portions of the line are accorded with the regulatory standards of its supervisory authority.
different classifications or are not subject to
classification, comments should clearly set forth the An institution must request an “express determination"
reasoning for the split treatment. letter before making the election. To continue using the tax-
• Management's Intentions - Comments should book conformity method, the institution must request a new
include any corrective program contemplated by letter at each subsequent examination that covers the loan
management. review process. If the examiner does not issue an "express
determination" letter at the end of such an examination, the
Examiners should avoid arbitrary or penalty classifications, institution's election of the tax-book conformity method is
nor should "conceded" or "agreed" be given as the principal revoked automatically as of the beginning of the taxable
reason for adverse classifications. Management's opinions year that includes the date of examination. However, that
and ideas should not have to be emphasized; if a examiner's decision not to issue an "express determination"
classification is well-founded, the facts will speak for letter does not invalidate an institution's election for any
themselves. If well-written, there is little need for long prior years. The supervisory authority is not required to
summary comments reemphasizing major points of the loan rescind any previously issued "express determination"
write-up. letters.

When the volume of loan classifications reaches the point When an examiner does not issue an "express
of causing supervisory concern, analysis of present and determination" letter, the institution is still allowed tax
previous classifications from the standpoint of source and deductions for loans that are wholly or partially worthless.
disposition becomes very important. For this reason, the However, the burden of proof is placed on the institution to
Analysis of Loans Subject to Adverse Classification page support its tax deductions for loan charge-offs.
should be completed in banks possessing characteristics
which present special supervisory problems; when the Examination Guidelines - Institutions are responsible for
volume or composition of adversely classified loans has requesting "express determination" letters during
changed significantly since the previous examination, examinations that cover their loan review process, i.e.,
including both upward and downward movements; and, in during safety and soundness examinations. Examiners
such other special or unusual situations as examiners deem should not alter the scope or frequency of examinations
appropriate. Generally, the page should not include merely to permit banks to use the tax-book conformity
consumer loans and overdrafts and it should be footnoted to method.
indicate that these assets are not included.
When requested by an institution that has made or intends
Issuance of "Express Determination" Letters to make the election under Section 1.166-2(d)(3) of the tax
regulations, the examiner-in-charge should issue an
to Institutions for Federal Income Tax "express determination" letter, provided the institution does
Purposes maintain and apply loan loss classification standards that are
consistent with the FDIC's regulatory standards. The letter
Tax Rules - The Internal Revenue Code and tax regulations should only be issued at the completion of a safety and
allow a deduction for a loan that becomes wholly or partially soundness examination at which the examiner-in-charge has
worthless. All pertinent evidence is taken into account in concluded that the issuance of the letter is appropriate.
determining worthlessness. Special tax rules permit a
federally supervised depository institution to elect a method An "express determination" letter should be issued to an
of accounting under which it conforms its tax accounting for institution only if:
bad debts to its regulatory accounting for loan charge-offs,
provided certain conditions are satisfied. Under these rules, • The examination indicates that the institution
loans that are charged-off pursuant to specific orders of the maintains and applies loan loss classification
institution's supervisory authority or that are classified by standards that are consistent with the FDIC's standards

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LOANS Section 3.2

regarding the identification and charge-off of such the work performed by examiners in their review of the
loans; and institution's loan loss classification standards should be
• There are no material deviations from the FDIC's maintained in the workpapers. A copy of the letter should
standards. also be forwarded to the regional office with the Report of
Examination. The issuance of an “express determination”
Minor criticisms of the institution's loan review process as letter should be noted in the Report of Examination
it relates to loan charge-offs or immaterial individual according to procedure in the Report of Examination
deviations from the FDIC's standards should not preclude Instructions. An express determination letter should not be
the issuance of an "express determination" letter. issued subsequent to the Report of Examination being
finalized and distributed to the institution.
An "express determination" letter should not be issued if:
When an examiner-in-charge concludes that the conditions
• The institution's loan review process relating to for issuing a requested "express determination" letter have
charge-offs is subject to significant criticism; not been met, the examiner-in-charge should discuss the
• Loan charge-offs reported in the Report of Condition reasons for this conclusion with the regional office. The
and Income (Call Reports) are consistently overstated examiner-in-charge should then advise institution
or understated; or management that the letter cannot be issued and explain the
• There is a pattern of loan charge-offs not being basis for this conclusion. A comment indicating that a
recognized in the appropriate year. requested "express determination" letter could not be
issued, together with a brief statement of the reasons for not
When the issuance of an "express determination" letter is issuing the letter are addressed in the Report of Examination
appropriate, it should be prepared on FDIC letterhead using Instructions.
the following format. The letter should be signed and dated
by the examiner-in-charge and provided to the institution ←
for its files. The letter is not part of the Report of CONCENTRATIONS
Examination.
Generally a concentration is a significantly large volume of
economically-related assets that an institution has advanced
Express Determination Letter for IRS Regulation 1.166- or committed to one person, entity, or affiliated group.
2(d)(3) These assets may in the aggregate present a substantial risk
to the safety and soundness of the institution. Adequate
“In connection with the most recent examination of [Name diversification of risk allows the institution to avoid the
of Bank], by the Federal Deposit Insurance Corporation, as excessive risks imposed by credit concentrations. It should
of [examination date], we reviewed the institution’s loan also be recognized, however, that factors such as location
review process as it relates to loan charge-offs. Based on and economic environment of the area limit some
our review, we concluded that the institution, as of that date, institutions' ability to diversify. Where reasonable
maintained and applied loan loss classification standards diversification realistically cannot be achieved, the resultant
that were consistent with regulatory standards regarding concentration calls for capital levels higher than the
loan charge-offs. regulatory minimums.

This statement is made on the basis of a review that was Concentrations generally are not inherently bad, but do add
conducted in accordance with our normal examination a dimension of risk which the management of the institution
procedures and criteria. It does not in any way limit or should consider when formulating plans and policies. In
preclude any formal or informal supervisory action formulating these policies, management typically addresses
(including enforcement actions) by this supervisory goals for portfolio mix and limits within the loan and other
authority relating to the institution’s loan review process or asset categories. The institution's business strategy,
the level at which it maintains its allowance for loan and management expertise and location should be considered
lease losses. when reviewing the policy. Management should also
consider the need to track and monitor the economic and
[signature] financial condition of specific geographic locations,
Examiner-in-charge industries and groups of borrowers in which the institution
[date signed] has invested heavily. All concentrations should be
monitored closely by management and receive a more
When an "express determination" letter is issued to an in-depth review than the diversified portions of the
institution, a copy of the letter as well as documentation of institution's assets. Failure to monitor concentrations can
result in management being unaware how significant

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economic events might impact the overall portfolio. This Another area of potential risk involves selling federal funds
will also allow management to consider areas where to an institution which may be acting as an intermediary
concentration reductions may be necessary. Management between the selling institution and the ultimate buying
and the board can monitor any reduction program using institution. In this instance, the intermediary institution is
accurate concentration reports. If management is not acting as agent with the true liability for repayment accruing
properly monitoring concentration levels and limits, to the third institution. Therefore, it is particularly
examiners may consider criticizing management. important that the original selling institution be aware of this
situation, ascertain the ultimate disposition of its funds, and
To establish a meaningful tracking system for be satisfied as to the creditworthiness of the ultimate buyer
concentrations of credit, financial institutions should be of the funds.
encouraged to consider the use of codes to track individual
borrowers, related groups of borrowers, industries, and Clearly, the "risk free" philosophy regarding the sale of
individual foreign countries. Financial institutions should federal funds is inappropriate. Selling banks must take the
also be encouraged to use the North American Industry necessary steps to assure protection of their position. The
Classification System (NAICS) or similar code to track examiner is charged with the responsibility of ascertaining
industry concentrations. Any monitoring program should that selling banks have implemented and adhered to policy
be reported regularly to the board of directors. directives in this regard to forestall any potentially
Refer to the Report of Examination Instructions for hazardous situations.
guidance in identifying and listing concentrations in the
examination report. Examiners should encourage management of banks
engaged in selling federal funds to implement a policy with
← respect to such activity. This policy generally would
FEDERAL FUNDS SOLD AND consider matters such as the aggregate sum to be sold at any
REPURCHASE AGREEMENTS one time, the maximum amount to be sold to any one buyer,
the maximum duration of time the institution will sell to any
one buyer, a list of acceptable buyers, and the terms under
Federal funds sold and securities purchased under
which a sale will be made. As in any form of lending,
agreement for resale represent convenient methods to
thorough credit evaluation of the prospective purchaser,
employ excess funds to enhance earnings. Federal funds are
both before granting the credit extension and on a
excess reserve balances and take the form of a one-day
continuing basis, is a necessity. Such credit analysis
transfer of funds between banks. These funds carry a
emphasizes the borrower's ability to repay, the source of
specified rate of interest and are free of the risk of loss due
repayment, and alternative sources of repayment should the
to fluctuations in market prices entailed in buying and
primary source fail to materialize. While sales of federal
selling securities. However, these transactions are usually
funds are normally unsecured unless otherwise regulated by
unsecured and therefore do entail potential credit risk.
state statutes, and while collateral protection is no substitute
Securities purchased under agreement for resale represent
for thorough credit review, it is prudent for the selling
an agreement between the buying and selling banks that
institution to consider the possibility of requiring security if
stipulates the selling institution will buy back the securities
sales agreements are entered into on a continuing basis for
sold at an agreed price at the expiration of a specified period
specific but extended periods of time, or for overnight
of time.
transactions which have evolved into longer term sales.
Where the decision is made to sell federal funds on an
Federal funds sold are not "risk free" as is often supposed,
unsecured basis, the selling institution should be able to
and the examiner will need to recognize the elements of risk
present logical reasons for such action based on conclusions
involved in such transactions. While the selling of funds is
drawn from its credit analysis of the buyer and bearing in
on a one-day basis, these transactions may evolve into a
mind the potential risk involved.
continuing situation. This development is usually the result
of liability management techniques whereby the buying
A review of federal funds sold between examinations may
institution attempts to utilize the acquired funds to support
prompt examiners to broaden the scope of their analysis of
a rapid expansion of its loan-investment posture and as a
such activity if the transactions are not being handled in
means of enhancing profits. Of particular concern to the
accordance with sound practices as outlined above. Where
examiner is that, in many cases, the selling institution will
the institution has not developed a formal policy regarding
automatically conclude that the buying institution's
the sale of federal funds or fails to conduct a credit analysis
financial condition is above reproach without proper
of the buyer prior to a sale and during a continuous sale of
investigation and analysis. If this becomes the case, the
such funds, the matter should be discussed with
selling institution may be taking an unacceptable risk
management. In such discussion, it is incumbent upon
unknowingly.
examiners to inform management that their remarks are not

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intended to cast doubt upon the financial strength of any The following is a statement regarding such credits which
institution to whom federal funds are sold. Rather, the intent may be used in applicable situations:
is to advise the banker of the potential risks of such practices
unless safeguards are developed. The need for policy The foregoing obligation of a federally insured banking
formulation and credit review on all Federal funds sold institution is listed for special mention because of publicly
should be reinforced via a comment in the Report of available information which suggests the obligation
Examination. Also, if federal funds sold to any one buyer contains risk which is some degree greater than normal. The
equals or exceeds 100 percent of the selling institution's Tier following is a standard statement of the FDIC's position
1 Capital, it should be listed on the Concentrations schedule regarding such credits.
unless secured by U.S. Government securities. Based on the
circumstances, the examiner should determine the "In reviewing bank-to-bank debt, the FDIC is placed in a
appropriateness of additional comments regarding risk position of basic conflict. We may or may not be in
diversification. possession of confidential information arising from our
regulatory function with respect to the other institution. The
Securities purchased under an agreement to resell are responsibility for properly appraising the assets of the bank
generally purchased at prevailing market rates of interest. under examination in such an instance may suggest the need
The purchasing institution must keep in mind that the to disclose adverse information, while the implied
transaction merely represents another form of lending. arrangement under which we received the information
Therefore, considerations normally associated with granting would preclude us, in good faith, from making the
secured credit should be made. Repayment or repurchases disclosure. It is our policy, in view of the foregoing, not to
by the selling institution is a major consideration, and the classify such credits adversely except where we can support
buying institution should satisfy itself that the selling the classification without the use of information gathered
institution will be able to generate the necessary funds to solely through privileged sources. Rather, we bring the
repurchase the securities on the prescribed date. Policy existence of this credit to the board's attention for whatever
guidelines typically limit the amount of money extended to review or other action it believes consistent with its sworn
one seller. Collateral coverage arrangements should be responsibilities to the stockholders and depositors of the
controlled by procedures similar to the safeguards used to bank under examination."
control any type of liquid collateral. Securities held under
such an arrangement should not be included in the ←
institution's investment portfolio but should be reflected in FUNDAMENTAL LEGAL CONCEPTS AND
the Report of Examination under the caption Securities DEFINITIONS
Purchased Under Agreements to Resell. Transactions of
this nature do not require entries to the securities account of
Laws and regulations that apply to credit extended by banks
either institution with the selling institution continuing to
are more complicated and continually in a state of change.
collect all interest and transmit such payments to the buying
However, certain fundamental legal principles apply no
institution.
matter how complex or innovative a lending transaction. To
avoid needless litigation and ensure that each loan is a
Assessing Bank-to-Bank Credit legally enforceable claim against the borrower or collateral,
adherence to certain rules and prudent practices relating to
Because of the FDIC’s regulatory role, examiners often loan transactions and documentation is essential. An
possess confidential information concerning a bank important objective of the examiner's analysis of collateral
obligated on unsecured lines, Federal funds, or subordinated and credit files is not only to obtain information about the
notes and debentures to another bank under examination. loan, but also to determine if proper documentation
The files of the bank under examination may contain procedures and practices are being utilized. While
insufficient information to make an informed assessment of examiners are not expected to be experts on legal matters, it
the credit. When this is the case, and when there is is important they be familiar with the Uniform Commercial
information in the public domain to suggest that the line Code (UCC) adopted by their respective states as well as
involves more than a normal degree of risk, the matter other applicable state laws governing credit transactions. A
should be brought to the attention of management and the good working knowledge of the various documents
board of the bank under examination. necessary to attain the desired collateral or secured position,
and how those documents are to be used or handled in the
However, if the bank’s credit files or public record contain jurisdiction relevant to the institution under examination, is
sufficient information to justify adverse classification of the also essential.
debt, then it should be classified in the report of
examination.

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Uniform Commercial Code – Secured mean the creditor necessarily takes physical possession of
Transactions the property, or does it mean acquisition of ownership of the
property. Rather, it means that before attachment, the
Article 9 of the UCC governs secured transactions; i.e., borrower's property is free of any legal encumbrance, but
those transactions which create a security interest in after attachment, the property is legally bound by the
personal property or fixtures including goods, documents, creditor's security interest. In order for the creditor's
instruments, general intangibles, chattel paper or accounts. security interest to attach, there must be a security
Article 9 was significantly revised effective July 1, 2001, agreement in which the debtor authenticates and provides a
but each individual state must adopt the changes for it to description of the collateral. A creditor's security interest
become law. Because some states have enacted modified can be possessory or nonpossessory, a secured party with
versions of the UCC and subsequent revisions, each possession pursuant to “agreement” means that the
applicable state statute should be consulted. “agreement” for possession has to be an agreement that the
person will have possession for purposes of security. The
General Provisions general rule is an institution must take possession of deposit
accounts (proprietary), letter of credit rights, electronic
A Security Agreement is an agreement between a debtor and chattel, paper, stocks and bonds to perfect a security interest
a secured party that creates or provides for a security therein. In a transaction involving a nonpossessory security
interest. The Debtor is the person that has an interest in the interest, the debtor retains possession of the collateral. A
collateral other than a security interest. The term Debtor security interest in collateral automatically attaches to the
also includes a seller of payment intangibles or promissory proceeds of the collateral and is automatically perfected in
notes. The obligor is the person who owes on a secured the proceeds if the credit was advanced to enable the
transaction. The Secured Party is the lender, seller or other purchase
person in whose favor there is a security interest.
A party's security interest in personal property is not
Grant of Security Interest protected against a debtor's other creditors unless it has been
perfected. A security interest is perfected when it has
For a security interest to be enforceable against the debtor attached and when all of the applicable steps required for
or third party with respect to the collateral, the collateral perfection, such as the filing of a financing statement or
must be in the possession of the secured party pursuant to possession of the collateral, have been taken. These
agreement, or the debtor must sign a security agreement provisions are designed to give notice to others of the
which covers the description of the collateral. secured party's interest in the collateral, and offer the
secured party the first opportunity at the collateral if the
Collateral need to foreclose should arise. If the security interest is not
perfected, the secured party loses its secured status.
Any description of personal property or real estate is a
sufficient description of the collateral whether or not it is Right to Possess and Dispose of Collateral
specific if it reasonably identifies what is described. If the
parties seek to include property acquired after the signing of Unless otherwise agreed, when a debtor defaults on a
the security agreement as collateral, additional requirements secured loan, a secured party has the right to take possession
must be met. of the collateral without going to court if this can be done
without breaching the peace. Alternatively, if the security
Unless otherwise agreed a security agreement gives the agreement so provides, the secured party may require the
secured party the rights to proceeds from the sale, exchange, debtor to assemble the collateral and make it available to the
collection or disposition of the collateral. secured party at a place to be designated by the secured
In some cases, the collateral that secures an obligation under party which is reasonably convenient to both parties.
one security agreement can be used to secure a new loan,
too. This can be done by using a cross-collateralization A secured party may then sell, lease or otherwise dispose of
clause in the security agreement. the collateral with the proceeds applied as follows: (a)
foreclosure expenses, including reasonable attorneys' fees
Perfecting the Security Interest and legal expenses; (b) the satisfaction of indebtedness
secured by the secured party's security interest in the
Three terms basic to secured transactions are attachment, collateral; and (c) the satisfaction of indebtedness secured
security agreement and security interest. Attachment refers by any subordinate security interest in the collateral if the
to that point when the creditor's legal rights in the debtor's secured party receives written notification of demand before
property come into existence or "attach.” This does not the distribution of the proceeds is completed. If requested
by the secured party, the holder of a subordinate security

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interest must furnish reasonable proof of his interest, and them. If permitted by the filing office, parties may file and
unless he does so, the secured party need not comply with otherwise communicate by means of records communicated
his demand. and stored in a media other than paper. A peculiarity
common to all states is the filing of a lien on aircraft; the
Examiners should determine institution policy concerning security agreement must be submitted to the Federal
the verification of lien positions prior to advancing funds. Aviation Administration in Oklahoma City, Oklahoma.
Failure to perform this simple procedure may result in the
institution unknowingly assuming a junior lien position and, Default and Foreclosure - As a secured party, an
thereby, greater potential loss exposure. Management may institution's rights in collateral only come into play when the
check filing records personally or a lien search may be obligor is in default. What constitutes default varies
performed by the filing authority or other responsible party. according to the specific provisions of each promissory
This is especially important when the institution grants new note, loan agreement, security agreement, or other related
credit lines. documents. After an obligor has defaulted, the creditor
usually has the right to foreclose, which means the creditor
Agricultural Liens seizes the security pledged to the loan, sells it and applies
the proceeds to the unpaid balance of the loan. For
An agricultural lien is generally defined as an interest, other consumer transactions, there are strict consumer notification
than a security interest, in farm products that meets the requirements prior to disposition of the collateral. For
following three conditions: consumer transactions, the lender must provide the debtor
with certain information regarding the surplus or deficiency
• The lien secures payment or performance of an in the disposition of collateral. There may be more than one
obligation for goods or services furnished in creditor claiming a right to the sale proceeds in foreclosure
connection with a debtor’s farming operation or rent situations. When this occurs, priority is generally
on real property leased by a debtor in connection with established as follows: (1) Creditors with a perfected
its farming operation. security interest (in the order in which lien perfection was
• The lien is created by statute in favor of a person that attained); (2) Creditors with an unperfected security
in the ordinary course of its business furnished goods interest; and (3) General creditors.
or services to a debtor in connection with a debtor’s
farming operation or leased property to a debtor in Under the UCC procedure for foreclosing security interests,
connection with the debtor’s farming operation. four concepts are involved. First is repossession or taking
• The lien’s effectiveness does not depend on the physical possession of the collateral, which may be
person’s possession of the personal property. accomplished with judicial process or without judicial
process (known as self-help repossession), so long as the
An agricultural lien is therefore non-possessory. Law creditor commits no breach of the peace. The former is
outside of UCC-9 governs creation of agricultural liens and usually initiated by a replevin action in which the sheriff
their attachment to collateral. An agricultural lien cannot be seizes the collateral under court order. A second important
created or attached under Article 9. Article 9, however, concept of UCC foreclosure procedures is redemption or the
does govern perfection. In order to perfect an agricultural debtor's right to redeem the security after it has been
lien, a financing statement must be filed. A perfected repossessed. Generally, the borrower must pay the entire
agricultural lien on collateral has priority over a conflicting balance of the debt plus all expenses incurred by the
security interest in or agricultural lien on the same collateral institution in repossessing and holding the collateral. The
if the statute creating the agricultural lien provides for such third concept is retention that allows the institution to retain
priority. Otherwise, the agricultural lien is subject to the the collateral in return for releasing the debtor from all
same priority rules as security interests (for example, date further liability on the loan. The borrower must agree to this
of filing). action, hence would likely be so motivated only when the
value of the security is likely to be less than or about equal
A distinction is made with respect to proceeds of collateral to the outstanding debt. Finally, if retention is not agreeable
for security interests and agricultural liens. For security to both borrower and lender, the fourth concept, resale of
interests, collateral includes the proceeds under Article 9. the security, comes into play. Although sale of the collateral
For agricultural liens, the collateral does not include may be public or private, notice to the debtor and other
proceeds unless state law creating the agricultural lien gives secured parties must generally be given. The sale must be
the secured party a lien on proceeds of the collateral subject commercially reasonable in all respects. Debtors are
to the lien. entitled to any surplus resulting from sale price of the
collateral less any unpaid debt. If a deficiency occurs (i.e.,
Special Filing Requirements – There is a national uniform the proceeds from sale of the collateral were inadequate to
Filing System form. Filers, however are not required to use fully extinguish the debt obligation), the institution has the

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right to sue the borrower for this shortfall. This is a right it either by the board of directors or by expressed or implied
does not have under the retention concept. general powers. Usually a special resolution expressly
gives certain officers the right to obligate the corporate
Exceptions to the Rule of Priority - There are three entity, pledge assets as collateral, agree to other terms of the
exceptions to the general rule that the creditor with the indebtedness and sign all necessary documentation on
earliest perfected security interest has priority. The first behalf of the corporate entity.
concerns a specific secured transaction in which a creditor
makes a loan to a dealer and takes a security interest in the Although a general resolution is perhaps satisfactory for the
dealer's inventory. Suppose such a creditor files a financing short-term, unsecured borrowings of a corporation, a
statement with the appropriate public official to perfect the specific resolution of the corporation's board of directors is
security interest. While it might be possible for the dealer's generally advisable to authorize such transactions as term
customers to determine if an outstanding security interest loans, loans secured by security interests in the corporation's
already exists against the inventory, it would be impractical personal property, or mortgages on real estate. Further,
to do so. Therefore, an exception is made to the general rule mortgaging or pledging substantially all of the corporation's
and provides that a buyer in the ordinary course of business, assets without prior approval of the shareholders of the
i.e., an innocent purchaser for value who buys in the normal corporation is often prohibited, therefore, an institution may
manner, cuts off a prior perfected security interest in the need to seek advice of counsel to determine if shareholder
collateral. consent is required for certain contemplated transactions.

The second exception to the rule of priority concerns the Loans to corporations should indicate on their face that the
vulnerability of security interests perfected by doing corporation is the borrower. The corporate name should
nothing. While these interests are perfected automatically, appear followed by the name, title and signature of the
with the date of perfection being the date of attachment, they appropriate officer. If the writing is a negotiable instrument,
are extremely vulnerable at the hands of subsequent bona the UCC states the party signing is personally liable as a
fide purchasers. Suppose, for example, a dealer sells a general rule. To enforce payment against a corporation, the
television set on a secured basis to an ultimate consumer. note or other writing should clearly show that the debtor is
Since the collateral is consumer goods, the security interest a corporation.
is perfected the moment if attaches. But if the original buyer
sells the television set to another person who buys it in good Bond and Stock Powers
faith and in ignorance of the outstanding security interest,
the UCC provides that the subsequent purchase cuts off the As mentioned previously, an institution generally obtains a
dealer's security interest. This second exception is much the security interest in stocks and bonds by possession. The
same as the first except for one important difference: the documents which allow the institution to sell the securities
dealer (creditor) in this case can be protected against if the borrower defaults are called stock powers and bond
purchase of a customer's collateral by filing a financing powers. The examiner should ensure the institution has, for
statement with the appropriate public official. each borrower who has pledged stocks or bonds, one signed
stock power for all stock certificates of a single issuer, and
The third exception regards the after-acquired property a separate signed bond power for each bond instrument.
clause that protects the value of the collateral in which the The signature must agree with the name on the actual stock
creditor has a perfected security interest. The after-acquired certificate or bond instrument. Refer to Federal Reserve
property clause ordinarily gives the original creditor senior Board Regulations Part 221 (Reg U) for further information
priority over creditors with later perfected interests. on loans secured by investment securities.
However, it is waived as regards the creditor who supplies
replacements or additions to the collateral or the artisan who Co-maker
supplies materials and services that enhance the value of the
collateral as long as a perfected security interest in the Two or more persons who are parties to a contract or
replacement or additions, or collateral is held. promise to pay are known as co-makers. They are a unit to
the performance of one act and are considered primarily
Borrowing Authorization liable. In the case of default on an unsecured loan, a
judgment would be obtained against all. A release against
Borrowing authorizations in essence permit one party to one is a release against all because there is but one
incur liability for another. In the context of lending, this obligation and if that obligation is released as to one obligor,
usually concerns corporations. A corporation may enter it is released as to all others.
into contracts within the scope of the powers authorized by
its charter. In order to make binding contracts on behalf of
the corporation, the officers must be authorized to do so

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Loan Guarantee Subordination Agreement

Since banks often condition credit advances upon the An institution extending credit to a closely held corporation
backup support provided by third party guarantees, may want to have the company's officers and shareholders
examiners should understand the legal fundamentals subordinate to the institution's loan any indebtedness owed
governing guarantees. A guarantee may be a guarantee of them by the corporation. This is accomplished by execution
payment or of collection. "Payment guaranteed" or of a subordination agreement by the officers and
equivalent words added to a signature means that if the shareholders. Subordination agreements are also commonly
instrument is not paid when due, the guarantor will pay it referred to as standby agreements. Their basic purpose is to
according to its terms without resort by the holder to any prevent diversion of funds from reduction of institution debt
other party. "Collection guaranteed" or equivalent words to reduction of advances made by the firm's owners or
added to a signature means that if the instrument is not paid officers.
when due, the guarantor will pay it, but only after the holder
has reduced to judgment a claim against the maker and Hypothecation Agreement
execution has been returned unsatisfied, or after the maker
has become insolvent or it is otherwise useless to proceed This is an agreement whereby the owner of property grants
against such a party. a security interest in collateral to the institution to secure the
indebtedness of a third party. Institutions often take
Contracts of guarantee are further divided into a limited possession of the stock certificates, plus stock powers
guarantee which relates to a specific note (often referred to endorsed in blank, in lieu of a hypothecation agreement.
as an "endorsement") or for a fixed period of time, or a Caution, however, dictates that the institution take a
continuing guarantee which, in contrast, is represented by a hypothecation agreement setting forth the institution's rights
separate instrument and enforceable for future (duration in the event of default.
depends upon state law) transactions between the institution
and the borrower or until revoked. A well-drawn continuing Real Estate Mortgage
guarantee contains language substantially similar to the
following: "This is an absolute and unconditional guarantee A mortgage may be defined as a conveyance of realty given
of payment, is unconditionally delivered, and is not subject with the intention of providing security for the payment of
to the procurement of a guarantee from any person other debt. There are several different types of mortgage
than the undersigned, or to the performance or happening of instruments but those commonly encountered are regular
any other condition." The aforementioned unambiguous mortgages, deeds of trust, equitable mortgages, and deeds
terms are necessary to the enforceability of contracts of absolute given as security.
guarantee, as they are frequently entered into solely as an
accommodation for the borrower and without the Regular Mortgages - The regular mortgage involves only
guarantor's participation in the benefits of the loan. Thus, two parties, the borrower and the lender. The mortgage
courts tend to construe contracts of guarantee strictly document encountered in many states today is referred to as
against the party claiming under the contract. Unless the the regular mortgage. It is, in form, a deed or conveyance
guarantee is given prior to or at the time the initial loan is of realty by the borrower to the lender followed or preceded
made, the guarantee may not be enforceable because of the by a description of the debt and the property, and includes a
difficulty of establishing that consideration was given. provision to the effect that the mortgage be released upon
Institutions should not disburse funds on such loans until full payment of the debt. Content of additional paragraphs
they have the executed guarantee agreement in their and provisions varies considerably.
possession. Institutions should also require the guarantee be
signed in the presence of the loan officer, or, alternatively, Deeds of Trust - In the trust deed, also known as the deed
that the guarantor's signature be notarized. If the proposed of trust, the borrower conveys the realty not to the lender
guarantor is a partnership, joint venture, or corporation, the but to a third party, a trustee, in trust for the benefit of the
examiner should ensure the signing party has the legal holder of the notes(s) that constitutes the mortgage debt.
authority to enter into the guarantee agreement. Whenever The deed of trust form of mortgage has certain advantages,
there is a question concerning a corporation's authority to the principle being that in a number of states it can be
guarantee a loan, counsel should be consulted and a special foreclosed by trustee's sale under the power of sale clause
corporate resolution passed by the organization's board of without court proceedings.
directors.
Equitable Mortgages - As a general rule, any instrument in
writing by which the parties show their intention that realty
be held as security for the payment of a debt, constitutes an

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equitable mortgage capable of being foreclosed in a court of such as life insurance company or the payor of an assigned
equity. contract, an acknowledgement should be obtained from that
party as to the institution's assigned interest in the asset for
Deeds Absolute Given as Security - Landowners who collateral purposes.
borrow money may give as security an absolute deed to the
land. "Absolute deed" means a quitclaim or warranty deed ←
such as is used in an ordinary realty sale. On its face, the CONSIDERATION OF BANKRUPTCY
transaction appears to be a sale of the realty; however, the
LAW AS IT RELATES TO
courts treat such a deed as a mortgage where the evidence
shows that the instrument was really intended only as COLLECTIBILITY OF A DEBT
security for a debt. If such proof is available, the borrower
is entitled to pay the debt and demand reconveyance from Introduction
the lender, as in the case of an ordinary mortgage. If the
debt is not paid, the grantee must foreclose as if a regular Familiarity with the basic terms and concepts of the federal
mortgage had been made. bankruptcy law (formally known as the Bankruptcy Reform
Act of 1978) is necessary in order for examiners to make
The examiner should determine whether the institution has informed judgments concerning the likelihood of collection
performed a title and lien search of the property prior to of loans to bankrupt individuals or organizations. The
taking a mortgage or advancing funds. Proper procedure following paragraphs present an overview of the subject.
calls for an abstractor bringing the abstract up to date, and Complex situations may arise where more in-depth
review of the abstract by an attorney or title insurance consideration of the bankruptcy provisions may be
company. If an attorney performs the task, the abstract will necessary and warrant consultation with the institution's
be examined and an opinion prepared indicating with whom attorney, regional counsel or other member of the regional
title rests, along with any defects and encumbrances office staff. For the most part, however, knowledge of the
disclosed by the abstract. Like an abstractor, an attorney is following information when coupled with review of credit
liable only for damages caused by negligence. If a title file data and discussion with institution management should
insurance company performs the task of reviewing the enable examiners to reach sound conclusions as to the
abstract, it does essentially the same thing; however, when eventual repayment of the institution's loans.
title insurance is obtained, it represents a contract to make
good, loss arising through defects in title to real estate or Forms of Bankruptcy Relief
liens or encumbrances thereon. Title insurance covers
various items not covered in an abstract and title opinion. Liquidation and rehabilitation are the two basic types of
Some of the more common are errors by abstractors or bankruptcy proceedings. Liquidation is pursued under
attorneys include unauthorized corporate action, mistaken Chapter 7 of the law and involves the bankruptcy trustee
legal interpretations, and unintentional errors in public collecting all of the debtor's nonexempt property,
records by public officials. Once the institution determines converting it into cash and distributing the proceeds among
title and lien status of the property, the mortgage can be the debtor's creditors. In return, the debtor obtains a
prepared and funds advanced. The institution should record discharge of all debts outstanding at the time the petition
the mortgage immediately after closing the loan. Form, was filed which releases the debtor from all liability for
execution, and recording of mortgages vary from state to those pre-bankruptcy debts.
state and therefore must conform to the requirements of
state law. Rehabilitation (sometimes known as reorganization) is
effected through Chapter 11 or Chapter 13 of the law and in
Collateral Assignment essence provides that creditors' claims are satisfied not via
liquidation of the obligor's assets but rather from future
An assignment is generally considered as the transfer of a earnings. That is, debtors are allowed to retain their assets
legal right from one person to another. The rights acquired but their obligations are restructured and a plan is
under a contract may be assigned if they relate to money or implemented whereby creditors may be paid.
property, but personal services may not be assigned.
Collateral assignments are used to establish the institution's Chapter 11 bankruptcy is available to all debtors, whether
rights as lender in the property or asset serving as collateral. individuals, corporations or partnerships. Chapter 13
It is generally used for loans secured by savings deposits, (sometimes referred to as the "wage earner plan"), on the
certificates of deposit or other cash accounts as well as loans other hand, may be used only by individuals with regular
backed by cash surrender value of life insurance. In some incomes and when their unsecured debts are under $100,000
instances, it is used in financing accounts receivable and and secured debts less than $350,000. The aforementioned
contracts. If a third party holder of the collateral is involved, rehabilitation plan is essentially a contract between the

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debtor and the creditors. Before the plan may be confirmed, the estate, the bankruptcy case is dismissed, the debtor
the bankruptcy court must find it has been proposed in good obtains or is denied a discharge, or the bankruptcy court
faith and that creditors will receive an amount at least equal approves a creditor's request for termination of the stay.
to what would be received in a Chapter 7 proceeding. In Two of the more important grounds applicable to secured
Chapter 11 reorganization, all creditors are entitled to vote creditors under which they may request termination are as
on whether or not to accept the repayment plan. In Chapter follows: (1) The debtor has no equity in the encumbered
13 proceedings, only secured creditors are so entitled. A property, and the property is not necessary to an effective
majority vote binds the minority to the plan, provided the rehabilitation plan; or (2) The creditor's interest in the
latter will receive pursuant to the plan at least the amount secured property is not adequately protected. In the latter
they would have received in a straight liquidation. The plan case, the law provides three methods by which the creditor's
is fashioned so that it may be carried out in three years interests may be adequately protected: the creditor may
although the court may extend this to five years. receive periodic payments equal to the decrease in value of
the creditor's interest in the collateral; an additional or
Most cases in bankruptcy courts are Chapter 7 proceedings, substitute lien on other property may be obtained; or some
but reorganization cases are increasingly common. From other protection is arranged (e.g., a guarantee by a third
the creditor's point of view, Chapter 11 or 13 filings party) to adequately safeguard the creditor's interests. If
generally result in greater debt recovery than do liquidation these alternatives result in the secured creditor being
situations under Chapter 7. Nonetheless, the fact that adequately protected, relief from the automatic stay will not
reorganization plans are tailored to the facts and be granted. If relief from the stay is obtained, creditors may
circumstances applicable to each bankrupt situation means continue to press their claims upon the bankrupt's property
that they vary considerably and the amount recovered by the free from interference by the debtor or the bankruptcy court.
creditor may similarly vary from nominal to virtually
complete recovery. Property of the Estate
Functions of Bankruptcy Trustees When a borrower files a bankruptcy petition, an "estate" is
created and, under Chapter 7 of the law, the property of the
Trustees are selected by the borrower's creditors and are estate is passed to the trustee for distribution to the creditors.
responsible for administering the affairs of the bankrupt Certain of the debtor's property is exempt from distribution
debtor's estate. The bankrupt's property may be viewed as under all provisions of the law (not just Chapter 7), as
a trust for the benefit of the creditors, consequently it follows: homeowner's equity up to $7,500; automobile
follows the latter should, through their elected equity and household items up to $1,200; jewelry up to
representatives, exercise substantial control over this $500; cash surrender value of life insurance up to $4,000;
property. Social Security benefits (unlimited); and miscellaneous
items up to $400 plus any unused portion of the
Voluntary and Involuntary Bankruptcy homeowner's equity. The bankruptcy code recognizes a
greater amount of exemptions may be available under state
When a debtor files a bankruptcy petition with the court, the law and, if state law is silent or unless it provides to the
case is described as a voluntary one. It is not necessary the contrary, the debtor is given the option of electing either the
individual or organization be insolvent in order to file a federal or state exemptions. Examiners should note that
voluntary case. Creditors may also file a petition, in which some liens on exempt property which would otherwise be
case the proceeding is known as an involuntary bankruptcy. enforceable are rendered unenforceable by the bankruptcy.
However, this alternative applies only to Chapter 7 cases A secured lender may thus become unsecured with respect
and the debtor generally must be insolvent, i.e., unable to to the exempt property. The basic rule in these situations is
pay debts as they mature, in order for an involuntary that the debtor can render unenforceable judicial liens on
bankruptcy to be filed. any exempt property and security interests that are both
nonpurchase money and nonpossessory on certain
household goods, tools of the trade and health aids.
Automatic Stay
Filing of the bankruptcy petition requires (with limited Discharge and Objections to Discharge
exceptions) creditors to stop or "stay" further action to
collect their claims or enforce their liens or judgements. The discharge, as mentioned previously, protects the debtor
Actions to accelerate, set off or otherwise collect the debt from further liability on the debts discharged. Sometimes,
are prohibited once the petition is filed, as are however, a debtor is not discharged at all (i.e., the creditor
post- bankruptcy contacts with the obligor. The stay has successfully obtained an "objection to discharge") or is
remains in effect until the debtor's property is released from discharged only as regards to a specific creditor(s) and a

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specific debt(s) (an action known as "exception to claims for wages and salaries up to $2,000 per person,
discharge"). The borrower obviously remains liable for all unsecured claims for employee benefit plans, unsecured
obligations not discharged, and creditors may pursue claims of individuals up to $900 each for deposits in
customary collection procedures with respect thereto. conjunction with rental or lease of property, unsecured
Grounds for an "objection to discharge" include the claims of governmental units and certain tax liabilities.
following actions or inactions by the bankrupt debtor (this Secured creditors are only secured up to the extent of the
is not an all-inclusive list): fraudulent conveyance within 12 value of their collateral. They become unsecured in the
months of filing the petition; unjustifiable failure to keep or amount by which collateral is insufficient to satisfy the
preserve financial records; false oath or account or claim. Unsecured creditors are of course the last class in
presentation of a false claim in the bankruptcy case and terms of priority.
estate, respectively; withholding of books or records from
the trustee; failure to satisfactorily explain any loss or Preferences
deficiency of assets; refusal to testify when legally required
to do so; and receiving a discharge in bankruptcy within the Certain actions taken by a creditor before or during
last six full years. Some of the bases upon which creditors bankruptcy proceedings may be invalidated by the trustee if
may file "exceptions to discharge" are: nonpayment of they result in some creditors receiving more than their share
income taxes for the three years preceding the bankruptcy; of the debtor's estate. These actions are called "transfers"
money, property or services obtained through fraud, false and fall into two categories. The first involves absolute
pretenses or false representation; debts not scheduled on the transfers, such as payments received by a creditor; the
bankruptcy petition and which the creditor had no notice; trustee may invalidate this action and require the payment
alimony or child support payments (this exception may be be returned and made the property of the bankrupt estate. A
asserted only by the debtor's spouse or children, property transfer of security, such as the granting of a mortgage, may
settlements are dischargeable); and submission of false or also be invalidated by the trustee. Hence, the trustee may
incomplete financial statements. If an institution attempts require previously encumbered property be made
to seek an exception on the basis of false financial unencumbered, in which case the secured party becomes an
information, it must prove the written financial statement unsecured creditor. This has obvious implications as
was materially false, it reasonably relied on the statement, regards loan collectibility.
and the debtor intended to deceive the institution. These
assertions can be difficult to prove. Discharges are Preferences are a potentially troublesome area for banks and
unavailable to corporations or partnerships. Therefore, after examiners should have an understanding of basic principles
a bankruptcy, corporations and partnerships often dissolve applicable to them. Some of the more important of these are
or become defunct. listed here.

Reaffirmation • A preference may be invalidated (also known as

"avoided") if it has all of these elements: the transfer
Debtors sometimes promise their creditors after a was to or for the benefit of a creditor; the transfer was
bankruptcy discharge that they will repay a discharged debt. made for or on account of a debt already outstanding;
An example wherein a debtor may be so motivated involves the transfer has the effect of increasing the amount a
the home mortgage. To keep the home and discourage the creditor would receive in Chapter 7 proceedings; the
mortgagee from foreclosing, a debtor may reaffirm this transfer was made within 90 days of the bankruptcy
obligation. This process of reaffirmation is an agreement filing, or within one year if the transfer was to an
enforceable through the judicial system. The law sets forth insider who had reasonable cause to believe the debtor
these basic limitations on reaffirmations: the agreement was insolvent at the time of transfer; and the debtor
must be signed before the discharge is granted; a hearing is was insolvent at the time of the transfer. Under
held and the bankruptcy judge informs the borrower there is bankruptcy law, borrowers are presumed insolvent for
no requirement to reaffirm; and the debtor has the right to 90 days prior to filing the bankruptcy petition.
rescind the reaffirmation if such action is taken within 30 • Payment to a fully secured creditor is not a preference
days. because such a transfer would not have the effect of
increasing the amount the creditor would otherwise
Classes of Creditors receive in a Chapter 7 proceeding. Payment to a
partially secured creditor does, however, have the
The first class of creditors is known as priority creditors. As effect of increasing the creditor's share and is thus
the name implies, these creditors are entitled to receive deemed a preference which the trustee may avoid.
payment prior to any others. Priority payments include
administrative expenses of the debtor's estate, unsecured

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• Preference rules also apply to a transfer of a lien to from participation loans in that lenders participate jointly in
secure past debts, if the transfer has all five elements the origination process, as opposed to one originator selling
set forth under the first point. undivided participation interests to third parties. In a
• There are certain situations wherein a debtor has given syndicated transaction, each financial institution receives a
a preference to a creditor but the trustee is not pro rata share of the income based on the level of
permitted to invalidate it. A common example participation in the credit. Additionally, one or more
concerns floating liens on inventory under the lenders take on the role of lead or agent (co-agents in the
Uniform Commercial Code. These matters are subject case of more than one) of the credit and assume
to complex rules, however, and consultation with the responsibility of administering the loan for the other
regional office may be advisable when this issue lenders. The agent may retain varying percentages of the
arises. credit, which is commonly referred to as the hold level.

Setoffs The syndicated-lending market formed to meet basic needs

of lenders and borrowers, such as:
Setoffs occur when a party is both a creditor and a debtor of
another; amounts which a party owes are netted against • Raising large amounts of money,
amounts which are owed to that party. If an institution • Enabling geographic diversification,
exercises its right of setoff properly and before the • Obtaining working capital quickly and efficiently,
bankruptcy filing, the action is generally upheld in the • Diversifying credit risk among banks, and
bankruptcy proceedings. Setoffs made after the bankruptcy • Gaining attractive pricing advantages.
may also be valid but certain requirements must be met of
which the following are especially important: First, the In times of excess liquidity in the marketplace, spreads
debts must be between the same parties in the same right typically are quite narrow for investment-grade facilities,
and capacity. For example, it would be improper for the thus making it a borrower’s market. This may be
institution to setoff the debtor's loan against a checking accompanied by an easing of the structuring and covenants.
account of the estate of the obligor's father, of which the In spite of tightening margins, commercial banks are
debtor is executor. Second, both the debt and the deposit motivated to compete regarding pricing in order to retain
must precede the bankruptcy petition filing. Third, the other business as well as generate fee income.
setoff may be disallowed if funds were deposited in the
institution within 90 days of the bankruptcy filing and for Relaxing covenants and pricing may result in lenders
the purpose of creating or increasing the amount to be set relying heavily on market valuations, or so-called
off. "enterprise values" in arriving at credit decisions. These
values are derived by applying a current-period multiple to
Transfers Not Timely Perfected or Recorded cash flows (which uses data from comparable companies
within the same industry), or discounting projected cash
Under most circumstances, an institution which has not flows over several years (which typically uses an average
recorded its mortgage or otherwise fails to perfect its cost of capital as the discount rate). This value represents
security interest in a proper timely manner runs great risk of the intangible business value of a company as a going
losing its security. This is a complex area of the law but concern, which often exceeds its underlying hard assets.
prudence clearly dictates that liens be properly obtained and
promptly filed so that the possibility of losing the protection Many deals involve merger and acquisition financing.
provided by collateral is eliminated. While the primary originators of the syndicated loans are
commercial banks, most of the volume is sold and held by
← other investors.
SYNDICATED LENDING
A subset of syndicated lending is leveraged lending which
refers to borrowers with an elevated level of debt and debt
Overview service compared with cash flow. By their very nature,
these instruments are of higher risk.
Syndicated loans often represent a substantial portion of the
commercial and industrial loan portfolios of large banks. A
syndicated loan involves two or more banks contracting
Syndication Process
with a borrower, typically a large or middle market
There are four phases in loan syndications: Pre-Launch,
corporation, to provide funds at specified terms under the
Launch, Post-Launch, and Post-Closing.
same credit facility. The average commercial syndicated
credit is in excess of $100 million. Syndicated credits differ

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The Pre-Launch Process - During this phase, the Loan Covenants

syndicators identify the borrower’s needs and perform their
initial due diligence. Industry information is gathered and Loan covenants are special conditions included in a loan
analyzed, and background checks may be performed. agreement that the borrower is required to fulfill in order for
Potential pricing and structure of the transaction takes the loan agreement to remain valid. Typically, covenants
shape. Formal credit write-ups are sent to credit officers for cover several domains but can broadly be divided into
review and to senior members of the syndication group for financial and non-financial categories. Effective financial
pricing approval. Competitive bids are sent to the borrower. covenants establish an operating framework using
The group then prepares for the launch. conditions defined in absolute amounts or ratios. If
exceeded by the borrower, the covenants provide lenders the
An information memorandum is prepared by the agent. opportunity to further strengthen collateral controls or
This memorandum is a formal and confidential document adjust interest rates. Some examples are:
that should address all principal credit issues relating to the
borrower and to the project being financed. It typically Net Worth test: restricts the total amount of debt a borrower
contains an overview of the transaction including a term can incur, expressed as a percentage of net worth.
sheet, an overview of the borrower’s business, and quarterly
and annual certified financial statements. This document Current Ratio/ Quick Ratio test: measures liquidity.
acts as both the marketing tool and as the source of
information for the syndication. Interest, Debt Service or Fixed Charge Coverage test:
assures that some level of cash flow is generated by a
The Launch Phase - The transaction is launched into the company above its interest expense and other fixed
market when banks are sent the information memoranda obligations. The proxy for cash flow is usually EBITDA
mentioned above. Legal counsel commences to prepare the (earnings before interest, taxes, depreciation and
documentation. Negotiations take place between the banks amortization).
and the borrower over pricing, collateral, covenants, and
other terms. Often there is an institution meeting so Capital Expenditure Limitations: generally set according to
potential participants can discuss the company’s business the company’s business plan and then measured
and industry both with the lead agent and with the company. accordingly.

Post-Launch Phase - Typically there is a two-week period Borrowing Base Limitations: lending formula typically
for potential participants to evaluate the transaction and to based on eligible accounts receivable and inventory. At
decide whether or not to participate in the syndication. times, the formula may also include real estate or other non-
During this period, banks do their due diligence and credit current assets.
approval. Often this entails running projection models,
including stress tests, doing business and industry research, Leverage test: actual leverage covenant levels vary by
and presenting the transaction for the approval process once industry segment. Typical ratios include Total Debt divided
the decision is made to commit to the transaction. by EBITDA, Senior Debt divided by EBITDA and Net Debt
(subtracts cash) divided by EBITDA.
After the commitment due date, participating banks receive
a draft credit agreement for their comments. Depending Non-financial covenants may include restrictions on other
upon the complexity of the agreement, they usually have matters such as management changes, provisions of
about a week to make comments. The final credit information, guarantees, disposal of assets, etc.
agreement is then negotiated based on the comments and the
loan would then close two to five days after the credit Credit Rating Agencies
agreement is finalized.
The large credit rating agencies (Standard and Poor’s,
Post-Closing Phase - Post-Closing, there usually is an Moody’s, and Fitch Investor Services) provide coverage of
ongoing dialogue with the borrower about many syndicated loans at origination and periodically
financial/operating performance as well as quarterly credit during the life of the loan. Credit ratings issued by these
agreement covenant compliance checks. Annually, a full agencies reflect a qualitative and quantitative evaluation of
credit analysis typically is done as well as annual meetings financial and other information of the prospective borrower,
of the participants for updates on financial and operating including information provided by the borrower and other
performance. Both the agent institution and the participants non-public information.
need to assess the loan protection level by analyzing the
business risk as well as the financial risk. Each industry has
particular dominant risks to be assessed.

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Credit ratings may represent the overall corporate credit • International credits or commitments administered in a
rating of a borrower or reflect analysis of a borrower’s foreign office; or
specific financial instruments, such as their syndicated • Direct credits to sovereign borrowers.
loans. Credit ratings for each financial instrument reflect
the general credit risk of the borrower, their ability to repay SNC Review and Rating Process
the debt, and the probability of the borrower defaulting on
the instrument in question. Some credit rating agencies also Teams of interagency examiners review and risk rate a
provide separate ratings that consider the financial loss the sample of credits at agent banks during the first and third
holder of a financial instrument such as a syndicated loan quarters of each year. Of note, SNC reviews occur regularly
may incur if a borrower defaults. at agent banks originating a significant level of SNC credits.
For agent banks with smaller SNC portfolios, credits are
Overview of the Shared National Credit only reviewed through the program on an ad hoc basis. The
(SNC) Program SNC review sample is based on internal rating, industry,
size, and the number of regulated participants. The
The Shared National Credit (SNC) Program is an regulatory rating assigned by an interagency team of
interagency initiative administered jointly by the FDIC, examiners is reported to all participating banks shortly after
Federal Reserve Board, and the Office of the Comptroller the conclusion of the on-site review voting period. Ratings
of the Currency. The program was established in the 1970's remain active on a rolling two review basis (approximately
for the purpose of ensuring consistency among the three 1 year), thus avoiding duplicate reviews of the same loan
federal banking regulators in the classification of large and ensuring consistent treatment with regard to regulatory
syndicated credits. credit ratings. Examiners should not change SNC ratings
during risk management examinations. Any material
Definition of a SNC change in a borrower’s condition should be reported to the
national SNC coordinator.
Any loan or formal loan commitment, including any asset
such as other real estate, stocks, notes, bonds and debentures The SNC rating process includes risk rating, accrual and
taken for debts previously contracted, extended to a TDR status. Impairment measurement and ALLL treatment
borrower by a supervised institution, or any of its are not addressed in the SNC rating and should be reviewed
subsidiaries and affiliates, which in original amount at each participant institution. Current and historical SNC
aggregates $100 million or more and, which is shared by ratings can be accessed through the FDIC’s internal
three or more unaffiliated institutions under a formal systems. Designated SNC credits not reviewed in the
lending agreement; or, a portion of which is sold to two or current SNC sample will be listed as “Not Rated.” These
more unaffiliated institutions, with the purchasing credits may be reviewed separately at the participant
institution(s) assuming its pro rata share of the credit risk. institution if significant to the examination scope or an
examiner believes that the credit may carry an adverse
SNCs generally include: rating.

• Loans administered by a domestic office of a The FDIC’s SNC office can provide examiners with
supervised institution; additional information to facilitate the review of “Not
• Domestic commercial and real estate loans and all Rated” credits or copies of line sheets used in the
international loans to borrowers in the private sector; interagency SNC review to help examiners explain rating
and rationales to participant banks. In those situations where a
“Not Rated” credit is reviewed at the participant institution
• Acceptances, commercial letters of credit, standby
and an adverse rating is assigned, examiners should
letters of credit or similar bonds or guarantees, note
communicate their findings to the national SNC
issuance facilities, revolving underwriting facilities,
coordinator.
Eurodollar facilities, syndications, and similar
extensions or commitments, and lease financing
receivables. SNC Rating Communication and Distribution Process

At the conclusion of each semi-annual SNC review,

SNCs do not include:
electronic reports are generated, and notifications are sent
via email to participant institution contacts. They are
• Credits shared solely between affiliated supervised
provided a link to retrieve a summary of ratings, applicable
institutions;
loan write-ups, cover letter and a list of agent institution
• Private sector credits that are 100 percent guaranteed contacts. These reports are available to examiners upon
by a sovereign entity; request and can be retransmitted to the participant

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institution contact if needed. The notification email also in the past. This efficiency has enabled some banks to
marks the beginning of a 14 day window for banks to file an expand their lending into national markets and originate
appeal. loan volumes once considered infeasible. Scoring also
reduces unit-underwriting costs, while yielding a more
Appeals Process consistent loan portfolio that is easily securitized. These
benefits have been the primary motivation for the
Agent and participant banks may appeal any preliminary proliferation of credit scoring systems among both large and
rating. Agent and participant banks have 14 days from the small institutions.
electronic distribution of preliminary results to submit an
appeal. The written appeal details the reasons why the Credit scoring systems identify specific characteristics that
institution is disputing the classification and includes help define predictive variables for acceptable performance
documentation supporting the institution’s position. The (delinquency, amount owed on accounts, length of credit
written appeal is sent to the applicable agency of the agent history, home ownership, occupation, income, etc.) and
institution for the credit in question. An interagency appeals assign point values relative to their overall importance.
panel reviews the appeal, determines the final disposition of These values are then totaled to calculate a credit score,
the credit, and informs the institution of its decision in which helps institutions to rank order risk for a given
writing. Ratings changed by the appeals process are population. Generally, an individual with a higher score
communicated electronically to all affected participant will perform better relative to an individual with a lower
banks. credit score.

Additional Risks Associated with Syndicated Few, if any, institutions have an automated underwriting
Loan Participations system where the credit score is used exclusively to make
the credit decision. Some level of human review is usually
An institution that purchases a participation interest in large present to provide the flexibility needed to address
loan syndications faces the same risks as an institution individual circumstances. Institutions typically establish a
purchasing an ordinary loan participation from another minimum cut-off score below which applicants are denied
institution. Examiners should reference the manual section and a second cutoff score above which applicants are
on Loan Participations for a more in depth discussion of approved. However, there is usually a range, or “gray area,”
related risks. As discussed in that section, an institution in between the two cut-off scores where credits are
purchasing a participation loan is expected to perform the manually reviewed and credit decisions are judgmentally
same degree of independent credit analysis on the loan as if determined.
it were the originator. The same holds true for banks
purchasing participation interests in large syndications. Most, if not all, systems also provide for overrides of
Institutions that lack the resources or skill sets to perform an established cut-off scores. If the institution’s scoring
independent credit analysis on a complex loan syndication system effectively predicts loss rates and reflects
generally refrain from participating in such a transaction. management’s risk parameters, excessive overrides will
negate the benefits of an automated scoring system.
In some cases, an institution may enter into a sub- Therefore, it is critical for management to monitor and
participation agreement in which the institution purchases a control overrides. Institutions typically develop acceptable
piece of a participation from another syndicated loan override limits and prepare monthly override reports that
participant rather than directly from the agent institution. provide comparisons over time and against the institution’s
As a result, the sub-participant may not be registered with parameters. Override reports also typically identify the
or known to the agent institution and may not receive timely approving officer and include the reason for the override.
notification of risk ratings or adverse credit actions from
either the agent institution or the SNC system. Additionally, Although banks often use more than one type of credit
sub-participants may not have the same legal rights or scoring methodology in their underwriting and account
remedies as participants of record in the syndicate, which management practices, many systems incorporate credit
may give rise to other transactional and operational risk bureau scores. Credit bureau scores are updated
concerns. periodically and validated on an ongoing basis against
performance in credit bureau files. Scores are designed to
← be comparable across the major credit bureaus; however, the
ability of any score to estimate performance outcome
CREDIT SCORING
probabilities depends on the quality, quantity, and timely
submission of lender data to the various credit bureaus.
Automated credit scoring systems allow institutions to
Often, the depth and thoroughness of data available to each
underwrite and price loans more quickly than was possible

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credit bureau varies, and as a consequence, the quality of of the business. While this may be appropriate in some
scores varies. cases, it is important to remember that the income from
small business remains the primary source of repayment for
As a precaution, institutions that rely on credit bureau scores most loans. Institutions that do not analyze business
often sample and compare credit bureau reports to financial statements or periodically review their lines of
determine which credit bureau most effectively captures credit may lose an opportunity for early detection of credit
data for the market(s) in which the institution does business. problems.
For institutions that acquire credit from multiple regions,
use of multiple scorecards may be appropriate, depending The effectiveness of any scoring system directly depends on
on apparent regional credit bureau strength. In some the policies and procedures established to guide and enforce
instances, it may be worthwhile for institutions to pull proper use. The most effective policies include an overview
scores from each of the major credit bureaus and establish of the institution’s scoring objectives and operations; the
rules for selecting an average value. By tracking credit establishment of authorities and responsibilities over
bureau scores over time and capturing performance data to scoring systems; the use of a chronology log to track internal
differentiate which score seems to best indicate probable and external events that affect the scoring system; the
performance outcome, institutions can select the best score establishment of institution officials responsible for
for any given market. Documenting such efforts to reporting, monitoring, and reviewing overrides; as well as
differentiate and select the best credit bureau score supports the provision of a scoring system maintenance program to
a deliberative decision process. ensure that the system continues to rank risk and to predict
default and loss under the original parameters.
Although some institutions develop their own scoring
models, most are built by outside vendors and subsequently Examiners should refer to the Credit Card Specialty Bank
maintained by the institution. Vendors build scoring models Examination Guidelines and the Credit Card Activities
based upon specific information and parameters provided section of the Examination Modules for additional
by institution management. Therefore, management must information on credit scoring systems.
clearly communicate with the vendor and ensure that the
scorecard developer clearly understands the institution’s ←
objectives. Bank management that adheres closely to SUBPRIME LENDING
vendor manual specifications for system maintenance and
management, particularly those that provide guidance for Introduction
periodically assessing performance of the system, achieve
the most reliable results.
There is no universal definition of a subprime loan in the
industry, but subprime lending is generally characterized as
Scoring models generally become less predictive as time
a lending program or strategy that targets borrowers who
passes. Certain characteristics about an applicant, such as
pose a significantly higher risk of default than traditional
income, job stability, and age change over time, as do
retail banking customers. Institutions often refer to
overall demographics. One-by-one, these changes will
subprime lending by other names such as the nonprime,
result in significant shifts in the profile of the population.
nonconforming, high coupon, or alternative lending market.
Once a fundamental change in the profile occurs, the model
is less able to identify potentially good and bad applicants.
Well-managed subprime lending can be a profitable
As these changes continue, the model loses its ability to rank
business line; however, it is a high-risk lending activity.
order risk. Thus, for the best results, institutions must
Successful subprime lenders carefully control the elevated
periodically validate the system’s predictability, refine
credit, operating, compliance, legal, market, and other risks
scoring characteristics when necessary, and document these
as well as the higher overhead costs associated with more
efforts.
labor-intensive underwriting, servicing, and collections.
Subprime lending should only be conducted by institutions
Institutions initially used credit scoring for consumer
that have a clear understanding of the business and its
lending applications such as credit card, auto, and mortgage
inherent risks, and have determined these risks to be
lending. However, credit scoring eventually gained
acceptable and controllable given the institution’s staff,
acceptance in the small business sector. Depending on the
financial condition, size, and level of capital support. In
manner in which it is implemented, credit scoring for small
addition, subprime lending should only be conducted within
business lending may represent a fundamental shift in
a comprehensive lending program that employs strong risk
underwriting philosophy if institutions view a small
management practices to identify, measure, monitor, and
business loan as more of a high-end consumer loan and,
control the elevated risks that are inherent in this activity.
thus, grant credit more on the strength of the principals’
Finally, subprime lenders need to retain capital support that
personal credit history and less on the fundamental strength

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is consistent with the volume and nature of the additional determining whether a portfolio of loans to borrowers with
risks assumed. If the risks associated with this activity are limited credit histories should be treated as subprime for
not properly controlled, subprime lending may be examination purposes.
considered an unsafe and unsound banking practice.
Subprime lending typically refers to a lending program that
The term, subprime, refers to the credit characteristics of the targets subprime borrowers. Institutions engaging in
borrower at the loan’s origination, rather than the type of subprime lending generally have knowingly and
credit or collateral considerations. Subprime borrowers purposefully focused on subprime lending through planned
typically have weakened credit histories that may include a business strategies, tailored products, and explicit borrower
combination of payment delinquencies, charge-offs, targeting. An institution’s underwriting guidelines and
judgments, and bankruptcies. They may also display target markets should provide a basis for determining
reduced repayment capacity as measured by credit scores, whether it should be considered a subprime lender. The
debt-to-income ratios, or other criteria. Generally, average credit risk profile of subprime loan programs will
subprime borrowers will display a range of credit risk exhibit the credit risk characteristics listed above, and will
characteristics that may include one or more of the likely display significantly higher delinquency and/or loss
following: rates than prime portfolios. High interest rates and fees are
a common and relatively easily identifiable characteristic of
• Two or more 30-day delinquencies in the last 12 subprime lending. However, high interest rates and fees by
months, or one or more 60-day delinquencies in the themselves do not constitute subprime lending.
last 24 months;
• Judgment, foreclosure, repossession, or charge-off in Subprime lending does not include traditional consumer
the prior 24 months; lending that has historically been the mainstay of
• Bankruptcy in the last 5 years; community banking, nor does it include making loans to
• Relatively high default probability as evidenced by, subprime borrowers as discretionary exceptions to the
for example, a Fair Isaac and Co. risk score (FICO) of institution’s prime retail lending policy. In addition,
660 or below (depending on the product/collateral), or subprime lending does not refer to: prime loans that develop
other bureau or proprietary scores with an equivalent credit problems after acquisition; loans initially extended in
default probability likelihood; and subprime programs that are later upgraded, as a result of
• Debt service-to-income ratio of 50 percent or greater, their performance, to programs targeted to prime borrowers;
or otherwise limited ability to cover family living or community development loans as defined in the CRA
expenses after deducting total monthly debt-service regulations.
requirements from monthly income.
For supervisory purposes, a subprime lender is defined as
This list is illustrative rather than exhaustive and is not an insured institution or institution subsidiary that has a
meant to define specific parameters for all subprime subprime lending program with an aggregate credit
borrowers. Additionally, this definition may not match all exposure greater than or equal to 25 percent of Tier 1 capital
market or institution-specific subprime definitions, but plus ALLL. Aggregate exposure includes principal
should be viewed as a starting point from which examiners outstanding and committed, accrued and unpaid interest,
should expand their review of the institution’s lending and any retained residual assets relating to securitized
program. subprime loans.

Subprime lenders typically use the criteria above to segment Capitalization

prospects into subcategories such as, for example, A, B, C,
and D. However, subprime subcategories can vary The FDIC’s minimum capital requirements generally apply
significantly among lenders based on the credit grading to portfolios that exhibit substantially lower risk profiles
criteria. What may be an “A” grade definition at one than exist in subprime loan programs. Therefore, these
institution may be a “B” grade at another institution, but requirements may not be sufficient to reflect the risks
generally each grade represents a different level of credit associated with subprime portfolios. Each subprime lender
risk. is responsible for quantifying the amount of capital needed
to offset the additional risk in subprime lending activities,
While the industry often includes borrowers with limited or and for fully documenting the methodology and analysis
no credit histories in the subprime category, these borrowers supporting the amount specified.
can represent a substantially different risk profile than those
with a derogatory credit history and are not inherently Examiners will evaluate the capital adequacy of subprime
considered subprime. Rather, consideration should be given lenders on a case-by-case basis, considering, among other
to underwriting criteria and portfolio performance when factors, the institution’s own documented analysis of the

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capital needed to support its subprime lending activities. and may not require additional capital if adequate controls
Capital levels are typically risk sensitive, that is, allocated are in place to address the additional risks. On the other
capital should reflect the level and variability of loss hand, institutions that underwrite higher-risk subprime
estimates within reasonably conservative parameters. pools, such as unsecured loans or high loan-to-value second
Institutions generally specify a direct link between the mortgages, may need significantly higher levels of capital,
estimated loss rates used to determine an appropriate ALLL, perhaps as high as 100% of the loans outstanding depending
and the unexpected loss estimates used to determine capital. on the level and volatility of risk. Because of the higher
inherent risk levels and the increased impact that subprime
The sophistication of this analysis should be commensurate portfolios may have on an institution’s overall capital,
with the size, concentration level, and relative risk of the examiners should document and reference each institution’s
institution’s subprime lending activities and consider the subprime capital evaluation in their comments and
following elements: conclusions regarding capital adequacy.

• Portfolio growth rates; Stress Testing

• Trends in the level and volatility of expected losses;
• The level of subprime loan losses incurred over one or An institution’s capital adequacy analysis typically includes
more economic downturns, if such data/analyses are stress testing as a tool for estimating unexpected losses in
available; its subprime lending pools. Institutions may project the
• The impact of planned underwriting or marketing performance of their subprime loan pools under
changes on the credit characteristics of the portfolio, conservative stress test scenarios, including an estimation of
including the relative levels of risk of default, loss in the portfolio’s susceptibility to deteriorating economic,
the event of default, and the level of classified assets; market, and business conditions. Portfolio stress testing
• Any deterioration in the average credit quality over scenarios may include “shock” testing of basic assumptions
time due to adverse selection or retention; such as delinquency rates, loss rates, and recovery rates on
• The amount, quality, and liquidity of collateral collateral. It may also consider other potentially adverse
securing the individual loans; scenarios, such as: changing attrition or prepayment rates;
• Any asset, income, or funding source concentrations; changing utilization rates for revolving products; changes in
• The degree of concentration of subprime credits; credit score distribution; and changes in the capital markets
• The extent to which current capitalization consists of demand for whole loans, or asset-backed securities
residual assets or other potentially volatile supported by subprime loans.
components;
• The degree of legal and other risks associated with the These are representative examples. Actual factors will vary
subprime business line(s) pursued; and by product, market segment, and the size and complexity of
the portfolio relative to the institution’s overall operations.
• The amount of capital necessary to support the
Whether stress test scenarios are performed manually, or
institution’s other risks and activities.
through automated modeling techniques, the Regulatory
Agencies will expect that:
Given the higher risk inherent in subprime lending
programs, examiners should reasonably expect, as a starting
point, that an institution would hold capital against such • The process is clearly documented, rational, and easily
portfolios in an amount that is one and one half to three understood by the board and senior management;
times greater than what is appropriate for non-subprime • The inputs are reliable and relate directly to the
assets of a similar type. Refinements typically depend on subject portfolios;
the factors analyzed above, with particular emphasis on the • Assumptions are well documented and conservative;
trends in the level and volatility of loss rates, and the and
amount, quality, and liquidity of collateral securing the • Any models are subject to a comprehensive validation
loans. Institutions with significant subprime programs process.
generally have capital ratios that are well above the averages
for their traditional peer groups or other similarly situated The results of the stress test exercises should be a
institutions that are not engaged in subprime lending. documented factor in the analysis and determination of
capital adequacy for the subprime portfolios.
Some subprime asset pools warrant increased supervisory
scrutiny and monitoring, but not necessarily additional Institutions that engage in subprime lending without
capital. For example, well-secured loans to borrowers who adequate procedures to estimate and document the level of
are slightly below what is considered prime quality may capital necessary to support their activities should be
entail minimal additional risks compared to prime loans, criticized. Where capital is deemed inadequate to support

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the risk in subprime lending activities, examiners should Lending Policies and Procedures. Lenders typically have
consult with their regional office to determine the comprehensive written policies and procedures, specific to
appropriate course of action. each subprime lending product that set limits on the amount
of risk that will be assumed and address how the institution
Risk Management will control portfolio quality and avoid excessive exposure.
Prudent institutions implement policies and procedures
The following items are essential components of an before initiating the activity. Institutions may originate
effective risk management program for subprime lenders. subprime loans through a variety of channels, including
dealers, brokers, correspondents, and marketing firms.
Planning and Strategy. Prior to engaging in subprime Regardless of the source, it is critical that underwriting
lending, the board and management ensure that proposed policies and procedures incorporate the risk tolerances
activities are consistent with the institution's overall established by the board and management and explicitly
business strategy and risk tolerances, and that all involved define underwriting criteria and exception processes.
parties have properly acknowledged and addressed critical Subprime lending policies and procedures typically address
business risk issues. These issues include the costs the items outlined in the loan reference module of the ED
associated with attracting and retaining qualified personnel, Modules for subprime lending. If the institution elects to
investments in the technology necessary to manage a more use scoring systems for approvals or pricing, the model
complex portfolio, a clear solicitation and origination should be tailored to address the behavioral and credit
strategy that allows for after-the-fact assessment of characteristics of the subprime population targeted and the
underwriting performance, and establishing appropriate products offered. It is generally not acceptable to rely on
feedback and control systems. Appropriate risk assessment models developed for standard risk borrowers or products.
processes extend beyond credit risk and appropriately Furthermore, the models should be reviewed frequently and
incorporate operating, compliance, market, liquidity, and updated as necessary to ensure assumptions remain valid.
legal risks.
Given the higher credit risk associated with the subprime
Institutions establishing an appropriate subprime lending borrower, effective subprime lenders use mitigating
program proceed slowly and cautiously into this activity to underwriting guidelines and risk-based pricing to reduce the
minimize the impact of unforeseen personnel, technology, overall risk of the loan. These guidelines include lower
or internal control problems and to determine if favorable loan-to-value ratio requirements and lower maximum loan
initial profitability estimates are realistic and sustainable. amounts relative to each risk grade within the portfolio.
Strategic plan performance analysis is generally conducted Given the high-risk nature of subprime lending, the need for
frequently in order to detect adverse trends or circumstances thorough analysis and documentation is heightened relative
and take appropriate action in a timely manner. to prime lending. Compromises in analysis or
documentation can substantially increase the risk and
Management and Staff. Prior to engaging in subprime severity of loss. In addition, successful subprime lenders
lending, the board typically ensures that management and develop criteria for limiting the risk profile of borrowers
staff possess sufficient expertise to appropriately manage selected, giving consideration to factors such as the
the risks in subprime lending and that staffing levels are frequency, recentness, and severity of delinquencies and
adequate for the planned volume of activity. Subprime derogatory items; length of time with re-established credit;
lending requires specialized knowledge and skills that many and reason for the poor credit history.
financial institutions may not possess. Marketing, account
origination, and collections strategies and techniques often Since the past credit deficiencies of subprime borrowers
differ from those employed for prime credit; thus it is reflect a higher risk profile, appropriate subprime loan
generally not sufficient to have the same staff responsible programs are based upon the borrowers’ current reasonable
for both subprime and prime loans. Servicing and collecting ability to repay and a prudent debt amortization schedule.
subprime loans can be very labor intensive and requires a Loan repayment should not be based upon foreclosure
greater volume of staff with smaller caseloads. Lenders proceedings or collateral repossession. Institutions are to
should monitor staffing levels, staff experience, and the recognize the additional default risks and determine if these
need for additional training as performance is assessed over risks are acceptable and controllable without resorting to
time. Compensation programs should not depend primarily foreclosure or repossession that could have been
on volume or growth targets. Any targets used should be predetermined by the loan structure at inception.
weighted towards factors such as portfolio quality and risk-
adjusted profitability. Profitability and Pricing. A key consideration for lenders
in the subprime market is the ability to earn risk-adjusted
yields that appropriately compensate the institution for the
increased risk and costs assumed. Successful institutions

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have a comprehensive framework for pricing decisions and Cure programs include practices such as loan restructuring,
profitability analysis that considers all costs associated with re-aging, renewal, extension, or consumer credit
each subprime product, including origination, counseling. Cure programs typically are used only when the
administrative/servicing, expected charge-offs, funding, institution has substantiated the customer’s renewed
and capital. In addition, such pricing frameworks allow for willingness and ability to pay. Appropriate controls help
fluctuations in the economic cycle. Fees often comprise a ensure cure programs do not mask poor initial credit risk
significant portion of revenue in subprime lending. selection or defer losses. Effective subprime lenders may
Consideration should be given to the portion of revenues use short-term loan restructure programs to assist borrowers
derived from fees and the extent to which the fees are a in bringing loans current when warranted, but will often
recurring and viable source of revenue. Profitability continue to report past due status on a contractual basis.
projections typically are incorporated into the business plan. Cure programs that alter the contractual past due status may
Also, effective management teams track actual performance mask actual portfolio performance and inhibit the ability of
against projections regularly and have a process for management to understand and monitor the true credit
addressing variances. quality of the portfolio.

Loan Review and Monitoring. Consistent with the safety Repossession and resale programs are integral to the
and soundness standards prescribed in Appendix A to Part subprime business model. Policies and procedures for
364 of the FDIC Rules and Regulations, institutions must foreclosure and repossession activities typically specifically
have comprehensive analysis and information systems that address the types of cost/benefit analysis to be performed
identify, measure, monitor and control the risks associated before pursuing collateral, including valuation methods
with subprime lending. Such analysis promotes employed; timing of foreclosure or repossession; and
understanding of the portfolio and early identification of accounting and legal requirements. Effective policies
adverse quality/performance trends. Systems employed clearly outline whether the institution will finance the sale
must possess the level of detail necessary to properly of the repossessed collateral, and if so, the limitations that
evaluate subprime activity. Examples of portfolio apply. Institutions that track the performance of such loans
segmentation and trend analyses are discussed in the are able to assess the adequacy of these policies.
subprime lending loan reference module of the ED
Modules. Compliance and Legal Risks. Subprime lenders generally
run a greater risk of incurring legal action given the higher
Comprehensive analysis considers the effects of portfolio fees, interest rates, and profits; targeting customers who
growth and seasoning, which can mask true performance by have little experience with credit or damaged credit records;
distorting delinquency and loss ratios. Vintage, lagged and aggressive collection efforts. Because the risk is
delinquency, and lagged loss analysis methods are dependent, in part, upon the public perception of a lender’s
sometimes used to account for growth, seasoning, and practices, the nature of these risks is inherently
changes in underwriting. Analysis should also take into unpredictable. Institutions that engage in subprime lending
account the effect of cure programs on portfolio must take special care to avoid violating consumer
performance. Refer to the glossary of the Credit Card protection laws. An adequate compliance management
Specialty Bank Examination Guidelines for definitions of program must identify, monitor and control the consumer
vintage, roll rate, and migration analysis. protection hazards associated with subprime lending. The
institution should have a process in place to handle the
Servicing and Collections. Defaults occur sooner and in potential for heightened legal action. In addition,
greater volume than in prime lending; thus a well-developed management should have a system in place to monitor
servicing and collections function is essential for the consumer complaints for recurring issues and ensure
effective management of subprime lending. Strong appropriate action is taken to resolve legitimate disputes.
procedures and controls are necessary throughout the
servicing process; however, particular attention is warranted Audit. The institution’s audit scope should provide for
in the areas of new loan setup and collections to ensure the comprehensive independent reviews of subprime activities.
early intervention necessary to properly manage higher risk Appropriate audit procedures include, among other things,
borrowers. Prudent lenders also have well-defined written a sample of a sufficient volume of accounts to verify the
collection policies and procedures that address default integrity of the records, particularly with respect to
management (e.g., cure programs and repossessions), payments processing.
collateral disposition, and strategies to minimize
delinquencies and losses. This aspect of subprime lending Third Parties. Subprime lenders may use third parties for
is very labor intensive but critical to the program's success. a number of functions from origination to collections. In
dealing with high credit-risk products, effective
management teams take steps to ensure that exposures from

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third-party practices or financial instability are minimized. transactions and ensure compliance with existing regulatory
This includes proper due diligence performed prior to guidance. Refer to outstanding examination instructions for
contracting with a third party vendor and on an ongoing further information regarding securitizations.
basis. Appropriate contracts provide the institution with the
ability to control and monitor third party activities (e.g. Classification
growth restrictions, underwriting guidelines, outside audits,
etc.) and discontinue relationships that prove detrimental to The Uniform Retail Credit Classification and Account
the institution. Management Policy (Retail Classification Policy) governs
the evaluation of consumer loans. This policy establishes
Special care must be taken when purchasing loans from general classification thresholds based on delinquency, but
third party originators. Some originators who sell subprime also grants examiners the discretion to classify individual
loans charge borrowers high up-front fees, which may be retail loans that exhibit signs of credit weakness regardless
financed into the loan. These fees provide incentive for of delinquency status. An examiner may also classify retail
originators to produce a high volume of loans with little portfolios, or segments thereof, where underwriting
emphasis on quality, to the detriment of a potential standards are weak and present unreasonable credit risk, and
purchaser. These fees also increase the likelihood that the may criticize account management practices that are
originator will attempt to refinance the loans. Appropriate deficient. Given the high-risk nature of subprime portfolios
contracts restrict the originator from the churning of and their greater potential for loan losses, the delinquency
customers. Further, subprime loans, especially those thresholds for classification set forth in the Retail
purchased from outside the institution's lending area, are at Classification Policy should be considered minimums.
special risk for fraud or misrepresentation. Effective Well-managed subprime lenders recognize the heightened
management also ensures that third party conflicts of risk-of-loss characteristics in their portfolios and, if
interest are avoided. For example, if a loan originator warranted, internally classify their delinquent accounts well
provides recourse for poorly performing loans purchased by before the timeframes outlined in the interagency policy. If
the institution, the originator or related interest thereof examination classifications are more severe than the Retail
should not also be responsible for processing and Classification Policy suggests, the examination report
determining the past due status of the loans. should explain the weaknesses in the portfolio and fully
document the methodology used to determine adverse
Securitizations. Securitizing subprime loans carries classifications.
inherent risks, including interim credit, liquidity, interest
rate, and other risks, that are potentially greater than those ALLL Analysis
for securitizing prime loans. The subprime loan secondary
market can be volatile, resulting in significant liquidity risk An institution’s appropriately documented ALLL analysis
when originating a large volume of loans intended for identifies subprime loans as a specific risk exposure
securitization and sale. Investors can quickly lose their separate from the prime portfolio. In addition, the analysis
appetite for risk in an economic downturn or when financial segments the subprime lending portfolios by risk exposure
markets become volatile. As a result, institutions may be such as specific product, vintage, origination channel, risk
forced to sell loan pools at deep discounts. If an institution grade, loan to value ratio, or other grouping deemed
lacks adequate personnel, risk management procedures, or relevant.
capital support to hold subprime loans originally intended
for sale, these loans may strain an institution's liquidity, Adversely classified subprime loans (to include, at a
asset quality, earnings, and capital. Consequently, minimum, all loans past due 90 days or more) should be
institutions actively involved in the securitization and sale reviewed for impairment, and an appropriate allowance
of subprime loans typically develop a contingency plan that should be established consistent with accounting
addresses back-up purchasers of the securities, whole loans, requirements. For subprime loans that are not adversely
or the attendant servicing functions, alternate funding classified, the ALLL should be sufficient to absorb at least
sources, and measures for raising additional capital. An all estimated credit losses on outstanding balances over the
institution’s liquidity and funding structure should not be current operating cycle, typically 12 months. To the extent
overly dependent upon the sale of subprime loans. that the historical net charge-off rate is used to estimate
credit losses, it should be adjusted for changes in trends,
Given some of the unique characteristics of subprime conditions, and other relevant factors, including business
lending, accounting for the securitization process requires volume, underwriting, risk selection, account management
assumptions that can be difficult to quantify reliably, and practices, and current economic or business conditions that
erroneous assumptions can lead to the significant may alter such experience.
overstatement of an institution's assets. Prudent institutions
take a conservative approach when accounting for these

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Subprime Auto Lending a limited degree through purchases of subprime loans and
guarantees of subprime securitizations.
Underwriting. Subprime auto lenders use risk-based
pricing of loans in addition to more stringent advance rates, Servicing and Collections. Collection calls begin early,
discounting, and dealer reserves than those typically used generally within the first 10 days of delinquency, within the
for prime auto loans to mitigate the increased credit risk. As framework of existing laws. Lenders generally send written
credit risk increases, advance rates on collateral decrease correspondence of intent to foreclosure or initiate other
while interest rates, dealer paper discounts, and dealer legal action early, often as early as 31 days delinquent. The
reserves increase. In addition to lower advance rates, foreclosure process is generally initiated as soon as allowed
collateral values are typically based on the wholesale value by law. Updated collateral valuations are typically obtained
of the car. Lenders will typically treat a new dealer with early in the collections process to assist in determining
greater caution, using higher discounts and/or purchasing appropriate collection efforts. Frequent collateral
the dealer’s higher quality paper until a database and inspections are often used by lenders to monitor the
working relationship is developed. condition of the collateral.

Servicing and Collections. Repossession is quick, Subprime Credit Card Lending

generally ranging between 30 to 60 days past due and
sometimes earlier. The capacity of a repossession and Underwriting. Subprime credit card lenders use risk-based
resale operation operated by a prime lender could easily be pricing as well as tightly controlled credit limits to mitigate
overwhelmed if the lender begins targeting subprime the increased credit risk. In addition, lenders may require
borrowers, leaving the lender unable to dispose of cars full or partial collateral coverage, typically in the form of a
quickly. Resale methods include wholesale auction, retail deposit account at the institution, for the higher-risk
lot sale, and/or maintaining a database of retail contacts. segments of the subprime market. Initial credit lines are set
While retail sale will command a greater price, subprime at low levels, such as $300 to $1,000, and subsequent line
lenders may consider limiting the time allocated to retail increases are typically smaller than for prime credit card
sales before sending cars to auction in order to ensure accounts. Increases in credit lines should be subject to
adequate cash flow and avoid excessive inventory build-up. stringent underwriting criteria similar to that required at
Refinancing resales are usually limited and tightly origination.
controlled, as this practice can mask losses. Lenders
typically implement a system for tracking the location of the Underwriting for subprime credit cards is typically based
collateral. upon credit scores generated by sophisticated scoring
models. These scoring models use a substantial number of
Subprime Residential Real Estate Lending attributes, including the frequency, severity, and recency of
previous delinquencies and major, derogatory items, to
Underwriting. To mitigate the increased risk, subprime determine the probability of loss for a potential borrower.
residential real estate lenders use risk-based pricing in Subprime lenders typically target particular subprime
addition to more conservative LTV ratio requirements and populations through prescreening models, such as
cash-out restrictions than those typically used for prime individuals who have recently emerged from bankruptcy.
mortgage loans. As the credit risk of the borrower increases, Review of the attributes in these models often reveals the
the interest rate increases and the loan-to-value ratio and nature of the institution’s target population.
cash-out limit decreases. Prudent loan-to-value ratios are an
essential risk mitigant in subprime real estate lending and Servicing and Collections. Lenders continually monitor
generally range anywhere from 85 percent to 90 percent for customer behavior and credit quality and take proactive
A- loans, to 65 percent for lower grades. High loan-to-value measures to avert potential problems, such as decreasing or
(HLTV) loans are generally not considered prudent in freezing credit lines or providing consumer counseling,
subprime lending. HLTV loans should be targeted at before the problems become severe or in some instances
individuals who warrant large unsecured debt, and then only before the loans become delinquent. Lenders often use
in accordance with outstanding regulatory guidance. The sophisticated scoring systems to assist in monitoring credit
appraisal process takes on increased importance given the quality and frequently re-score customers. Collection calls
greater emphasis on collateral. Prepayment penalties are on delinquent loans begin early, generally within the first 10
sometimes used on subprime real estate loans, where days delinquent, and sometimes as early as 1-day
allowed by law, given that prepayment rates are generally delinquent, within the framework of existing laws. Lenders
higher and more volatile for subprime real estate loans. generally send written correspondence within the first 30
Government Sponsored entities, Fannie Mae and Freddie days in addition to calling. Account suspensions occur
Mac, have participated in the subprime mortgage market to early, generally within the first 45 days of delinquency or
immediately upon a negative event such as refusal to pay.

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Accounts over 90 days past due are generally subject to Examiners may conduct targeted examinations of a third
account closure and charge-off. In addition, account party bank partner where appropriate. Authority to conduct
closures based upon a borrower’s action, such as repeated examinations of third parties may be established under
refusal to pay or broken promises to bring the account several circumstances, including through the bank's written
current within a specified time frame, may occur at any time agreement with the third party, section 7 of the Bank Service
in the collection process. Account closure practices are Company Act, or through powers granted under section 10
generally more aggressive for relatively new credit card of the Federal Deposit Insurance Act. Third party
accounts, such as those originated in the last six months. examination activities would typically include, but not be
limited to, a review of compensation and staffing practices;
Payday Lending marketing and pricing policies; management information
systems; and compliance with bank policy as well as
Payday lending is a subset of subprime lending. Payday applicable laws and regulations. Third party reviews should
loans are usually priced at a fixed dollar fee per $100 also include testing of individual loans for compliance with
borrowed, which represents the finance charge. Because underwriting and loan administration guidelines, and
these loans have such short terms to maturity, usually appropriate treatment under delinquency, and re-aging and
ranging from 14 to 45 days, the cost of borrowing, expressed cure programs.
as an annual percentage rate may be high.
Underwriting
In return for the loan, the borrower usually provides the
lender with a debit authorization for the amount of the loan Institutions making payday loans may use a variety of
plus the fee. Repayment is often provided through an underwriting techniques, such as scoring systems, review of
electronic payment of the fee and the advance with the next current pay stub or proof of a regular income source and
direct deposit. In addition, lenders allow payment by mail evidence that the customer has a checking account,
or other means rather than electronic transfer, and may consultation of nationwide databases that track bounced
charge a lower fee/finance charge for consumers that choose checks and persons with outstanding payday loans, among
to pay electronically. If the borrower informs the lender that others. As described above, the Interagency Guidelines
he or she does not have the funds to repay the loan, the loan Establishing Standards for Safety and Soundness
is often refinanced through payment of another fee. (Guidelines) set out the safety and soundness standards that
the agencies use to identify and address problems at insured
General depository institutions before capital becomes
impaired. The Loan Documentation prong of the
The examination instructions described in this section apply Guidelines addresses assessing the ability of the borrower
to banks with payday lending programs that the bank to repay the indebtedness in a timely manner and ensuring
administers directly or through a third party that partners that any claim against a borrower is legally
with the bank to offer payday loans to consumers. These enforceable. The Credit Underwriting prong addresses
instructions do not apply to situations where a bank makes providing for consideration, prior to credit commitment, of
occasional small-dollar loans as an accommodation to the borrower's overall financial condition and resources, the
borrowers that do not fall within the definition of payday financial responsibility of any guarantor, the nature and
loans above nor do they apply to banks offering products value of any underlying collateral, and the borrower's
and services, such as deposit accounts and extensions of character and willingness to repay as agreed. Institutions
credit, to non-bank payday lenders. These instructions that choose to offer payday loans with strong risk
apply regardless of whether an institution is a subprime management frameworks might adopt the following
lender, as described in the section above. controls, among others, to demonstrate their conformance
with these prongs of the Guidelines:
Due to the heightened safety and soundness risks posed by
payday lending, concurrent risk management and consumer • Consideration of the consumer’s overall short-term
protection examinations should be conducted absent debt obligations relative to resources;
overriding resource or scheduling problems. In all cases, a • Consideration of the total length of time a consumer
review of each discipline's examinations and workpapers has had payday loan debt outstanding as an indication
should be part of the examination planning process. of the customer’s ability to repay the payday loan
Relevant state examinations also should be reviewed. The according to its term without reborrowing; and
subprime lending loan reference module of the ED Modules • Consideration of any applicable laws and regulations.
provides procedures to assist examiners in evaluating a
payday lending program.

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Payday Lending Through Third Parties • Require the third party to indemnify the institution for
potential liability resulting from action of the third
Insured depository institutions may have payday lending party with regard to the payday lending program; and
programs that they administer directly, using their own • Address customer complaints, including any
employees, or they may enter into arrangements with third responsibility for third-party forwarding and
parties. In the latter arrangements, the institution typically responding to such complaints.
enters into an agreement in which the institution funds
payday loans originated through the third party. These Effective bank management sufficiently monitors the third
arrangements also may involve the sale to the third party of party with respect to its activities and performance. This
the loans or servicing rights to the loans. Institutions also includes dedicating sufficient staff with the necessary
may rely on the third party to provide additional services expertise to oversee the third party. An appropriate
that the institution might otherwise provide, including oversight program also includes monitoring the third party’s
collections, advertising and soliciting applications. The financial condition, internal controls, and the quality of its
existence of third party arrangements when not properly service and support, including the resolution of consumer
managed, can increase institutions’ transaction and legal complaints if handled by the third party. Oversight
risks. programs that are documented sufficiently facilitate the
monitoring and management of the risks associated with
The use of third parties in no way diminishes the third-party relationships.
responsibility of the board of directors and management to
ensure that the activity performed on behalf of the bank is Concentrations
conducted in a safe and sound manner that complies with
applicable consumer protection laws. Appropriate Given the potential risk of payday lending, concentrations
corrective actions, including enforcement actions, may be of credit in this line of business pose a significant safety and
pursued for deficiencies related to a third-party relationship soundness concern. In the context of payday lending, a
that poses safety and soundness issues or compliance with concentration would be defined as a volume of payday loans
consumer protection laws. totaling 25 percent or more of an institution’s common
equity tier 1 capital plus the ALLL or the ACL for loans and
The FDIC's principal concern relating to third parties is leases, as applicable. Appropriate supervisory action may be
whether effective risk controls are implemented. Examiners necessary to address concentrations, including directing the
should assess the institution's risk management program for institution to reduce its loans to an appropriate level, or
third-party payday lending relationships. An assessment of raising additional capital.
third-party relationships should include an evaluation of the
bank's risk assessment and strategic planning, as well as the Capital Adequacy
bank's due diligence process for selecting a competent and
qualified third party provider. Examiners should determine The minimum capital requirements generally apply to
whether arrangements with third parties are guided by a portfolios that exhibit substantially lower risk profiles and
written contract and approved by the institution’s board. that are subject to more stringent underwriting procedures
Appropriate arrangements typically: than exist in payday lending programs. Therefore,
minimum capital requirements may not be sufficient to
• Describe the duties and responsibilities of each party, offset the risks associated with payday lending. Institutions
including the scope of the arrangement; that underwrite payday loans may need to maintain capital
• Specify that the third party will comply with all levels as high as one hundred percent of the loans
applicable laws and regulations; outstanding (i.e. dollar-for-dollar capital), depending on the
• Specify which party will provide consumer level and volatility of risk. Risks to consider when
compliance related disclosures; determining the appropriate amount of capital include the
• Authorize the institution to monitor the third party and unsecured nature of the credit, the relative levels of risk of
periodically review and verify that the third party and default, loss in the event of default, and the level of
its representatives are complying with its agreement classified assets. The degree of legal risk associated with
with the institution; payday lending should also be considered, especially as it
• Authorize the institution and the appropriate banking relates to third party agreements.
agency to have access to such records of the third
party and conduct onsite transaction testing and Allowance for Loan and Lease Losses
operational reviews at the third party locations as
necessary or appropriate to evaluate such compliance; As with other loan types, institutions should maintain an
ALLL or an ACL for loans and leases as applicable, that is
appropriate to absorb estimated credit losses with the

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payday portfolio. Although the contractual term of each Payday loans are typically classified as Substandard.
payday loan may be short, institutions’ methodologies for Payday loans for which the institution has documented
estimating credit losses on these loans should take into adequate paying capacity of the obligors and/or sufficient
account if payday loans remain outstanding for longer collateral protection or credit enhancement are not
periods because of renewals and rollovers. In addition, classified.
examiners should evaluate the institution’s assessment of
the collectibility of accrued fees and finance charges on Payday loans that have been outstanding for extended
payday loans and whether the institution employs periods of time evidence a high risk of loss. While such
appropriate methods to ensure that income is accurately loans may have some recovery value, it is not practical or
measured. desirable to defer writing off these essentially worthless
assets. Short-term Payday loans that are outstanding for
Examiners should determine that institutions engaged in greater than 60 days from origination generally meet the
payday lending have methodologies and analyses in place definition of Loss. In certain circumstances, earlier charge-
that demonstrate and document that the level of the ALLL off may be appropriate (e.g., the institution does not renew
or the ACL for payday loans is appropriate. The application beyond the first payday and the borrower is unable to pay,
of historical loss rates to the payday loan portfolio, adjusted the institution closes an account). The institution’s policies
for the current environmental factors, including reasonable regarding consecutive advances also should be considered
and supportable forecast for institutions that have adopted when determining Loss classifications. Where the
CECL, is one way to determine the ALLL or ACL needed economic substance of consecutive advances is
for these loans. Environmental factors include levels of and substantially similar to “rollovers” – without intervening
trends in delinquencies and charge-offs, trends in loan “cooling off” or waiting periods – examiners should treat
volume, effects of changes in risk selection and these loans as continuous advances and classify
underwriting standards and in account management accordingly.
practices, and current economic conditions. Examiners
should be mindful that for institutions that do not have loss Renewals/Rewrites
experience of their own, it may be appropriate to reference
the payday loan loss experience of other institutions with The Retail Classification Policy provides guidelines for
payday loan portfolios with similar attributes. Other extensions, deferrals, renewals, or rewrites of closed-end
methods, such as loss estimation models, are acceptable if accounts. Despite the short-term nature of payday loans,
they estimate losses in accordance with generally accepted borrowers that request an extension, deferral, renewal, or
accounting principles. Examiners should review rewrite are typically expected by institutions to exhibit a
documentation to determine that institutions’ loss estimates renewed willingness and ability to repay the loan.
and allowance methodologies reflect consideration of the Institutions can refer to the Retail Classification Policy
principles discussed in the 2001 and 2006 Interagency principles that address the use of extensions, deferrals,
policy statements on ALLL, or if the institution has adopted renewals, or rewrites of payday loans. In consideration of
CECL, the 2020 Interagency Policy Statement on the Retail Classification Policy, institutions typically:
Allowances for Credit Losses.
• Limit the number and frequency of extensions,
Classifications deferrals, renewals, and rewrites;
• Prohibit additional advances to finance unpaid interest
The Retail Classification Policy addresses general and fees and simultaneous loans to the same customer;
classification thresholds for consumer loans based on and
delinquency, but also discusses examiners’ discretion to • Ensure that comprehensive and effective risk
classify individual retail loans that exhibit signs of credit management, reporting, and internal controls are
weakness regardless of delinquency status. Examiners also established and maintained.
may classify retail portfolios, or segments thereof, where
underwriting standards are weak and present unreasonable Accrued Fees and Finance Charges
credit risk, and may criticize account management practices
that are deficient. Examiners should determine whether institutions evaluate
the collectibility of accrued fees and finance charges on
Payday loans may have well-defined weaknesses that may payday loans because a portion of accrued interest and fees
jeopardize the liquidation of the debt. Weaknesses include is generally not collectible. (For more guidance on
limited or no analysis of repayment capacity and the accounting for delinquency fees, refer to ASC Section 310-
unsecured nature of the credit. In addition, payday loan 10-25, Receivables – Overall - Recognition.) Although
portfolios can be characterized by a marked proportion of regulatory reporting instructions do not require payday
obligors whose paying capacity is questionable, and such loans to be placed on nonaccrual based on delinquency

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status, examiners should assess whether the institution

employs appropriate methods to ensure that income is
accurately measured. Such methods may include providing
loss allowances for uncollectible fees and finance charges
or placing delinquent and impaired receivables on
nonaccrual status. After a loan is placed on nonaccrual
status, subsequent fees and finance charges imposed on the
borrower would not be recognized in income and accrued,
but unpaid fees and finance charges normally would be
reversed from income.

Recovery Practices

After a loan is charged off, institutions must properly report

any subsequent collections on the loan (refer to ASC
Section 310-10-25, Receivables – Overall - Recognition.)
Typically, some or all of such collections are reported as
recoveries to the ALLL or ACL for loans and leases. In
some instances, the total amount credited to the ALLL or
ACL for loans and leases as recoveries on an individual loan
(which may have included principal, finance charges, and
fees) may exceed the amount previously charged off against
the ALLL or ACL on that loan (which may have been
limited to principal). Such a practice understates an
institution's net charge-off experience, which is an
important indicator of the credit quality and performance of
an institution's portfolio.

Consistent with regulatory reporting instructions, recoveries

represent collections on amounts that were previously
charged off against the ALLL or ACL for loans and leases.
Accordingly, institutions must ensure that the total amount
credited to the ALLL or ACL as recoveries on a loan is
limited to the amount previously charged off on that loan.
Any amounts collected in excess of this limit should be
recognized as income.

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