LOANS Section 3.

INTRODUCTION however, certain broad areas of consideration and concern

that should be addressed in the lending policies of all
The examiners evaluation of a banks lending policies, banks regardless of size or location. These include the
credit administration, and the quality of the loan portfolio following, as minimums:
is among the most important aspects of the examination
process. To a great extent, it is the quality of a bank's loan General fields of lending in which the bank will
portfolio that determines the risk to depositors and to the engage and the kinds or types of loans within each
FDIC's insurance fund. Conclusions regarding the banks general field;
condition and the quality of its management are weighted Lending authority of each loan officer;
heavily by the examiner's findings with regard to lending Lending authority of a loan or executive committee, if
practices. Emphasis on review and appraisal of the loan any;
portfolio and its administration by bank management Responsibility of the board of directors in reviewing,
during examinations recognizes, that loans comprise a ratifying, or approving loans;
major portion of most banks assets; and, that it is the Guidelines under which unsecured loans will be
asset category which ordinarily presents the greatest credit granted;
risk and potential loss exposure to banks. Moreover, Guidelines for rates of interest and the terms of
pressure for increased profitability, liquidity repayment for secured and unsecured loans;
considerations, and a vastly more complex society have Limitations on the amount advanced in relation to the
produced great innovations in credit instruments and value of the collateral and the documentation required
approaches to lending. Loans have consequently become by the bank for each type of secured loan;
much more complex. Examiners therefore find it Guidelines for obtaining and reviewing real estate
necessary to devote a large portion of time and attention appraisals as well as for ordering reappraisals, when
to loan portfolio examination. needed;
Maintenance and review of complete and current
credit files on each borrower;
LOAN ADMINISTRATION Appropriate and adequate collection procedures
including, but not limited to, actions to be taken
Lending Policies against borrowers who fail to make timely payments;
Limitations on the maximum volume of loans in
The examiner's evaluation of the loan portfolio involves relation to total assets;
much more than merely appraising individual loans. Limitations on the extension of credit through
Prudent management and administration of the overall overdrafts;
loan account, including establishment of sound lending Description of the bank's normal trade area and
and collection policies, are of vital importance if the bank circumstances under which the bank may extend
is to be continuously operated in an acceptable manner. credit outside of such area;
Guidelines, which at a minimum, address the goals for
Lending policies should be clearly defined and set forth in portfolio mix and risk diversification and cover the
such a manner as to provide effective supervision by the bank's plans for monitoring and taking appropriate
directors and senior officers. The board of directors of corrective action, if deemed necessary, on any
every bank has the legal responsibility to formulate concentrations that may exist;
lending policies and to supervise their implementation. Guidelines addressing the bank's loan review and
Therefore examiners should encourage establishment and grading system ("Watch list");
maintenance of written, up-to-date lending policies which Guidelines addressing the bank's review of the
have been approved by the board of directors. A lending Allowance for Loan and Lease Losses (ALLL); and
policy should not be a static document, but must be Guidelines for adequate safeguards to minimize
reviewed periodically and revised in light of changing potential environmental liability.
circumstances surrounding the borrowing needs of the
bank's customers as well as changes that may occur within The above are only as guidelines for areas that should be
the bank itself. To a large extent, the economy of the considered during the loan policy evaluation. Examiners
community served by the bank dictates the composition of should also encourage management to develop specific
the loan portfolio. The widely divergent circumstances of guidelines for each lending department or function. As
regional economies and the considerable variance in with overall lending policies, it is not the FDIC's intent to
characteristics of individual loans preclude establishment suggest universal or standard loan policies for specific
of standard or universal lending policies. There are, types of credit. The establishment of these policies is the

RMS Manual of Examination Policies 3.2-1 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

responsibility of each bank's Board and management.

Therefore, the following discussion of basic principles Accurate and timely credit grading is a primary component
applicable to various types of credit will not include or of an effective loan review system. Credit grading
allude to acceptable ratios, levels, comparisons or terms. involves an assessment of credit quality, the identification
These matters should, however, be addressed in each of problem loans, and the assignment of risk ratings. An
bank's lending policy, and it will be the examiner's effective system provides information for use in
responsibility to determine whether the policies are establishing valuation allowances for specific credits and
realistic and being followed. for the determination of an overall ALLL level.

Much of the rest of this section of the Manual discusses Credit grading systems often place primary reliance on
areas that should be considered in the bank's lending loan officers for identifying emerging credit problems.
policies. Guidelines for their consideration are discussed However, given the importance and subjective nature of
under the appropriate areas. credit grading, a loan officers judgement regarding the
assignment of a particular credit grade should generally be
Loan Review Systems subject to review. Reviews may be performed by peers,
superiors, loan committee(s), or other internal or external
The term loan review system refers to the responsibilities credit review specialists. Credit grading reviews
assigned to various areas such as credit underwriting, loan performed by individuals independent of the lending
administration, problem loan workout, or other areas. function are preferred because they can often provide a
Responsibilities may include assigning initial credit more objective assessment of credit quality. A loan
grades, ensuring grade changes are made when needed, or review system should, at a minimum, include the
compiling information necessary to assess ALLL. following:

The complexity and scope of a loan review system will A formal credit grading system that can be reconciled
vary based upon an institutions size, type of operations, with the framework used by Federal regulatory
and management practices. Systems may include agencies;
components that are independent of the lending function, An identification of loans or loan pools that warrant
or may place some reliance on loan officers. Although special attention;
smaller institutions are not expected to maintain separate A mechanism for reporting identified loans, and any
loan review departments, it is essential that all institutions corrective action taken, to senior management and the
have an effective loan review system. Regardless of its board of directors; and
complexity, an effective loan review system is generally Documentation of an institutions credit loss
designed to address the following objectives: experience for various components of the loan and
lease portfolio.
To promptly identify loans with well-defined credit
weaknesses so that timely action can be taken to Loan Review System Elements
minimize credit loss;
To provide essential information for determining the Management should maintain a written loan review policy
adequacy of the ALLL; that is reviewed and approved at least annually by the
To identify relevant trends affecting the collectibility board of directors. Policy guidelines should include a
of the loan portfolio and isolate potential problem written description of the overall credit grading process,
areas; and establish responsibilities for the various loan review
To evaluate the activities of lending personnel; functions. The policy should generally address the
To assess the adequacy of, and adherence to, loan following items:
policies and procedures, and to monitor compliance
with relevant laws and regulations; Qualifications of loan review personnel;
To provide the board of directors and senior Independence of loan review personnel;
management with an objective assessment of the Frequency of reviews;
overall portfolio quality; and Scope of reviews;
To provide management with information related to Depth of reviews;
credit quality that can be used for financial and Review of findings and follow-up; and
regulatory reporting purposes. Workpaper and report distribution.

Credit Grading Systems

Loans (8-16) 3.2-2 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

loans, recently renewed credits, or loans affected by

Qualifications of Loan Review Personnel common repayment factors. The percentage of the
portfolio selected for review should provide reasonable
Personnel involved in the loan review function should be assurance that all major credit risks have been identified.
qualified based on level of education, experience, and
extent of formal training. They should be knowledgeable Depth of Reviews
of both sound lending practices and their own institutions
specific lending guidelines. In addition, they should be Loan reviews should analyze a number of important credit
knowledgeable of pertinent laws and regulations that factors, including:
affect lending activities.
Credit quality;
Loan Review Personnel Independence Sufficiency of credit and collateral documentation;
Proper lien perfection;
Loan officers should be responsible for ongoing credit Proper loan approval;
analysis and the prompt identification of emerging Adherence to loan covenants;
problems. Because of their frequent contact with Compliance with internal policies and procedures, and
borrowers, loan officers can usually identify potential applicable laws and regulations; and
problems before they become apparent to others. The accuracy and timeliness of credit grades assigned
However, institutions should be careful to avoid over by loan officers.
reliance upon loan officers. Management should ensure
that, when feasible, all significant loans are reviewed by Review of Findings and Follow-up
individuals that are not part of, or influenced by anyone
associated with, the loan approval process. Loan review findings should be reviewed with appropriate
loan officers, department managers, and members of
Larger institutions typically establish separate loan review senior management. Any existing or planned corrective
departments staffed by independent credit analysts. Cost action (including estimated timeframes) should be
and volume considerations may not justify such a system obtained for all noted deficiencies. All deficiencies that
in smaller institutions. Often, members of senior remain unresolved should be reported to senior
management that are independent of the credit management and the board of directors.
administration process, a committee of outside directors,
or an outside loan review consultant fill this role. Workpaper and Report Distribution
Regardless of the method used, loan review personnel
should report their findings directly to the board of A list of the loans reviewed, including the review date, and
directors or a board committee. documentation supporting assigned ratings should be
prepared. A report that summarizes the results of the
Frequency of Reviews review should be submitted to the board at least quarterly.
Findings should address adherence to internal policies and
The loan review function should provide feedback on the procedures, and applicable laws and regulations, so that
effectiveness of the lending process in identifying deficiencies can be remedied in a timely manner. A
emerging problems. Reviews of significant credits should written response from management with corrective action
generally be performed annually, upon renewal, or more outlined, should be provided in response to any
frequently when factors indicate a potential for substantive criticisms or recommendations.
deteriorating credit quality. A system of periodic reviews
is particularly important to the ALLL determination
process.
Allowance for Loan and Lease Losses (ALLL)

Scope of Reviews Each bank must maintain an ALLL adequate to absorb

estimated credit losses associated with the loan and lease
Reviews should cover all loans that are considered portfolio, i.e., loans and leases that the bank has the intent
significant. In addition to loans over a predetermined size, and ability to hold for the foreseeable future or until
management will normally review smaller loans that maturity or payoff. Each bank should also maintain, as a
present elevated risk characteristics such as credits that are separate liability account, an allowance sufficient to
delinquent, on nonaccrual status, restructured, previously absorb estimated credit losses associated with off-balance
classified, or designated as Special Mention. Additionally, sheet credit instruments such as off-balance sheet loan
management may wish to periodically review insider commitments, standby letters of credit, and guarantees.

RMS Manual of Examination Policies 3.2-3 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

This separate allowance for credit losses on off-balance For purposes of Reports of Condition and Income (Call
sheet credit exposures should not be reported as part of the Reports) and Thrift Financial Reports (TFR) an adequate
ALLL on a banks balance sheet. Because loans and ALLL should, after deduction of all assets classified loss,
leases held for sale are carried on the balance sheet at the be no less than the sum of the following items:
lower of cost or fair value, no ALLL should be established
for such loans and leases. For loans and leases classified Substandard or
Doubtful, whether analyzed and provided for
The term "estimated credit losses" means an estimate of individually or as part of pools, all estimated credit
the current amount of the loan and lease portfolio (net of losses over the remaining effective lives of these
unearned income) that is not likely to be collected; that is, loans.
net chargeoffs that are likely to be realized for a loan, or For loans and leases that are not classified, all
pool of loans. The estimated credit losses should meet the estimated credit losses over the upcoming 12 months.
criteria for accrual of a loss contingency (i.e., a provision Amounts for estimated losses from transfer risk on
to the ALLL) set forth in generally accepted accounting international loans.
principles (GAAP). When available information confirms
specific loans and leases, or portions thereof, to be Furthermore, managements analysis of an adequate
uncollectible, these amounts should be promptly charged- reserve level should be conservative to reflect a margin for
off against the ALLL. the imprecision inherent in most estimates of expected
credit losses. This additional margin might be
Estimated credit losses should reflect consideration of all incorporated through amounts attributed to individual
significant factors that affect repayment as of the loans or groups of loans, or in an unallocated portion of
evaluation date. Estimated losses on loan pools should the ALLL.
reflect historical net charge-off levels for similar loans,
adjusted for changes in current conditions or other relevant When determining an appropriate allowance, primary
factors. Calculation of historical charge-off rates can reliance should normally be placed on analysis of the
range from a simple average of net charge-offs over a various components of a portfolio, including all significant
relevant period, to more complex techniques, such as credits reviewed on an individual basis. Examiners should
migration analysis. refer to Statement of Financial Accounting Standards No.
(FAS) 114, Accounting by Creditors for Impairment of a
Portions of the ALLL can be attributed to, or based upon Loan, for guidance in establishing reserves for impaired
the risks associated with, individual loans or groups of credits that are reviewed individually. When analyzing the
loans. However, the ALLL is available to absorb credit adequacy of an allowance, portfolios should be segmented
losses that arise from the entire portfolio. It is not into as many components as practical. Each component
segregated for any particular loan, or group of loans. should normally have similar characteristics, such as risk
classification, past due status, type of loan, industry, or
Responsibility of the Board and Management collateral. A depository institution may, for example,
analyze the following components of its portfolio and
It is the responsibility of the board of directors and provide for them in the ALLL:
management to maintain the ALLL at an adequate level.
The allowance adequacy should be evaluated, and Significant credits reviewed on an individual basis;
appropriate provisions made, at least quarterly. In Loans and leases that are not reviewed individually,
carrying out their responsibilities, the board and but which present elevated risk characteristics, such as
management are expected to: delinquency, adverse classification, or Special
Mention designation;
Establish and maintain a loan review system that Homogenous loans that are not reviewed individually,
identifies, monitors, and addresses asset quality and do not present elevated risk characteristics; and
problems in a timely manner. All other loans and loan commitments that have not
Ensure the prompt charge-off of loans, or portions of been considered or provided for elsewhere.
loans, deemed uncollectible.
Ensure that the process for determining an adequate In addition to estimated credit losses, the losses that arise
allowance level is based on comprehensive, from the transfer risk associated with an institutions
adequately documented, and consistently applied cross-border lending activities require special
analysis. consideration. Over and above any minimum amount that
is required by the Interagency Country Exposure Review

Loans (8-16) 3.2-4 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Committee to be provided in the Allocated Transfer the adequacy of the ALLL. Examiners should consider all
Reserve (or charged to the ALLL), an institution must significant factors that affect the collectibility of the
determine if their ALLL is adequate to absorb estimated portfolio. Examination procedures for reviewing the
losses from transfer risk associated with its cross-border adequacy of the ALLL are included in the Examination
lending exposure. Documentation (ED) Modules..

Factors to Consider in Estimating Credit Losses In assessing the overall adequacy of an ALLL, it is
important to recognize that the related process,
Estimated credit losses should reflect consideration of all methodology, and underlying assumptions require a
significant factors that affect the portfolios collectibility substantial degree of judgement. Credit loss estimates will
as of the evaluation date. While historical loss experience not be precise due to the wide range of factors that must be
provides a reasonable starting point, historical losses, or considered. Furthermore, the ability to estimate credit
even recent trends in losses, are not by themselves, a losses on specific loans and categories of loans improves
sufficient basis to determine an adequate level. over time. Therefore, examiners will generally accept
Management should also consider any factors that are managements estimates of credit losses in their
likely to cause estimated losses to differ from historical assessment of the overall adequacy of the ALLL when
loss experience, including, but not limited to: 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 adequate ALLL.
lending management;
Changes in the volume and severity of past due, If, after the completion of all aspects of the ALLL review
nonaccrual, restructured, or classified loans; described in this section, the examiner does not concur that
Changes in the quality of an institutions loan review the reported ALLL level is adequate, or the ALLL
system or the degree of oversight by the board of evaluation process is deficient, recommendations for
directors; and, correcting these problems, including any examiner
The existence of, or changes in the level of, any concerns regarding an appropriate level for the ALLL,
concentrations of credit. should be noted in the Report of Examination.

Institutions are also encouraged to use ratio analysis as a Regulatory Reporting of the ALLL
supplemental check for evaluating the overall
reasonableness of an ALLL. Ratio analysis can be useful An ALLL established in accordance with the guidelines
in identifying trends in the relationship of the ALLL to provided above should fall within a range of acceptable
classified and nonclassified credits, to past due and estimates. When an ALLL is deemed inadequate,
nonaccrual loans, to total loans and leases and binding management will be required to increase the provision for
commitments, and to historical chargeoff levels. loan and lease loss expense sufficiently to restore the
However, while such comparisons can be helpful as a ALLL reported in its Call Report or TFR to an adequate
supplemental check of the reasonableness of level.
managements assumptions and analysis, they are not, by
themselves, a sufficient basis for determining an adequate Accounting and Reporting Treatment
ALLL level. Such comparisons do not eliminate the need
for a comprehensive analysis of the loan and lease FAS 5, Accounting for Contingencies, provides the basic
portfolio and the factors affecting its collectibility. guidance for recognition of a loss contingency, such as the
collectibility of loans (receivables), when it is probable
Examiner Responsibilities that a loss has been incurred and the amount can be
reasonably estimated. FAS 114, provides more specific
Generally, following the quality assessment of the loan guidance about the measurement and disclosure of
and lease portfolio, the loan review system, and the impairment for certain types of loans. Specifically, FAS
lending policies, examiners are responsible for assessing 114 applies to loans that are identified for evaluation on an
individual basis. Loans are considered impaired when,

RMS Manual of Examination Policies 3.2-5 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

based on current information and events, it is probable that similar risk characteristics for evaluation and analysis
the creditor will be unable to collect all interest and under FAS 5;
principal payments due according to the contractual terms Consider all known relevant internal and external
of the loan agreement. factors that may affect loan collectibility;
Be applied consistently but, when appropriate, be
For individually impaired loans, FAS 114 provides modified for new factors affecting collectibility;
guidance on the acceptable methods to measure Consider the particular risks inherent in different
impairment. Specifically, FAS 114 states that when a loan kinds of lending;
is impaired, a creditor should measure impairment based Consider current collateral values (less costs to sell),
on the present value of expected future principal and where applicable;
interest cash flows discounted at the loans effective Require that analyses, estimates, reviews and other
interest rate, except that as a practical expedient, a creditor ALLL methodology functions be performed by
may measure impairment based on a loans observable competent and well-trained personnel;
market price or the fair value of collateral, if the loan is Be based on current and reliable data;
collateral dependent. When developing the estimate of Be well-documented, in writing, with clear
expected future cash flows for a loan, an institution should explanations of the supporting analyses and rationale;
consider all available information reflecting past events and,
and current conditions, including the effect of existing Include a systematic and logical method to consolidate
environmental factors. the loss estimates and ensure the ALLL balance is
recorded in accordance with GAAP.
Large groups of smaller-balance homogenous loans that
are collectively evaluated for impairment are not included A systematic methodology that is properly designed and
in the scope of FAS 114. Such groups of loans may implemented should result in an institutions best estimate
include, but are not limited to, credit card, residential of the ALLL. Accordingly, institutions should adjust their
mortgage, and consumer installment loans. FAS 5 ALLL balance, either upward or downward, in each period
addresses the accounting for impairment of these loans. for differences between the results of the systematic
Also, FAS 5 provides the accounting guidance for determination process and the unadjusted ALLL balance
impairment of loans that are not identified for evaluation in the general ledger.
on an individual basis and loans that are individually
evaluated but are not individually considered impaired. Examiners are encouraged, with the acknowledgement of
management, to communicate with an institutions
Institutions should not layer their loan loss allowances. external auditors and request an explanation of their
Layering is the inappropriate practice of recording in the rationale and findings, when differences in judgment
ALLL more than one amount for the same probable loan concerning the adequacy of the institution's ALLL exist.
loss. Layering can happen when an institution includes a In case of controversy, the auditors may be reminded of
loan in one segment, determines its best estimate of loss the consensus reached by the Financial Accounting
for that loan either individually or on a group basis (after Standards Board's Emerging Issues Task Force (EITF) on
taking into account all appropriate environmental factors, Issue No. 85-44, Differences Between Loan Loss
conditions, and events), and then includes the loan in Allowances for GAAP and RAP. This issue deals with
another group, which receives an additional ALLL the situation where regulators mandated that institutions
amount. establish loan loss allowances under regulatory accounting
principles (RAP) that may be in excess of amounts
While different institutions may use different methods, recorded by the institution in preparing its financial
there are certain common elements that should be included statement under"GAAP. The EITF was asked whether and
in any ALLL methodology. Generally, an institutions under what circumstances this can occur. The consensus
methodology should: indicated that auditors should be particularly skeptical in
the case of GAAP/RAP differences and must justify them
Include a detailed loan portfolio analysis, performed based on the particular facts and circumstances.
regularly;
Consider all loans (whether on an individual or group Additional guidance on the establishment of loan review
basis); systems and an adequate ALLL is provided in the
Identify loans to be evaluated for impairment on an Interagency Statement of Policy on the ALLL dated
individual basis under FAS 114 and segment the December 21, 1993, and the Interagency Policy Statement
remainder of the portfolio into groups of loans with on Allowance for Loan and Lease Losses Methodologies

Loans (8-16) 3.2-6 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

and Documentation for Banks and Savings Associations, Accounts Receivable Financing
dated June 29, 2001.
Accounts receivable financing is a specialized area of
PORTFOLIO COMPOSITION commercial lending in which borrowers assign their
interests in accounts receivable to the lender as collateral.
Typical characteristics of accounts receivable borrowers
Commercial Loans are those businesses that are growing rapidly and need
year-round financing in amounts too large to justify
General unsecured credit, those that are nonseasonal and need
year-round financing because working capital and profits
Loans to business enterprises for commercial or industrial are insufficient to permit periodic cleanups, those whose
purposes, whether proprietorships, partnerships or working capital is inadequate for the volume of sales and
corporations, are commonly described as commercial type of operation, and those whose previous unsecured
loans. In asset distribution, commercial or business loans borrowings are no longer warranted because of various
frequently comprise one of the most important assets of a credit factors.
bank. They may be secured or unsecured and have short
or long-term maturities. Such loans include working Several advantages of accounts receivable financing from
capital advances, term loans and loans to individuals for the borrower's viewpoint are: it is an efficient way to
business purposes. finance an expanding operation because borrowing
capacity expands as sales increase; it permits the borrower
Short-term working capital and seasonal loans provide to take advantage of purchase discounts because the
temporary capital in excess of normal needs. They are company receives immediate cash on its sales and is able
used to finance seasonal requirements and are repaid at the to pay trade creditors on a satisfactory basis; it insures a
end of the cycle by converting inventory and accounts revolving, expanding line of credit; and actual interest paid
receivable into cash. Such loans may be unsecured; may be no more than that for a fixed amount unsecured
however, many working capital loans are advanced with loan.
accounts receivable and/or inventory as collateral. Firms
engaged in manufacturing, distribution, retailing and Advantages from the bank's viewpoint are: it generates a
service-oriented businesses use short-term working capital relatively high yield loan, new business, and a depository
loans. relationship; permits continuing banking relationships with
long-standing customers whose financial conditions no
Term business loans have assumed increasing importance. longer warrant unsecured credit; and minimizes potential
Such loans normally are granted for the purpose of loss when the loan is geared to a percentage of the
acquiring capital assets, such as plant and equipment. accounts receivable collateral. Although accounts
Term loans may involve a greater risk than do short-term receivable loans are collateralized, it is important to
advances, because of the length of time the credit is analyze the borrower's financial statements. Even if the
outstanding. Because of the potential for greater risk, term collateral is of good quality and in excess of the loan, the
loans are usually secured and generally require regular borrower must demonstrate financial progress. Full
amortization. Loan agreements on such credits may repayment through collateral liquidation is normally a
contain restrictive covenants during the life of the loan. In solution of last resort.
some instances, term loans may be used as a means of
liquidating, over a period of time, the accumulated and Banks use two basic methods to make accounts receivable
unpaid balance of credits originally advanced for seasonal advances. First, blanket assignment, wherein the borrower
needs. While such loans may reflect a borrower's past periodically informs the bank of the amount of receivables
operational problems, they may well prove to be the most outstanding on its books. Based on this information, the
viable means of salvaging a problem situation and bank advances the agreed percentage of the outstanding
effecting orderly debt collection. receivables. The receivables are usually pledged on a
non-notification basis and payments on receivables are
At a minimum, commercial lending policies should made directly to the borrower who then remits them to the
address acquisition of credit information, such as property, bank. The bank applies all or a portion of such funds to
operating and cash flow statements; factors that might the borrower's loan. Second, ledgering the accounts,
determine the need for collateral acquisition; acceptable wherein the lender receives duplicate copies of the
collateral margins; perfecting liens on collateral; lending invoices together with the shipping documents and/or
terms, and charge-offs. delivery receipts. Upon receipt of satisfactory
information, the bank advances the agreed percentage of

RMS Manual of Examination Policies 3.2-7 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

the outstanding receivables. The receivables are usually General

pledged on a notification basis. Under this method, the
bank maintains complete control of the funds paid on all Leveraged lending is an important type of financing for
accounts pledged by requiring the borrower's customer to national and global economies, and the U.S. financial
remit directly to the bank. industry plays an integral role in making credit available
and syndicating that credit to investors. In particular,
In the area of accounts receivable financing, a bank's financial institutions should ensure they do not
lending policy should address at least the acquisition of unnecessarily heighten risks by originating poorly
credit information such as property, operating and cash underwritten loans. For example, a poorly underwritten
flow statements. It should also address maintenance of an leveraged loan that is pooled with other loans or is
accounts receivable loan agreement that establishes a participated with other institutions may generate risks for
percentage advance against acceptable receivables, a the financial system.
maximum dollar amount due from any one account debtor,
financial strength of debtor accounts, insurance that Numerous definitions of leveraged lending exist
"acceptable receivables" are defined in light of the throughout the financial services industry and commonly
turnover of receivables pledged, aging of accounts contain some combination of the following:
receivable, and concentrations of debtor accounts. Proceeds used for buyouts, acquisitions, or capital
distributions.
Leveraged Lending Transactions where the borrowers Total Debt divided
by EBITDA (earnings before interest, taxes,
The Federal bank regulatory agencies initially issued depreciation, and amortization) or Senior Debt
guidance on April 9, 2001, concerning sound risk divided by EBITDA exceed 4.0X EBITDA or 3.0X
management practices for institutions engaged in EBITDA, respectively, or other defined levels
leveraged financing. In light of the developments and appropriate to the industry or sector.
experience gained since the initial guidance was issued, A borrower recognized in the debt markets as a highly
the Federal bank regulatory agencies issued new leveraged firm, which is characterized by a high debt-
Interagency Guidance on Leveraged Lending on May 21, to-net-worth ratio.
2013, to update and replace the 2001 guidance. Examiners Transactions when the borrowers post-financing
should also review the November 7, 2014, Frequently leverage, as measured by its leverage ratios (for
Asked Questions (FAQ) for Implementing March 2013 example, debt-to-assets, debt-to-net-worth, debt-to-
Interagency Guidance on Leveraged Lending. cash flow, or other similar standards common to
particular industries or sectors), significantly exceeds
Applicability industry norms or historical levels.

Implementation of this guidance should be consistent with A financial institution engaging in leveraged lending
the size and risk profile of an institutions leveraged should define it within the institutions policies and
activities relative to its assets, earnings, liquidity, and procedures in a manner sufficiently detailed to ensure
capital. Institutions that originate or sponsor leveraged consistent application across all business lines. A financial
transactions should consider all aspects and sections of the institutions definition should describe clearly the purposes
guidance. and financial characteristics common to these transactions,
and should cover risk to the institution from both direct
In contrast, the vast majority of community banks should exposure and indirect exposure via limited recourse
not be affected by this guidance as they have limited financing secured by leveraged loans, or financing
involvement in leveraged lending. The agencies do not extended to financial intermediaries (such as conduits and
intend that a financial institution that originates a small special purpose entities (SPEs)) that hold leveraged loans.
number of less complex, leveraged loans should have In general, supervisory expectations for sound risk
policies and procedures commensurate with a larger, more management of leveraged lending activities place
complex leveraged loan origination business. However, importance upon institutions developing and maintaining
any financial institution that participates in leveraged the following:
lending transactions should follow applicable supervisory Transactions structured to reflect a sound business
guidance provided in the Participations Purchased premise, an appropriate capital structure, and
section of the guidance. reasonable cash flow and balance sheet leverage.
Combined with supportable performance projections,
these elements of a safe-and-sound loan structure
should clearly support a borrowers capacity to repay

Loans (8-16) 3.2-8 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

and to de-lever to a sustainable level over a reasonable portfolio, aggregate pipeline exposure, and industry
period, whether underwritten to hold or distribute; and geographic concentrations. The limit framework
A definition of leveraged lending that facilitates should identify the related management approval
consistent application across all business lines; authorities and exception tracking provisions. In
Well-defined underwriting standards that, among addition to notional pipeline limits, the agencies
other things, define acceptable leverage levels and expect that financial institutions with significant
describe amortization expectations for senior and leveraged transactions will implement underwriting
subordinate debt; limit frameworks that assess stress losses, flex terms,
A credit limit and concentration framework consistent economic capital usage, and earnings at risk or that
with the institutions risk appetite; otherwise provide a more nuanced view of potential
Sound Management Information Systems (MIS) that risk;
enable management to identify, aggregate, and Procedures for ensuring the risks of leveraged lending
monitor leveraged exposures and comply with policy activities are appropriately reflected in an institutions
across all business lines; allowance for loan and lease losses (ALLL) and
Strong pipeline management policies and procedures capital adequacy analyses;
that, among other things, provide for real-time Credit and underwriting approval authorities,
information on exposures and limits, and exceptions including the procedures for approving and
to the timing of expected distributions and approved documenting changes to approved transaction
hold levels; and, structures and terms;
Guidelines for conducting periodic portfolio and Guidelines for appropriate oversight by senior
pipeline stress tests to quantify the potential impact of management, including adequate and timely reporting
economic and market conditions on the institutions to the board of directors;
asset quality, earnings, liquidity, and capital. Expected risk-adjusted returns for leveraged
transactions;
Risk Management Framework Minimum underwriting standards (see Underwriting
Standards section below); and,
Given the high risk profile of leveraged transactions, Effective underwriting practices for primary loan
financial institutions engaged in leveraged lending should origination and secondary loan acquisition.
adopt a risk management framework that has an intensive
and frequent review and monitoring process. The Participations Purchased
framework should have as its foundation written risk
objectives, risk acceptance criteria, and risk controls. A Financial institutions purchasing participations and
lack of robust risk management processes and controls at a assignments in leveraged lending transactions should make
financial institution with significant leveraged lending a thorough, independent evaluation of the transaction and
activities could contribute to supervisory findings that the the risks involved before committing any funds. They
financial institution is engaged in unsafe-and-unsound should apply the same standards of prudence, credit
banking practices. assessment and approval criteria, and in-house limits that
would be employed if the purchasing organization were
General Policy Expectations originating the loan. At a minimum, policies should
include requirements for:
A financial institutions credit policies and procedures for Obtaining and independently analyzing full credit
leveraged lending should address the following: information both before the participation is purchased
Identification of the financial institutions risk appetite and on a timely basis thereafter;
including clearly defined amounts of leveraged Obtaining from the lead lender copies of all executed
lending that the institution is willing to underwrite (for and proposed loan documents, legal opinions, title
example, pipeline limits) and is willing to retain (for insurance policies, Uniform Commercial Code (UCC)
example, transaction and aggregate hold levels). The searches, and other relevant documents;
institutions designated risk appetite should be Carefully monitoring the borrowers performance
supported by an analysis of the potential effect on throughout the life of the loan; and,
earnings, capital, liquidity, and other risks that result Establishing appropriate risk management guidelines
from these positions, and should be approved by its as described in this document.
board of directors;
A limit framework that includes limits or guidelines
for single obligors and transactions, aggregate hold

RMS Manual of Examination Policies 3.2-9 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

Underwriting Standards Whether loan agreements provide for distribution of

ongoing financial and other relevant credit
A financial institutions underwriting standards should be information to all participants and investors.
clear, written and measurable, and should accurately
reflect the institutions risk appetite for leveraged lending Credit Analysis
transactions. A financial institution should have clear
underwriting limits regarding leveraged transactions, Effective underwriting and management of leveraged
including the size that the institution will arrange both lending risk is highly dependent on the quality of analysis
individually and in the aggregate for distribution. The employed during the approval process as well as ongoing
originating institution should be mindful of reputational monitoring. At a minimum, analysis of leveraged lending
risks associated with poorly underwritten transactions, as transactions should ensure that:
these risks may find their way into a wide variety of Cash flow analyses do not rely on overly optimistic or
investment instruments and exacerbate systemic risks unsubstantiated projections of sales, margins, and
within the general economy. At a minimum, an merger and acquisition synergies;
institutions underwriting standards should consider the Liquidity analyses include performance metrics
following: appropriate for the borrowers industry; predictability
Whether the business premise for each transaction is of the borrowers cash flow; measurement of the
sound and the borrowers capital structure is borrowers operating cash needs; and ability to meet
sustainable regardless of whether the transaction is debt maturities;
underwritten for the institutions own portfolio or with Projections exhibit an adequate margin for
the intent to distribute. unanticipated merger-related integration costs;
A borrowers capacity to repay and ability to de-lever Projections are stress tested for one or two downside
to a sustainable level over a reasonable period. scenarios, including a covenant breach;
Expectations for the depth and breadth of due Transactions are reviewed at least quarterly to
diligence on leveraged transactions. determine variance from plan, the related risk
Standards for evaluating expected risk-adjusted implications, and the accuracy of risk ratings and
returns. accrual status.;
The degree of reliance on enterprise value and other Enterprise and collateral valuations are independently
intangible assets for loan repayment, along with derived or validated outside of the origination
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;
sponsors 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 borrowers ability to
asset-based loans that are part of the entire debt access the capital markets; and, (4) estimating the strength
structure also should outline expectations for the use of a secondary source of repayment. Institutions may also
of collateral controls (for example, inspections, view enterprise value as a useful benchmark for assessing
independent valuations, and payment lockbox), other a sponsors economic incentive to provide financial
types of collateral and account maintenance support. Given the specialized knowledge needed for the
agreements, and periodic reporting requirements; and, development of a credible enterprise valuation and the
importance of enterprise valuations in the underwriting

Loans (8-16) 3.2-10 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

and ongoing risk assessment processes, enterprise Enterprise value estimates derived from even the most
valuations should be performed by qualified persons rigorous procedures are imprecise and ultimately may not
independent of an institutions origination function. be realized. Therefore, institutions relying on enterprise
value or illiquid and hard-to-value collateral should have
There are several methods used for valuing businesses. policies that provide for appropriate loan-to-value ratios,
The most common valuation methods are assets, income, discount rates, and collateral margins. Based on the nature
and market. Asset valuation methods consider an of an institutions leveraged lending activities, the
enterprises underlying assets in terms of its net going- institution should establish limits for the proportion of
concern or liquidation value. Income valuation methods individual transactions and the total portfolio that are
consider an enterprises ongoing cash flows or earnings supported by enterprise value. Regardless of the
and apply appropriate capitalization or discounting methodology used, the assumptions underlying enterprise-
techniques. Market valuation methods derive value value estimates should be clearly documented, well
multiples from comparable company data or sales supported, and understood by the institutions appropriate
transactions. However, final value estimates should be decision-makers and risk oversight units. Further, an
based on the method or methods that give supportable and institutions valuation methods should be appropriate for
credible results. In many cases, the income method is the borrowers industry and condition.
generally considered the most reliable.
Risk Rating Leveraged Loans
There are two common approaches employed when using
the income method. The capitalized cash flow method The risk rating of leveraged loans involves the use of
determines the value of a company as the present value of realistic repayment assumptions to determine a borrowers
all future cash flows the business can generate in ability to de-lever to a sustainable level within a
perpetuity. An appropriate cash flow is determined and reasonable period of time. For example, supervisors
then divided by a risk-adjusted capitalization rate, most commonly assume that the ability to fully amortize senior
commonly the weighted average cost of capital. This secured debt or the ability to repay at least 50 percent of
method is most appropriate when cash flows are total debt over a five-to-seven year period provides
predictable and stable. The discounted cash flow evidence of adequate repayment capacity. If the projected
method is a multiple-period valuation model that converts capacity to pay down debt from cash flow is nominal with
a future series of cash flows into current value by refinancing the only viable option, the credit will usually
discounting those cash flows at a rate of return (referred to be adversely rated even if it has been recently
as the discount rate) that reflects the risk inherent underwritten. In cases when leveraged loan transactions
therein. This method is most appropriate when future cash have no reasonable or realistic prospects to de-lever, a
flows are cyclical or variable over time. Both income Substandard rating is likely. Furthermore, when assessing
methods involve numerous assumptions, and therefore, debt service capacity, extensions and restructures should
supporting documentation should fully explain the be scrutinized to ensure that the institution is not merely
evaluators reasoning and conclusions. masking repayment capacity problems by extending or
restructuring the loan.
When a borrower is experiencing a financial downturn or
facing adverse market conditions, a lender should reflect If the primary source of repayment becomes inadequate, it
those adverse conditions in its assumptions for key would generally be inappropriate for an institution to
variables such as cash flow, earnings, and sales multiples consider enterprise value as a secondary source of
when assessing enterprise value as a potential source of repayment unless that value is well supported. Evidence
repayment. Changes in the value of a borrowers assets of well-supported value may include binding purchase and
should be tested under a range of stress scenarios, sale agreements with qualified third parties or thorough
including business conditions more adverse than the base asset valuations that fully consider the effect of the
case scenario. Stress tests of enterprise values and their borrowers distressed circumstances and potential changes
underlying assumptions should be conducted and in business and market conditions. For such borrowers,
documented at origination of the transaction and when a portion of the loan may not be protected by
periodically thereafter, incorporating the actual pledged assets or a well-supported enterprise value,
performance of the borrower and any adjustments to examiners generally will rate that portion Doubtful or Loss
projections. The institution should perform its own and place the loan on nonaccrual status.
discounted cash flow analysis to validate the enterprise
value implied by proxy measures such as multiples of cash In addition, institutions need to ensure that the risks in
flow, earnings, or sales. leveraged lending activities are fully incorporated in the
ALLL and capital adequacy analysis. For allowance

RMS Manual of Examination Policies 3.2-11 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

purposes, leverage exposures should be taken into account Industry mix and maturity profile;
either through analysis of the expected losses from the Metrics derived from probabilities of default and loss
discrete portfolio or as part of an overall analysis of the given default;
portfolio utilizing the institution's internal risk grades or Portfolio performance measures, including
other factors. At the transaction level, exposures heavily noncompliance with covenants, restructurings,
reliant on enterprise value as a secondary source of delinquencies, non-performing amounts, and charge-
repayment should be scrutinized to determine the need for offs;
and adequacy of specific allocations. Amount of impaired assets and the nature of
impairment (that is, permanent, or temporary), and the
Problem Credit Management amount of the ALLL attributable to leveraged lending;
The aggregate level of policy exceptions and the
A financial institution should formulate individual action performance of that portfolio;
plans when working with borrowers experiencing Exposures by collateral type, including unsecured
diminished operating cash flows, depreciated collateral transactions and those where enterprise value will be
values, or other significant plan variances. Weak initial the source of repayment for leveraged loans.
underwriting of transactions, coupled with poor structure Reporting should also consider the implications of
and limited covenants, may make problem credit defaults that trigger pari passu treatment for all
discussions and eventual restructurings more difficult for lenders and, thus, dilute the secondary support from
an institution as well as result in less favorable outcomes. the sale of collateral;
Secondary market pricing data and trading volume,
A financial institution should formulate credit policies that when available;
define expectations for the management of adversely rated
Exposures and performance by deal sponsors. Deals
and other high-risk borrowers whose performance departs
introduced by sponsors may, in some cases, be
significantly from planned cash flows, asset sales,
considered exposure to related borrowers. An
collateral values, or other important targets. These
institution should identify, aggregate, and monitor
policies should stress the need for workout plans that
potential related exposures;
contain quantifiable objectives and measureable time
Gross and net exposures, hedge counterparty
frames. Actions may include working with the borrower
concentrations, and policy exceptions;
for an orderly resolution while preserving the institutions
Actual versus projected distribution of the syndicated
interests, sale of the credit in the secondary market, or
pipeline, with regular reports of excess levels over the
liquidation of collateral. Problem credits should be
hold targets for the syndication inventory. Pipeline
reviewed regularly for risk rating accuracy, accrual status,
definitions should clearly identify the type of
recognition of impairment through specific allocations,
exposure. This includes committed exposures that
and charge-offs.
have not been accepted by the borrower, commitments
accepted but not closed, and funded and unfunded
Reporting and Analytics
commitments that have closed but have not been
distributed;
Financial institutions should diligently monitor higher risk
credits, including leveraged loans. A financial Total and segmented leveraged lending exposures,
institutions management should receive comprehensive including subordinated debt and equity holdings,
reports about the characteristics and trends in such alongside established limits. Reports should provide a
exposures at least quarterly, and summaries should be detailed and comprehensive view of global exposures,
provided to the institutions board of directors. Policies including situations when an institution has indirect
and procedures should identify the fields to be populated exposure to an obligor or is holding a previously sold
and captured by a financial institutions MIS, which position as collateral or as a reference asset in a
should yield accurate and timely reporting to management derivative;
and the board of directors that may include the following: Borrower and counterparty leveraged lending
Individual and portfolio exposures within and across reporting should consider exposures booked in other
all business lines and legal vehicles, including the business units throughout the institution, including
pipeline; indirect exposures such as default swaps and total
return swaps, naming the distributed paper as a
Risk rating distribution and migration analysis,
covered or referenced asset or collateral exposure
including maintenance of a list of those borrowers
through repo transactions. Additionally, the institution
who have been removed from the leveraged portfolio
should consider positions held in available-for-sale or
due to improvements in their financial characteristics
traded portfolios or through structured investment
and overall risk profile;

Loans (8-16) 3.2-12 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

vehicles owned or sponsored by the originating to escalate inappropriate risks and other findings to their
institution or its subsidiaries or affiliates. senior management. Due to the elevated risks inherent in
leveraged lending, and depending on the relative size of a
Deal Sponsors financial institutions leveraged lending business, the
institutions credit review function should assess the
A financial institution that relies on sponsor support as a performance of the leveraged portfolio more frequently
secondary source of repayment should develop guidelines and in greater depth than other segments in the loan
for evaluating the qualifications of financial sponsors and portfolio. Such assessments should be performed by
should implement processes to regularly monitor a individuals with the expertise and experience for these
sponsors financial condition. Deal sponsors may provide types of loans and the borrowers industry. Portfolio
valuable support to borrowers such as strategic planning, reviews should generally be conducted at least annually.
management, and other tangible and intangible benefits. For many financial institutions, the risk characteristics of
Sponsors may also provide sources of financial support for leveraged portfolios, such as high reliance on enterprise
borrowers that fail to achieve projections. Generally, a value, concentrations, adverse risk rating trends, or
financial institution rates a borrower based on an analysis portfolio performance, may dictate more frequent reviews.
of the borrowers standalone financial condition. A financial institution should staff its internal credit
However, a financial institution may consider support review function appropriately and ensure that the function
from a sponsor in assigning internal risk ratings when the has sufficient resources to ensure timely, independent, and
institution can document the sponsors history of accurate assessments of leveraged lending transactions.
demonstrated support as well as the economic incentive, Reviews should evaluate the level of risk, risk rating
capacity, and stated intent to continue to support the integrity, valuation methodologies, and the quality of risk
transaction. However, even with documented capacity and management. Internal credit reviews should include the
a history of support, the sponsors potential contributions review of the institutions leveraged lending practices,
may not mitigate supervisory concerns absent a policies, and procedures to ensure that they are consistent
documented commitment of continued support. An with regulatory guidance.
evaluation of a sponsors financial support should include
the following: Stress Testing
The sponsors historical performance in supporting its
investments, financially and otherwise; A financial institution should develop and implement
The sponsors economic incentive to support, guidelines for conducting periodic portfolio stress tests on
including the nature and amount of capital contributed loans originated to hold as well as loans originated to
at inception; distribute, and sensitivity analyses to quantify the potential
Documentation of degree of support (for example, a impact of changing economic and market conditions on its
guarantee, comfort letter, or verbal assurance); asset quality, earnings, liquidity, and capital. The
Consideration of the sponsors contractual investment sophistication of stress-testing practices and sensitivity
limitations; analyses should be consistent with the size, complexity,
To the extent feasible, a periodic review of the and risk characteristics of the institutions leveraged loan
sponsors financial statements and trends, and an portfolio. To the extent a financial institution is required to
analysis of its liquidity, including the ability to fund conduct enterprise-wide stress tests, the leveraged
multiple deals; portfolio should be included in any such tests.
Consideration of the sponsors dividend and capital
contribution practices; Conflicts of Interest
The likelihood of the sponsor supporting a particular
borrower compared to other deals in the sponsors A financial institution should develop appropriate policies
portfolio; and, and procedures to address and to prevent potential
conflicts of interest when it has both equity and lending
Guidelines for evaluating the qualifications of a
positions. For example, an institution may be reluctant to
sponsor and a process to regularly monitor the
use an aggressive collection strategy with a problem
sponsors performance.
borrower because of the potential impact on the value of
an institutions equity interest. A financial institution may
Independent Credit Review
encounter pressure to provide financial or other privileged
client information that could benefit an affiliated equity
A financial institution should have a strong and
investor. Such conflicts also may occur when the
independent credit review function that demonstrates the
underwriting financial institution serves as financial
ability to identify portfolio risks and documented authority
advisor to the seller and simultaneously offers financing to

RMS Manual of Examination Policies 3.2-13 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

multiple buyers (that is, stapled financing). Similarly, there directly affected by changes in production and commodity
may be conflicting interests among the different lines of prices.
business within a financial institution or between the
financial institution and its affiliates. When these
situations occur, potential conflicts of interest arise Reserve-Based Lending
between the financial institution and its customers.
Policies and procedures should clearly define potential Loans for E&P activities are typically secured by proved
conflicts of interest, identify appropriate risk management reserves and governed by a borrowing base, an
controls and procedures, enable employees to report arrangement known as reserve-based lending, or RBL.
potential conflicts of interest to management for action Effective credit risk management in RBL requires
without fear of retribution, and ensure compliance with conservative underwriting, appropriate structuring,
applicable laws. Further, management should have an experienced and knowledgeable lending staff, and sound
established training program for employees on appropriate loan administration practices. The board and senior
practices to follow to avoid conflicts of interest. management should fully consider the unique risks
associated with this type of lending when developing RBL
policies and approving and administering such loans.
Oil and Gas Lending These risks include, but are not limited to, credit,
concentration, market volatility/pricing, limited purpose
collateral, production, operational, legal,
Industry Overview compliance/environmental, interest rate, liquidity,
strategic, and third-party risk.
Oil and gas (O&G) lending is complex and highly
specialized due to factors such as global supply and RBL may appear similar to traditional asset based lending
demand, geopolitical uncertainty, weather-related (ABL), but there are notable differences. The primary
disruptions, fluctuations and volatility in currency markets source of repayment for ABL is the orderly liquidation of
(i.e. the strength of the U.S. dollar compared to global the collateral (receivables and inventory) into cash. Such
currency markets), and changes in environmental and loans are typically structured with strong controls over the
other governmental policies. As such, companies and collateral, such as a lock box arrangement. In contrast, the
borrowers that are directly or indirectly tied to the O&G primary source of repayment for RBL is the cash flows
industry frequently experience expansion and contraction derived from the extraction of O&G reserves. An
within key operational areas of their businesses that will independent, third-party reserve engineering report serves
directly impact their financial condition and repayment as the primary underwriting tool to estimate the future cash
capacity. stream and establish a borrowing base, which is a
collateral base agreed to by the borrower and lender that is
The O&G industry has four interconnected segments: used to limit the amount of funds the lender advances the
borrower. The borrowing base is subject to periodic
Upstream - exploration and production (E&P) redeterminations, typically semiannually, that can result in
companies the reduction of the borrowing base commitment when
Midstream - transporting, treating, processing, storing, commodity prices and reserves are declining.
and marketing to Upstream companies
Downstream - refining and marketing Types of Reserves
Support/Services - equipment, services, or support
activities (e.g. drilling, workover units, and water Lenders should generally only consider proved reserves,
hauling services) defined as having at least a 90 percent probability that the
quantities actually recovered will equal or exceed the
O&G lending to Upstream companies for E&P activities is estimate, in determining collateral value. Within the
a specialized form of lending, and is the primary focus of proved reserves category, Proved Developed Producing
this section (see Reserve-Based Lending below). Loans to (PDP), Proved Developed Non-Producing (PDNP), and
Midstream, Downstream and Support/Service companies Proved Undeveloped (PUD) reserves are collectively
are generally structured similar to other commercial loans. known as P1. As described below, PDNP and PUD
In addition, Midstream companies often raise capital require capital expenditures (CAPEX) to bring the non-
through Master Limited Partnerships that are publicly producing and undeveloped reserves online as PDP:
traded. The highest credit risk is typically found in
Support/Services and Upstream lending, which are more PDP represents reserves that are recoverable from
existing wells with existing equipment and operating

Loans (8-16) 3.2-14 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

methods that are producing at the time of the discount rates, pricing assumptions, operating expense
engineering report estimate. escalation rates, and risk-adjustment guidelines limiting
PDNP reserves include both shut-in (PDSI) and higher risk reserves. The engineer will conduct an
behind the pipe (PDBP) reserves, and production can analysis of production reports from the subject properties,
be initiated or restored with relatively low and project estimated reserve depletion.
expenditures compared to the cost of drilling a new
well. Borrowing Base
- PDSI reserves are completion intervals that are
open, but have not started producing; were shut-in The collateral base securing each facility should be
for market conditions or pipeline connections; or primarily comprised of PDP reserves. Inclusion of PDNP
not capable of production for mechanical reasons. reserves in the collateral evaluation should be supported
- PDBP reserves are those expected to be recovered with sufficient documentation to demonstrate that the
from existing wells that require additional borrower has the financial capacity to convert PDNP
completion work or future completion prior to the reserves to PDP reserves by making the necessary
start of production. investments to restore or initiate production within the
PUD reserves are expected to be recovered only after near-term.
making future investment. These reserves have been
proved by independent engineering reports, but do not To include PUDs in the borrowing base calculation, the
have a well infrastructure in place. borrower should have sufficient liquidity and positive Free
Cash Flow to meet operational needs, and debt service
Other categories of reserves include probable (P2) and requirements, as well as be able to fund (or obtain the
possible (P3). Probable reserves are relatively funding for) the CAPEX that would be required to convert
uncertain, while possible reserves are considered these undeveloped reserves into production. Potential sale
speculative in nature. Probable and possible reserves and/or marketability of the PUDs can also be considered
should not receive any value when determining the when evaluating collateral values, provided there is
borrowing base. adequate documentation of recent PUD sales.

Reserve Engineering Reports Lenders use risk-adjustment factors to lower the value of
unseasoned producing and non-producing reserves before
Reserve engineering reports are an estimate of the volumes applying borrowing base advance rates. Bank
of O&G reserves that are likely to be recovered based on management should consider policy limits on production
reasonable assumptions regarding physical characteristics vs. non-production reserves, the oil and gas mix,
of the reservoir, available technology, and operating maximum production coming from one well (single well
efficiencies. The significant reliance on engineering concentration risk), and other risk-adjustment factors.
reports in underwriting RBL facilities requires sound Ideally, there should be diversification in the geographic
internal controls over the collateral evaluation process. location of reserve fields, and bank management should
Reserve reports must be objective; based on reasonable, establish limits on the lowest number of producing wells
well-documented assumptions; and completed needed to establish an acceptable borrowing base.
independently of the loan origination and collection
functions. Management must be able to document the Typically, the advance rate for high-quality proved (P1)
qualifications and independence of the engineer, and reserves should rarely exceed 65 percent (a typical range is
should periodically evaluate the production performance, 50 to 65 percent) of the PV of FNR. If the lender
which should include a comparison of production determines that PDNP or PUD reserves are to be
projections to actual results. considered in the borrowing base, these reserves should
generally not exceed 25 to 35 percent of the total
RBL collateral value consists of a point-in-time estimate of borrowing base. In addition, PDNP and PUD reserves
the present value (PV) of future net revenue (FNR) should be risk-adjusted (65 to 75 percent for PDNP and 25
derived from the production and sale of existing O&G to 50 percent for PUD, for example) prior to applying the
reserves, net of operating expenses, production taxes, advance rate. Lenders may apply separate risk-adjusted
royalties, and CAPEX, discounted at an appropriate rate. advance rates for each proved reserve category in the
The engineering reports should contain sufficient borrowing base. During extended periods of low or
information and documentation to support the assumptions declining commodity prices, it is not uncommon for banks
and the analysis used to derive the forecasted cash flows to increase the risk adjustment for PDNP and PUD
and discounted PV. Bank management should provide reserves.
clear guidance to the engineer at engagement regarding

RMS Manual of Examination Policies 3.2-15 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

As part of the underwriting process, lending personnel Price deck considerations include, for example, current
should prepare both base-case and sensitivity-case commodity pricing, forward curve projections (future
analyses that focus on the ability of converting the price considerations), cost assumptions, discount rates, and
underlying collateral into cash to repay the loan, including timing of the various reports. Management should also
an estimate of the impact that sustained adverse changes in document any risk-based adjustments applied to each
market conditions would have on a companys repayment proved reserve category. While the risk-adjusted base
ability. A base-case analysis uses standard assumption case projections will generally be used to underwrite
scenarios and generally includes a discount to current RBLs, management should consider the ability to repay
prices against the forward curve (projected futures pricing the debt using the risk-adjusted sensitivity case to
estimates of the commodity). A sensitivity case analysis determine potential exposure due to adverse market price
subjects the O&G reserves to adverse external factors such fluctuations.
as lower market prices and/or higher operating expenses to
ascertain the effect on loan repayment. Full debt service Loan Structure
capacity (DSC) should be analyzed using both the base-
case and sensitivity-case scenarios. RBL credit facilities are typically structured as a revolving
line of credit (RLOC), a reducing revolving line of credit
Discount Rates (RRLOC), or an amortizing term loan, governed by a well-
supported and fully documented borrowing base. These
The Securities and Exchange Commission (SEC) requires credit facilities generally should fully amortize within the
publicly traded companies to report the value of their half-life of the reserves (that is, the time in years required
reserves using a standard discount rate of 10 percent in to produce one-half of the total estimated recoverable
accordance with ASC 932 (Extractive Activities - Oil and production) with repayment aligning with projected cash
Gas). In evaluating collateral valuations for RBL flows. In other words, the term of the loans should be tied
facilities, banks often utilize alternative discount rates. to the economic life of the underlying asset. This is often
For creditworthy borrowers and during more benign represented as the reserve tail tests that are based on the
operating cycles, a 9 percent discount rate is commonly economic half-life of the reserves or the cash flow
used. For higher-risk borrowers or during volatile or remaining after projected loan payout.
declining market cycles for O&G, higher discount rates are
typically used. If a discount rate is selected that Loan durations should be fairly short-term and directly
significantly differs from generally accepted discount tied to the economic life of the asset (generally 50 to 60
rates, management should support and document its percent of the economic life of the proved reserves or the
rationale. Some banks may utilize multiple discount rates proved reserves half-life). The terms generally depend on
under certain circumstances. An example may include the projected and actual reserve production (reserve run
establishing a standard discount rate for performing credits data), as well as the type and range of collateral (PDP,
and a higher rate for higher risk facilities. PDNP, or PUD). A reasonable portion of the estimated
revenues should remain after the debt has fully amortized
(reserve tail). Borrowing bases should be re-determined at
Price Decks least semiannually, subject to an updated reserve
engineering report.
Management should regularly evaluate, and update as
necessary, its pricing assumptions for RBL, commonly Covenants
referred to as the banks price deck. The price deck is a
forecast used to derive cash flow and collateral value Appropriate use of covenants is imperative in managing
assumptions, and should be approved by the board of credit risk for O&G loans. Lenders should require
directors or a specifically designated board committee. financial covenants to instill discipline in the lending
Pricing assumptions typically represent the most relationship, including the borrowers leverage position,
significant variable in driving the final estimate of value, repayment capacity, and liquidity. In addition, covenants
and must be well-supported. should limit cash distributions to owners/shareholders, and
should include standard performance and financial
Each banks price deck should reflect both base-case and reporting requirements. Examples of commonly used
sensitivity-case pricing scenarios. Pricing assumptions for ratios/covenants for evaluating E&P companies include
the sensitivity case should be sufficiently conservative and Free Cash Flow (FCF), Interest Coverage, Fixed Charge
used to determine whether the borrower has the financial Coverage, Current Ratio, Quick Ratio, Senior
capacity to generate adequate cash flow to repay the debt Debt/EBITDA(X), and Total Debt/EBITDA(X). The
during a prolonged low commodity price environment. calculation of earnings before interest, taxes, depreciation,

Loans (8-16) 3.2-16 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

and amortization (EBITDA) should incorporate cycle, which reflects not only the ability to generate cash
maintenance CAPEX (X) due to its impact on the amount flow from production, but also the CAPEX necessary to
of projected FCF that is available after debt service to replace depleted reserves. Working capital management is
support operations. critically important, as delinquent payments to vendors can
result in a negative working capital position (due to
Hedging accounts payable increasing) and an increased leverage
ratio.
When used properly, hedging may be an effective tool to
help protect the borrower and the lender from sharp Financial analysis should include, but not be limited to, the
commodity price declines by providing a stable cash flow following:
stream. E&P companies frequently use hedging
instruments such as futures contracts, swaps, collars, and Adequacy of operating cash flows to service existing
put options to reduce price risk exposure. Generally, total debt;
hedges should be limited to no more than 85 percent of Overall compliance with financial covenants,
projected production volumes. Counterparties should be including borrowing base limitations as detailed in the
limited to reputable, financially sound companies that are loan agreement;
approved in accordance with the banks O&G loan policy. Reasonableness of the companys budget assumptions
If the hedges are taken as collateral or part of the and projections;
borrowing base, the advance rate and any limitations on Comparison of borrower provided production
the hedging position should be documented in the loan projections with actual results;
agreement. If hedges are sold or monetized, the proceeds Working capital, tangible net worth, and leverage
of such should generally be applied to the respective debt. positions; and
Impact of capital expenses and recent acquisitions.
Borrower and Financial Analysis
O&G Loan Policy Guidelines
Management should have a clear understanding of the
overall financial health of the borrower that includes an The O&G loan policy should provide sufficient guidance
assessment of the borrowers ability to maintain operations to loan officers, clearly convey appropriate policy
through adverse market conditions. E&P companies in limitations and monitoring procedures, and detail
sound financial condition should have strong cash flow appropriate underwriting standards and practices. The
from reliable revenue sources and well-controlled O&G policy should clearly indicate those industry
operating expenses. Companies should also have adequate segments (Upstream, Midstream, Downstream, and
sources of liquidity and effective working capital Support/Services) the board chooses to lend to and include
management, sound reserve development practices, well- guidance on each of those segments.
defined criteria for divestiture, adequate capital structure,
manageable levels of debt, and appropriate financial For institutions engaged in RBL, the policy should address
reporting. As part of the overall financial analysis of the reserve measurement and valuation analysis, borrowing
relationship, updated engineering data should be well- base determinations, production history analysis, financial
documented and should enable the lender to determine the statement and ratio analysis, commitment advances,
borrowers capacity to service the debt. Any over-advance discount rates, price deck formulation, financial covenants,
situation should have a reasonable plan and timeframe to steps to cure an over-advance situation, and ALLL
cure the over-advance. considerations. Specific guidelines should cover the
following areas:
The principals of successful E&P companies should be
experienced and have a well-documented track record of Lending objectives, risk appetite, portfolio limits,
managing through all stages of the business cycle. In good target market, and concentration limits;
times, company management should be able to identify, Methodology and requirements for monitoring O&G
acquire, and develop reserves profitably and in line with markets, including pricing, supply and demand trends,
expectations. During declining price cycles, company overall market trends, and industry analysis;
management should be able to demonstrate the ability to Board and committee oversight over the O&G lending
streamline operations, maintain reasonable production, and engineering departments;
manage working capital, strategically reduce CAPEX, and Officer and committee lending limits;
make sound divestitures to ensure repayment of debt. Borrowing base calculations and risk-adjustments;
Bank management should evaluate the borrowers cost Price deck considerations and adjustments;

RMS Manual of Examination Policies 3.2-17 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

Advance rates, risk-adjusted values for PDP, PDNP,

and PUD reserves, and requirement to risk adjust the The loan balance exceeds 65 percent of the PV of
discount value of nonproducing reserves before FNR of PDP, or the cash flow analysis indicates that
applying advance rates; the loan will not amortize within the reserve half-life;
Frequency and required details of borrowing base The credit is not performing in accordance with
redeterminations and price deck revaluations; contractual terms (repayment of interest and
Requirements for independent engineering reports and principal);
analysis thereof; Advance rates exceed the banks limits or industry
Well concentration guidelines and maximum per standards for proved reserves;
single well limits; Frequent over-advances occur at subsequent
Financial covenants, minimum ratio and other borrowing base redeterminations;
financial information requirements, and review Excessive operating leverage;
requirements (e.g. current ratio, fixed charge Covenant defaults;
coverage, cash flow coverage, leverage ratios); Delinquent payables, or other evidence of poor
Collateral valuation requirements, including required working capital management;
remaining collateral at payout; Significant current or likely future disruptions in
Renewal and restructuring guidelines, including production;
nonaccrual and troubled debt restructuring Frequent financial statement revisions or changes in
implications; chosen accounting method;
Remedies for declining collateral or over-advanced Maintenance or capital expenditures significantly
situations, such as Monthly Commitment Reductions, exceed budgeted forecasts; or
pledge of additional reserves as collateral, and sale of The credit is identified by the bank as a distressed
non-productive reserves; credit.
Minimum required insurance (including property,
liability, and environmental); Examiners are to consider all information relevant to
Defined loan safety or coverage factors and/or loan evaluating the prospects that the loan will be repaid,
value policies, including other debt that is pari- including the borrowers creditworthiness, the cash flow
passu (i.e. all debts sharing equally in the production provided by the borrowers operation, the collateral
cash flows available to amortize debt); supporting the loan, integrity and reliability of the
Typical amortization, payout, and loan repayment engineering data, borrowing base considerations, primary
terms, including maximum terms for production source of repayment, and any support provided by
revolvers and term loans; financially responsible guarantors and co-borrowers. If
Guarantor requirements; the borrowers circumstances reveal well-defined
Hedging requirements, policies, and limitations; weaknesses, adverse classification of the loan relationship
Stress-testing and sensitivity analysis and is likely warranted. The level and severity of classification
requirements thereof; and of distressed, collateral-dependent RBLs will depend on
Monitoring requirements for the risks inherent in the quality of the underlying collateral, based on the most
loans dependent on royalty interests in production recent re-determined and risk-adjusted borrowing base that
revenues for repayment. is contractually obligated to be funded.

Credit Risk Rating Assessment and Classification The portion of the loan commitment(s) secured by the
Guidelines NPV of total risk-adjusted proved reserves should be
classified Substandard. When the potential for loss may
The O&G loan policy also should address specific credit be mitigated by the outcome of certain pending events, or
risk review procedures for the O&G portfolio and O&G when loss is expected but the amount of the loss cannot be
loan grading criteria. Risk rating definitions should be reasonably determined, the remaining balance secured by
clearly defined. RBL that are adequately protected by the the NPV of total unrisked proved reserves should be
current sound worth and debt service capacity of the classified Doubtful. The portion of the loan
borrower, guarantor, or underlying collateral generally will commitment(s) that exceeds 100 percent of the NPV of
not be adversely classified for supervisory purposes. total unrisked proved reserves, and is uncollectible, should
However, if any of the following circumstances are be classified Loss. These guidelines may be adjusted
present, a more in-depth and comprehensive analysis of depending on the borrowers specific situation and should
the credit is needed to determine whether the loan has not replace examiner judgment.
potential or well-defined weaknesses:

Loans (8-16) 3.2-18 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

The following tables illustrate an example of the rating Real Estate Loans
methodology for a classified borrower. Actual pricing,
discount rates, and risk adjustment factors applied by the General
bank may vary according to current market conditions and
the nature of the reserves. Examiners should closely Real estate loans are part of the loan portfolios of almost
review the key assumptions made by the bank in arriving all commercial banks. Real estate loans include credits
at the current collateral valuation. advanced for the purchase of real property. However, the
term may also encompass extensions granted for other
Example: Collateral Valuation ($ Million) purposes, but for which primary collateral protection is
Discounted NPV at 9% and using NYMEX Strip Pricing
real property.
Valuation Hedges PDP PDNP PUD Total
Basis Proved The degree of risk in a real estate loan depends primarily
Unrisked $10 $50 $20 $40 $120 on the loan amount in relation to collateral value, the
NPV interest rate, and most importantly, the borrower's ability
Risk 100% 100% 75% 50% to repay in an orderly fashion. It is extremely important
adjustment
that a bank's real estate loan policy ensure that loans are
granted with the reasonable probability the debtor will be
factors
able and willing to meet the payment terms. Placing
Risked & $10 $50 $15 $20 $95 undue reliance upon a property's appraised value in lieu of
Adjusted an adequate initial assessment of a debtor's repayment
NPV ability is a potentially dangerous mistake.
Total collateral value: $95
Historically, many banks have jeopardized their capital
structure by granting ill-considered real estate mortgage
Example: Classification ($ Million)
loans. Apart from unusual, localized, adverse economic
Borrowing base commitment on RBL is $125 million
conditions which could not have been foreseen, resulting
TC Pass SM II III IV
in a temporary or permanent decline in realty values, the
RBL $125 $95 $25 $5 principal errors made in granting real estate loans include
Total $125 $95 $25 $5 inadequate regard to normal or even depressed realty
TC: Total Commitment SM: Special Mention values during periods when it is in great demand thus
II: Substandard III: Doubtful IV: Loss inflating the price structure, mortgage loan amortization,
the maximum debt load and repayment capacity of the
Note: The $25 million of Doubtful represents the borrower, and failure to reasonably restrict mortgage loans
difference between the unrisked NPV and the risked NPV. on properties for which there is limited demand.
If the borrower's prospects for further developing PDNP
and PUD reserves to producing status are unlikely or not A principal indication of a troublesome real estate loan is
supported by a pending event, this amount should be an improper relationship between the amount of the loan,
reflected as Loss. the potential sale price of the property, and the availability
of a market. The potential sale price of a property may or
Institutions should follow outstanding guidance when may not be the same as its appraised value. The current
determining whether a loan should be placed on potential sale price or liquidating value of the property is
nonaccrual. Each extension should be independently of primary importance and the appraised value is of
evaluated to determine whether it should be on nonaccrual; secondary importance. There may be little or no current
that is, nonaccrual status should not be automatically demand for the property at its appraised value and it may
applied to multiple loans or extensions of credit to a single have to be disposed of at a sacrifice value.
borrower if only one loan meets the criteria for nonaccrual
status. However, multiple loans to one borrower that are Examiners must appraise not only individual mortgage
structured as pari-passu to principal and interest and loans, but also the overall mortgage lending and
supported by the same repayment source should not be administration policies to ascertain the soundness of its
treated differently for nonaccrual or troubled debt mortgage loan operations as well as the liquidity contained
restructuring purposes, regardless of collateral lien in the account. The bank should establish policies that
position. address the following factors: the maximum amount that
may be loaned on a given property, in a given category,
and on all real estate loans; the need for appraisals

RMS Manual of Examination Policies 3.2-19 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

(professional judgments of the present and/or future value such loan with an LTV ratio that equals or exceeds 90
of the real property) and for amortization on certain loans. percent at origination, an institution should require
appropriate credit enhancement in the form of either
Real Estate Lending Standards mortgage insurance or readily marketable collateral.

Section 18(o) of the FDI Act requires the Federal banking Certain real estate loans are exempt from the supervisory
agencies to adopt uniform regulations prescribing LTV limits because of other factors that significantly
standards for loans secured by liens on real estate or made reduce risk. These include loans guaranteed or insured by
for the purpose of financing permanent improvements to the Federal, State or local government as well as loans to
real estate. For FDIC-supervised institutions, Part 365 of be sold promptly in the secondary market without
the FDIC Rules and Regulations requires each institution recourse. A complete list of excluded transactions is
to adopt and maintain written real estate lending policies included in the guidelines.
that are consistent with sound lending principles,
appropriate for the size of the institution and the nature Because there are a number of credit factors besides LTV
and scope of its operations. Within these general limits that influence credit quality, loans that meet the
parameters, the regulation specifically requires an supervisory LTV limits should not automatically be
institution to establish policies that include: considered sound, nor should loans that exceed the
supervisory LTV limits automatically be considered high
Portfolio diversification standards; risk. However, loans that exceed the supervisory LTV
Prudent underwriting standards including loan-to- limit should be identified in the institution's records and
value limits; the aggregate amount of these loans reported to the
Loan administration procedures; institution's board of directors at least quarterly. The
Documentation, approval and reporting requirements; guidelines further State that the aggregate amount of loans
and in excess of the supervisory LTV limits should not exceed
Procedures for monitoring real estate markets within the institution's total capital. Moreover, within that
the institution's lending area. aggregate limit, the total loans for all commercial,
agricultural and multi-family residential properties
These policies also should reflect consideration of the (excluding 1-to-4 family home loans) should not exceed
Interagency Guidelines for Real Estate Lending Policies 30 percent of total capital.
and must be reviewed and approved annually by the
institution's board of directors. Institutions should develop policies that are clear, concise,
consistent with sound real estate lending practices, and
The interagency guidelines, which are an appendix to Part meet their needs. Policies should not be so complex that
365, are intended to help institutions satisfy the regulatory they place excessive paperwork burden on the institution.
requirements by outlining the general factors to consider Therefore, when evaluating compliance with Part 365,
when developing real estate lending standards. The examiners should carefully consider the following:
guidelines suggest maximum supervisory loan-to-value
(LTV) limits for various categories of real estate loans and The size and financial condition of the institution;
explain how the agencies will monitor their use. The nature and scope of the institution's real estate
lending activities;
Institutions are expected to establish their own internal The quality of management and internal controls;
LTV limits consistent with their needs. These internal The size and expertise of the lending and
limits should not exceed the following recommended administrative staff; and
supervisory limits: Market conditions.

65 percent for raw land; It is important to distinguish between the regulation and
75 percent for land development; the interagency guidelines. While the guidelines are
80 percent for commercial, multi-family, and other included as an appendix to the regulation, they are not part
non-residential construction; of the regulation. Therefore, when an apparent violation
85 percent for construction of a 1-to-4 family of Part 365 is identified, it should be listed in the Report of
residence; Examination in the same manner as other apparent
85 percent for improved property; and violations. Conversely, when an examiner determines that
Owner-occupied 1-to-4 family home loans have no an institution is not in conformance with the guidelines
suggested supervisory LTV limits. However, for any and the deficiency is a safety and soundness concern, an
appropriate comment should be included in the

Loans (8-16) 3.2-20 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

examination report; however, the deficiency would not be controlling disbursements and collateral margins and
a violation of the regulation. assuring timely completion of the projects and repayment
of the bank's loans.
Examination procedures for various real estate loan
categories are included in the ED Modules. Before a construction loan agreement is entered into, the
bank should investigate the character, expertise, and
Commercial Real Estate Loans financial standing of all related parties. Documentation
files should include background information concerning
These loans comprise a major portion of many banks' loan reputation, work and credit experience, and financial
portfolios. When problems exist in the real estate markets statements. Such documentation should indicate that the
that the bank is servicing, it is necessary for examiners to developer, contractor, and subcontractors have
devote additional time to the review and evaluation of demonstrated the capacity to successfully complete the
loans in these markets. type of project to be undertaken. The appraisal techniques
used to value a proposed construction project are
There are several warning signs that real estate markets or essentially the same as those used for other types of real
projects are experiencing problems that may result in real estate. The bank should realize that appraised collateral
estate values decreasing from original appraisals or values are not usually met until funds are advanced and
projections. Adverse economic developments and/or an improvements made.
overbuilt market can cause real estate projects and loans to
become troubled. Signs of troubled real estate markets or The bank, the builder and the property owner should join
projects include, but are not limited to: in a written building loan agreement that specifies the
performance of each party during the entire course of
Rent concessions or sales discounts resulting in cash construction. Loan funds are generally disbursed based
flow below the level projected in the original upon either a standard payment plan or a progress payment
appraisal. plan. The standard payment plan is normally used for
Changes in concept or plan: for example, a residential and smaller commercial construction loans and
condominium project converting to an apartment utilizes a preestablished schedule for fixed payments at the
project. end of each specified stage of construction. The progress
Construction delays resulting in cost overruns which payment plan is normally used for larger, more complex,
may require renegotiation of loan terms. building projects. The plan is generally based upon
Slow leasing or lack of sustained sales activity and/or monthly disbursements totaling 90 percent of the value
increasing cancellations which may result in with 10 percent held back until the project is completed.
protracted repayment or default.
Lack of any sound feasibility study or analysis. Although many credits advanced for real estate
Periodic construction draws which exceed the amount acquisition, development or construction are properly
needed to cover construction costs and related considered loans secured by real estate, other such credits
overhead expenses. are, in economic substance, "investments in real estate
Identified problem credits, past due and non-accrual ventures" and categorization of the asset as "other real
loans. estate owned" may be appropriate. A key feature of these
transactions is that the bank as lender plans to share in the
Real Estate Construction Loans expected residual profit from the ultimate sale or other use
of the development. These profit sharing arrangements
A construction loan is used to construct a particular project may take the form of equity kickers, unusually high
within a specified period of time and should be controlled interest rates, a percentage of the gross rents or net cash
by supervised disbursement of a predetermined sum of flow generated by the project, or some other form of profit
money. It is generally secured by a first mortgage or deed participation over and above a reasonable amount for
of trust and backed by a purchase or takeout agreement interest and related loan fees. These extensions of credit
from a financially responsible permanent lender. may also include such other characteristics as nonrecourse
Construction loans are vulnerable to a wide variety of debt, 100 percent financing of the development cost
risks. The major risk arises from the necessity to complete (including origination fees, interest payments, construction
projects within specified cost and time limits. The risk costs, and even profit draws by the developer), and lack of
inherent in construction lending can be limited by any substantive financial support from the borrower or
establishing policies which specify type and extent of bank other guarantors. Acquisition, Development, and
involvement. Such policies should define procedures for Construction (ADC) arrangements that are in substance

RMS Manual of Examination Policies 3.2-21 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

real estate investments of the bank should be reported identical to that for commercial real estate loans.
accordingly. Supporting documentation should include a recorded
mortgage or deed of trust, title insurance policy and/or
On the other hand, if the bank will receive less than a title opinions, appropriate liability insurance and other
majority of the expected residual profit, the ADC loan may coverages, land appraisals, and evidence that taxes
be analogous to an interest in a joint real estate venture, have been paid to date. Additional documents relating
which would be, considered an investment in to commercial construction loans include loan
unconsolidated subsidiaries and associated companies. agreements, takeout commitments, tri-party (buy/sell)
agreements, completion or corporate bonds, and
The following are the basic types of construction lending: inspection or progress reports.

Unsecured Front Money - Unsecured front money Residential Construction Loans - Residential
loans are working capital advances to a borrower who construction loans may be made on a speculative basis
may be engaged in a new and unproven venture. or as prearranged permanent financing. Smaller banks
Many bankers believe that unsecured front money often engage in this type of financing and the
lending is not prudent unless the bank is involved in aggregate total of individual construction loans may
the latter stages of construction financing. A builder equal a significant portion of their capital funds.
planning to start a project before construction funding Prudence dictates that permanent financing be assured
is obtained often uses front money loans. The funds in advance because the cost of such financing can
may be used to acquire or develop a building site, have a substantial affect on sales. Proposals to
eliminate title impediments, pay architect or standby finance speculative housing should be evaluated in
fees, and/or meet minimum working capital accordance with predetermined policy standards
requirements established by construction lenders. compatible with the institution's size, technical
Repayment often comes from the first draw against competence of its management, and housing needs of
construction financing. Unsecured front money loans its service area. The prospective borrower's
used for a developer's equity investment in a project reputation, experience, and financial condition should
or to cover initial costs overruns are symptomatic of be reviewed. The finished project's marketability in
an undercapitalized, inexperienced or inept builder. favorable and unfavorable market conditions should
be realistically considered.
Land Development Loans - Land development loans
are generally secured purchase or development loans In addition to normal safeguards such as a recorded
or unsecured advances to investors and speculators. first mortgage, acceptable appraisal, construction
Secured purchase or development loans are usually a agreement, draws based on progress payment plans
form of financing involving the purchase of land and and inspection reports, a bank dealing with
lot development in anticipation of further construction speculative contractors should institute control
or sale of the property. A land development loan procedures tailored to the individual circumstances. A
should be predicated upon a proper title search and/or predetermined limit on the number of unsold units to
mortgage insurance. The loan amount should be be financed at any one time should be included in the
based on appraisals on an "as is" and "as completed" loan agreement to avoid overextending the
basis. Projections should be accompanied by a study contractor's capacity. Loans on larger residential
explaining the effect of property improvements on the construction projects are usually negotiated with
market value of the land. There should be a sufficient prearranged permanent financing. Documentation of
spread between the amount of the development loan tract loans frequently includes a master note allocated
and the estimated market value to allow for for the entire project and a master deed of trust or
unforeseen expenses. The repayment program should mortgage covering all land involved in the project.
be structured to follow the sales or development Payment of the loan will depend largely upon the sale
program. In the case of an unsecured land of the finished homes. As each sale is completed, the
development loan to investors or speculators, bank bank makes a partial release of the property covered
management should analyze the borrower's financial by its master collateral document. In addition to
statements for sources of repayment other than the making periodic inspections during the course of
expected return on the property development. construction, periodic progress reports (summary of
inventory lists maintained for each tract project)
Commercial Construction Loans - Loans financing should be made on the entire project. The inventory
commercial construction projects are usually list should show each lot number, type of structure,
collateralized, and such collateral is generally release price, sales price, and loan balance.

Loans (8-16) 3.2-22 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

stimulating abandonment of the property and default on

The exposure in any type of construction lending is that the debt secured by the housing. Certain features of home
the full value of the collateral does not exist at the time the equity loans make them particularly susceptible to such
loan is granted. The bank must ensure funds are used risks. First, while the variable rate feature of the debt
properly to complete construction or development of the reduces the interest rate risk of the lender, the variable
property serving as collateral. If default occurs, the bank payment size exposes the borrower to greater cash flow
must be in a position to either complete the project or to risks than would a fixed-rate loan, everything else being
salvage its construction advances. The various mechanic's equal. This, in turn, exposes the lender to greater credit
and materialmen's liens, tax liens, and other judgments that risk. Another risk is introduced by the very nature of the
arise in such cases are distressing to even the most home equity loan. Such loans are generally secured by a
seasoned lender. Every precaution should be taken by the junior lien. Thus, there is less effective equity protection
lender to minimize any outside attack on the collateral. than in a first lien instrument. Consequently, a decline in
The construction lender may not be in the preferred the value of the underlying housing results in a much
position indicated by documents in the file. Laws of some greater than proportional decline in the coverage of a
states favor the subcontractors (materialmen's liens, etc.), home equity loan. This added leverage makes them
although those of other states protect the construction correspondingly riskier than first mortgages.
lender to the point of first default, provided certain legal
requirements have been met. Depending on the type and Banks that make these kinds of loans should adopt specific
size of project being funded, construction lending can be a policies and procedures for dealing with this product line.
complex and fairly high-risk venture. For this reason, Management should have expertise in both mortgage
bank management should ensure that it has enacted lending as well as open-end credit procedures. Another
policies and retained sufficiently trained personnel before major concern is that borrowers will become overextended
engaging in this type of lending. and the bank will have to initiate foreclosure proceedings.
Therefore, underwriting standards should emphasize the
Home Equity Loans borrower's ability to service the line from cash flow rather
than the sale of the collateral, especially if the home equity
A home equity loan is a loan secured by the equity in a line is written on a variable rate basis. If the bank has
borrower's residence. It is generally structured in one of offered a low introductory interest rate, repayment
two ways. First, it can be structured as a traditional capacity should be analyzed at the rate that could be in
second mortgage loan, wherein the borrower obtains the effect at the conclusion of the initial term.
funds for the full amount of the loan immediately and
repays the debt with a fixed repayment schedule. Second, Other important considerations include acceptable loan-to-
the home equity borrowing can be structured as a line of value and debt-to-income ratios, and proper credit and
credit, with a check, credit card, or other access to the line collateral documentation, including adequate appraisals
over its life. and written evidence of prior lien status. Another
significant risk concerns the continued lien priority for
The home equity line of credit has evolved into the subsequent advances under a home equity line of credit.
dominant form of home equity lending. This credit State law governs the status of these subsequent advances.
instrument generally offers variable interest rates and It is also important that the bank's program include
flexible repayment terms. Additional characteristics of periodic reviews of the borrower's financial condition and
this product line include relatively low interest rates as continuing ability to repay the indebtedness.
compared to other forms of consumer credit, absorption by
some banks of certain fees (origination, title search, The variation in contract characteristics of home equity
appraisal, recordation cost, etc.) associated with debt affects the liquidity of this form of lending. For debt
establishing a real estate-related loan. The changes to be easily pooled and sold in the secondary market, it
imposed by the Tax Reform Act of 1986 relating to the needs to be fairly consistent in its credit and interest rate
income tax deductibility of interest paid on consumer debt characteristics. The complexity of the collateral structures,
led to the increased popularity of home equity lines of coupled with the uncertain maturity of revolving credit,
credit. makes home equity loans considerably less liquid than
straight first lien, fixed maturity mortgage loans.
Home equity lending is widely considered to be a low-risk
lending activity. These loans are secured by housing While home equity lending is considered to be fairly low-
assets, the value of which historically has performed well. risk, subprime home equity loans and lending programs
Nevertheless, the possibility exists that local housing exist at some banks. These programs have a higher level
values or household purchasing power may decline, of risk than traditional home equity lending programs.

RMS Manual of Examination Policies 3.2-23 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

Individual or pooled home equity loans that have subprime animals attain market weight and are sold for slaughter,
characteristics should be analyzed using the guidance the proceeds are used to repay the debt.
provided in the subprime section of this Manual.
Breeder Stock Loans - Intermediate-term credits (generally
Agricultural Loans three to five years) used to fund the acquisition of breeding
stock such as beef cows, sows, sheep, dairy cows, and
Introduction poultry. The primary repayment source is the proceeds
from the sale of the offspring of these stock animals, or
Agricultural loans are an important component of many their milk or egg production.
community bank loan portfolios. Agricultural banks
represent a material segment of commercial banks and Machinery and Equipment Loans - Intermediate-term
constitute an important portion of the group of banks over loans for the purchase of a wide array of equipment used
which the FDIC has the primary Federal supervisory in the production and handling of crops and livestock.
responsibility. Cash flow from farm earnings is the primary repayment
source. Loans for grain handling and storage facilities are
Agricultural loans are used to fund the production of also sometimes included in this category, especially if the
crops, fruits, vegetables, and livestock, or to fund the facilities are not permanently affixed to real estate.
purchase or refinance of capital assets such as farmland,
machinery and equipment, breeder livestock, and farm real Farm Real Estate Acquisition Loans - Long-term credits
estate improvements (for example, facilities for the for the purchase of farm real estate, with cash flow from
storage, housing, and handling of grain or livestock). The earnings representing the primary repayment source.
production of crops and livestock is especially vulnerable Significant, permanent improvements to the real estate,
to two risk factors that are largely outside the control of such as for livestock housing or grain storage, may also be
individual lenders and borrowers: commodity prices and included within this group.
weather conditions. While examiners must be alert to, and
critical of, operational and managerial weaknesses in Carryover Loans - This term is used to describe two types
agricultural lending activities, they must also recognize of agricultural credit. The first is production or feeder
when the bank is taking reasonable steps to deal with these livestock loans that are unable to be paid at their initial,
external risk factors. Accordingly, loan restructurings or short-term maturity, and which are rescheduled into an
extended repayment terms, or other constructive steps to intermediate or long-term amortization. This situation
deal with financial difficulties faced by agricultural arises when weather conditions cause lower crop yields,
borrowers because of adverse weather or commodity commodity prices are lower than anticipated, production
conditions, will not be criticized if done in a prudent costs are higher than expected, or other factors result in a
manner and with proper risk controls and management shortfall in available funds for debt repayment. The
oversight. Examiners should recognize these constructive second type of carryover loan refers to already-existing
steps and fairly portray them in oral and written term debt whose repayment terms or maturities need to be
communications regarding examination findings. This rescheduled because of inadequate cash flow to meet
does not imply, however, that analytical or classification existing repayment requirements. This need for
standards should be compromised. Rather, it means that restructuring can arise from the same factors that lead to
the banks response to these challenges will be considered carryover production or feeder livestock loans. Carryover
in supervisory decisions. loans are generally restructured on an intermediate or
long-term amortization, depending upon the type of
Agricultural Loan Types and Maturities collateral provided, the borrowers debt service capacity
from ongoing operations, the debtors overall financial
Production or Operating Loans - Short-term (one year or condition and trends, or other variables. The restructuring
less) credits to finance seed, fuel, chemicals, land and may also be accompanied by acquisition of Federal
machinery rent, labor, and other costs associated with the guarantees through the farm credit system to lessen risk to
production of crops. Family living expenses are also the bank.
sometimes funded, at least in part, with these loans. The
primary repayment source is sale of the crops at the end of Agricultural Loan Underwriting Guidelines
the production season when the harvest is completed.
Many underwriting standards applicable to commercial
Feeder Livestock Loans - Short-term loans for the loans also apply to agricultural credits. The discussion of
purchase of, or production expenses associated with, those shared standards is therefore not repeated. Some
cattle, hogs, sheep, poultry or other livestock. When the

Loans (8-16) 3.2-24 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

items, however, are especially pertinent to agricultural borrowers overall financial strength and trends,
credit and therefore warrant emphasis. profitability, financial leverage, degree of liquidity in asset
holdings, managerial and financial expertise, and amount
Financial and Other Credit Information - As with any type and type of credit. Nonetheless, as a general rule,
of lending, sufficient information must be available so that intermediate and long-term agricultural credit is typically
the bank can make informed credit decisions. Basic secured, and many times production and feeder livestock
information includes balance sheets, income statements, advances will also be collateralized. Often the security
cash flow projections, loan officer file comments, and takes the form of an all-inclusive lien on farm personal
collateral inspections, verifications, and valuations. property, such as growing crops, machinery and
Generally, financial information should be updated not equipment, livestock, and harvested grain. A lien on real
less than annually (loan officer files should be updated as estate is customarily taken if the loan was granted for the
needed and document all significant meetings and events). purchase of the property, or if the borrowers debts are
Credit information should be analyzed by management so being restructured because of debt servicing problems. In
that appropriate and timely actions are taken, as necessary, some cases, the bank may perfect a lien on real estate as an
to administer the credit. abundance of caution.

Banks should be given some reasonable flexibility as to Examiner review of agricultural related collateral
the level of sophistication or comprehensiveness of the valuations varies depending on the type of security
aforementioned financial information, and the frequency involved. Real estate collateral should be reviewed using
with which it is obtained, depending upon such factors as normal procedures and utilizing Part 323 of the FDICs
the credit size, the type of loans involved, the financial Rules and Regulations as needed. Feeder livestock and
strength and trends of the borrower, and the economic, grain are highly liquid commodities that are bought and
climatic or other external conditions which may affect loan sold daily in active, well-established markets. Their prices
repayment. It may therefore be inappropriate for the are widely reported in the daily media; so, obtaining their
examiner to insist that all agricultural borrowers be market values is generally easy. The market for breeder
supported with the full complement of balance sheets, livestock may be somewhat less liquid than feeder
income statements, and other data discussed above, livestock or grain, but values are nonetheless reasonably
regardless of the nature and amount of the credit or the well known and reported through local or regional media
debtors financial strength and payment record. or auction houses. If such information on breeding
Nonetheless, while recognizing some leeway is livestock is unavailable or is considered unreliable,
appropriate, most of the banks agricultural credit lines, slaughter prices may be used as an alternative (these
and all of its larger or more significant ones, should be slaughter prices comprise liquidation rather than going
sufficiently supported by the financial information concern values). The extent of use and level of
mentioned. maintenance received significantly affect machinery and
equipment values. Determining collateral values can
Cash Flow Analysis - History clearly demonstrated that therefore be very difficult as maintenance and usage levels
significant problems can develop when banks fail to pay vary significantly. Nonetheless, values for certain pre-
sufficient attention to cash flow adequacy in underwriting owned machinery and equipment, especially tractors,
agricultural loans. While collateral coverage is important, combines, and other harvesting or crop tillage equipment,
the primary repayment source for intermediate and long- are published in specialized guides and are based on prices
term agricultural loans is not collateral but cash flow from paid at farm equipment dealerships or auctions. These
ordinary operations. This principle should be incorporated used machinery guides may be used as a reasonableness
into the banks agricultural lending policies and check on the valuations presented on financial statements
implemented in its actual practices. Cash flow analysis is or in managements internal collateral analyses.
therefore an important aspect of the examiners review of
agricultural loans. Assumptions in cash flow projections Prudent agricultural loan underwriting also includes
should be reasonable and consider not only current systems and procedures to ensure that the bank has a valid
conditions but also the historical performance of the note receivable from the borrower and an enforceable
farming operation. security interest in the collateral, should judicial collection
measures be necessary. Among other things, such systems
Collateral Support - Whether a loan or line of credit and procedures will confirm that promissory notes, loan
warrants unsecured versus secured status in order to be agreements, collateral assignments, and lien perfection
prudent and sound is a matter the examiner has to documents are signed by the appropriate parties and are
determine based on the facts of the specific case. The filed, as needed, with the appropriate State, county, and/or
decision should generally consider such elements as the municipal authorities. Flaws in the legal enforceability of

RMS Manual of Examination Policies 3.2-25 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

loan instruments or collateral documents will generally be balance of, on the one hand, not interfering with the
unable to be corrected if they are discovered only when the debtors legitimate managerial decisions and marketing
credit is distressed and the borrower relationship strained. plans while, at the same time, taking prudent steps to
ensure its production loans are adequately protected and
Structuring - Orderly liquidation of agricultural debt, repaid on an appropriate basis. Examiners should
based on an appropriate repayment schedule and a clear generally not take exception to reasonable renewals or
understanding by the borrower of repayment expectations, extensions of production loans when the following factors
helps prevent collection problems from developing. are favorably resolved:
Amortization periods for term indebtedness should
correlate with the useful economic life of the underlying The borrower has sufficient financial strength to
collateral and with the operations debt service capacity. absorb market price fluctuations. Leverage and
A too-lengthy amortization period can leave the bank liquidity in the balance sheet, financial statement
under secured in the latter part of the life of the loan, when trends, profitability of the operation, and past
the borrowers financial circumstances may have changed. repayment performance are relevant indices.
A too-rapid amortization, on the other hand, can impose an The borrower has sufficient financial capacity to
undue burden on the cash flow capacity of the farming support both old and new production loans. That is,
operation and thus lead to loan default or disruption of in a few months subsequent to harvest, the farmer will
other legitimate financing needs of the enterprise. It is typically be incurring additional production debt for
also generally preferable that separate loans or lines of the upcoming crop season.
credit be established for each loan purpose category The bank has adequately satisfied itself of the amount
financed by the institution. and condition of grain in inventory, so that the
renewed or extended production loans are adequately
Administration of Agricultural Loans supported. Generally, this means that a current
inspection report will be available.
Two aspects of prudent loan administration deserve
emphasis: collateral control and renewal practices for
production loans. Classification Guidelines for Agricultural Credit

Collateral Control - Production and feeder livestock loans When determining the level of risk in a specific lending
are sometimes referred to as self liquidating because sale relationship, the relevant factual circumstances must be
of the crops after harvest, and of the livestock when they reviewed in total. This means, among other things, that
reach maturity, provides a ready repayment source for when an agricultural loans primary repayment source is
these credits. These self-liquidating benefits may be lost, jeopardized or unavailable, adverse classification is not
however, if the bank does not monitor and exercise automatic. Rather, such factors as the borrowers
sufficient control over the disposition of the proceeds from historical performance and financial strength, overall
the sale. In agricultural lending, collateral control is financial condition and trends, the value of any collateral,
mainly accomplished by periodic on-site inspections and and other sources of repayment must be considered. In
verifications of the security pledged, with the results of considering whether a given agricultural loan or line of
those inspections documented, and by implementing credit should be adversely classified, collateral margin is
procedures to ensure sales proceeds are applied to the an important, though not necessarily the determinative,
associated debt before those proceeds are released for factor. If that margin is so overwhelming as to remove all
other purposes. The recommended frequency of collateral reasonable prospect of the bank sustaining some loss, it is
inspections varies depending upon such things as the generally inappropriate to adversely classify such a loan.
nature of the farming operation, the overall credit Note, however, that if there is reasonable uncertainty as to
soundness, and the turnover rate of grain and livestock the value of that security, because of an illiquid market or
inventories. other reasons, that uncertainty can, when taken in
conjunction with other weaknesses, justify an adverse
Renewal of Production Loans - After completion of the classification of the credit, or, at minimum, may mean that
harvest, some farm borrowers may wish to defer the margin in the collateral needs to be greater to offset
repayment of some or all of that seasons production loans, this uncertainty. Moreover, when assessing the adequacy
in anticipation of higher market prices at a later point of the collateral margin, it must be remembered that
(typically, crop prices are lower at harvest time when the deteriorating financial trends will, if not arrested, typically
supply is greater). Such delayed crop marketing will result in a shrinking of that margin. Such deterioration can
generally require production loan extensions or renewals.. also reduce the amount of cash available for debt service
In these situations, the bank must strike an appropriate needs.

Loans (8-16) 3.2-26 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

adverse classification is not given in a particular case,

That portion of an agricultural loan(s) or line of credit, bank management should be informed of the reasons why.
which is secured by grain, feeder livestock, and/or breeder
livestock, will generally be withheld from adverse With the above principles, requirements, and standards in
classification. The basis for this approach is that grain and mind, the general guidelines for determining adverse
livestock are highly marketable and provide good classification for agricultural loans are as follows, listed by
protection from credit loss. However, that high loan type.
marketability also poses potential risks that must be
recognized and controlled. The following conditions must Feeder Livestock Loans - The self-liquidating nature of
therefore be met in order for this provision to apply: these credits means that they are generally not subject to
adverse classification. However, declines in livestock
The bank must take reasonable steps to verify the prices, increases in production costs, or other
existence and value of the grain and livestock. This unanticipated developments may result in the revenues
generally means that on-site inspections must be made from the sale of the livestock not being adequate to fully
and documented. Although the circumstances of each repay the loans. Adverse classification may then be
case must be taken into account, the general policy is appropriate, depending upon the support of secondary
that, for the classification exclusion to apply, repayment sources and collateral, and the borrowers
inspections should have been performed not more overall financial condition and trends.
than 90 days prior to the examination start date for
feeder livestock and grain collateral, and not more Production Loans - These loans are generally not subject
than six months prior to the examination start date for to adverse classification if the debtor has good liquidity
breeder stock collateral. Copies of invoices or bills of and/or significant fixed asset equities, or if the cash flow
sale are acceptable substitutes for inspection reports information suggests that current years operations should
prepared by bank management, in the case of loans for be sufficient to repay the advances. The examiner should
the purchase of livestock. also take into account any governmental support programs
Loans secured by grain warehouse receipts are or Federal crop insurance benefits from which the
generally excluded from adverse classification, up to borrower may benefit. If cash flow from ongoing
the market value of the grain represented by the operations appears insufficient to repay production loans,
receipts. adverse classification may be in order, depending upon the
The amount of credit to be given for the livestock or secondary repayment sources and collateral, and the
grain collateral should be based on the daily, borrowers overall financial condition and trends.
published, market value as of the examination start
date, less marketing and transportation costs, feed and Breeder Stock Loans - These loans are generally not
veterinary expenses (to the extent determinable), and, adversely classified if they are adequately secured by the
if material in amount, the accrued interest associated livestock and if the term debt payments are being met
with the loan(s). Current market values for breeder through the sale of offspring (or milk and eggs in the case
stock may be derived from local or regional of dairy and poultry operations). If one or both of these
newspapers, area auction barns, or other sources conditions is not met, adverse classification may be in
considered reliable. If such valuations for breeding order, depending upon the support of secondary repayment
livestock cannot be obtained, the animals slaughter sources and collateral, and the borrowers overall financial
values may be used. condition and trends.
The bank must have satisfactory practices for
controlling sales proceeds when the borrower sells Machinery and Equipment Loans - Loans for the
livestock and feed and grain. acquisition of machinery and equipment will generally not
The bank must have a properly perfected and be subject to adverse classification if they are adequately
enforceable security interest in the assets in question. secured, structured on an appropriate amortization
program (see above), and are paying as agreed. Farm
Examiners should exercise great caution in granting the machinery and equipment is often the second largest class
grain and livestock exclusion from adverse classification of agricultural collateral, hence its existence, general state
in those instances where the borrower is highly leveraged, of repair, and valuation should be verified and documented
or where the debtors basic operational viability is during the banks periodic on-site inspections of the
seriously in question, or if the bank is in an under-secured borrowers operation. Funding for the payments on
position. The issue of control over proceeds becomes machinery and equipment loans sometimes comes, at least
extremely critical in such highly distressed credit in part, from other loans provided by the bank, especially
situations. If the livestock and grain exclusion from production loans. When this is the case, the question

RMS Manual of Examination Policies 3.2-27 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

arises whether the payments are truly being made as fundamentally healthy financially, generates good
agreed. For examination purposes, such loans will be profitability and ample cash flow, and who provides a
considered to be paying as agreed if cash flow projections, comfortable margin in the security pledged. Carryover
payment history, or other available information, suggests loans to this group of borrowers will not ordinarily be
there is sufficient capacity to fully repay the production adversely classified.
loans when they mature at the end of the current
production cycle. If the machinery and equipment loan is Installment Loans
not adequately secured, or if the payments are not being
made as agreed, adverse classification should be An installment loan portfolio is usually comprised of a
considered. large number of small loans scheduled to be amortized
over a specific period. Most installment loans are made
Carryover Debt - Carryover debt results from the debtors directly for consumer purchases, but business loans
inability to generate sufficient cash flow to service the granted for the purchase of heavy equipment or industrial
obligation as it is currently structured. It therefore tends to vehicles may also be included. In addition, the department
contain a greater degree of credit risk and must receive may grant indirect loans for the purchase of consumer
close analysis by the examiner. When carryover debt goods.
arises, the bank should determine the basic viability of the
borrowers operation, so that an informed decision can be The examiner's emphasis in reviewing the installment loan
made on whether debt restructuring is appropriate. It will department should be on the overall procedures, policies
thus be useful for bank management to know how the and credit qualities. The goal should not be limited to
carryover debt came about: Did it result from the obligors identifying current portfolio problems, but should include
financial, operational or other managerial weaknesses; potential future problems that may result from ineffective
from inappropriate credit administration on the banks policies, unfavorable trends, potentially dangerous
part, such as over lending or improper debt structuring; concentrations, or nonadherence to established policies.
from external events such as adverse weather conditions At a minimum, the direct installment lending policies
that affected crop yields; or from other causes? In many should address the following factors: loan applications and
instances, it will be in the long-term best interests of both credit checks; terms in relation to collateral; collateral
the bank and the debtor to restructure the obligations. The margins; perfection of liens; extensions, renewals and
restructured obligation should generally be rescheduled on rewrites; delinquency notification and follow-up; and
a term basis and require clearly identified collateral, charge-offs and collections. For indirect lending, the
amortization period, and payment amounts. The policy additionally should address direct payment to the
amortization period may be intermediate or long term bank versus payment to the dealer, acquisition of dealer
depending upon the useful economic life of the available financial information, possible upper limits for any one
collateral, and on realistic projections of the operations dealer's paper, other standards governing acceptance of
payment capacity. dealer paper, and dealer reserves and charge-backs.

There are no hard and fast rules on whether carryover debt Direct Lease Financing
should be adversely classified, but the decision should
generally consider the following: borrowers overall Leasing is a recognized form of term debt financing for
financial condition and trends, especially financial fixed assets. While leases differ from loans in some
leverage (often measured in farm debtors with the debt-to- respects, they are similar from a credit viewpoint because
assets ratio); profitability levels, trends, and prospects; the basic considerations are cash flow, repayment capacity,
historical repayment performance; the amount of carryover credit history, management and projections of future
debt relative to the operations size; realistic projections of operations. Additional considerations for a lease
debt service capacity; and the support provided by transaction are the property type and its marketability in
secondary collateral. Accordingly, carryover loans to the event of default or lease termination. Those latter
borrowers who are moderately to highly leveraged, who considerations do not radically alter the manner in which
have a history of weak or no profitability and barely an examiner evaluates collateral for a lease. The
sufficient cash flow projections, as well as an adequate but assumption is that the lessee/borrower will generate
slim collateral margin, will generally be adversely sufficient funds to liquidate the lease/debt. Sale of leased
classified, at least until it is demonstrated through actual property/collateral remains a secondary repayment source
repayment performance that there is adequate capacity to and, except for the estimated residual value at the
service the rescheduled obligation. The classification expiration of the lease, will not, in most cases, become a
severity will normally depend upon the collateral position. factor in liquidating the advance. When the bank is
At the other extreme are cases where the customer remains

Loans (8-16) 3.2-28 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

requested to purchase property of significant value for variables. In addition, a bank can offer the lessee a lower
lease, it may issue a commitment to lease, describing the payment by assuming an artificially high residual value
property, indicating cost, and generally outlining the lease during the initial structuring of the lease. But this
terms. After all terms in the lease transaction are resolved technique may present the bank with serious long-term
by negotiation between the bank and its customer, an order problems because of the reliance on speculative or
is usually written requesting the bank to purchase the nonexistent residual values.
property. Upon receipt of that order, the bank purchases
the property requested and arranges for delivery and, if Often, lease contracts contain an option permitting the
necessary, installation. A lease contract is drawn lessee to continue use of the property at the end of the
incorporating all the points covered in the commitment original term, working capital restrictions and other
letter, as well as the rights of the bank and lessee in the restrictions or requirements similar to debt agreements and
event of default. The lease contract is generally signed lease termination penalties. Each lease is an individual
simultaneously with the signing of the order to purchase contract written to fulfill the lessee's needs. Consequently,
and the agreement to lease. there may be many variations of each of the above
provisions. However, the underlying factors remain the
The types of assets that may be leased are numerous, and same: there is a definite contractual understanding of the
the accounting for direct leasing is a complex subject positive right to use the property for a specific period of
which is discussed in detail in FAS 13. Familiarity with time, and required payments are irrevocable.
FAS 13 is a prerequisite for the management of any bank
engaging in or planning to engage in direct lease Examination procedures for reviewing direct lease
financing. The following terms are commonly financing activities are included in the ED Modules in the
encountered in direct lease financing: Loan References section.

Net Lease, one in which the bank is not directly or Floor Plan Loans
indirectly obligated to assume the expenses of
maintaining the equipment. This restriction does not Floor plan (wholesale) lending is a form of retail goods
prohibit the bank from paying delivery and set up inventory financing in which each loan advance is made
charges on the property. against a specific piece of collateral. As each piece of
Full Payout Lease, one for which the bank expects to collateral is sold by the dealer, the loan advance against
realize both the return of its full investment and the that piece of collateral is repaid. Items commonly subject
cost of financing the property over the term of the to floor plan debt are automobiles, home appliances,
lease. This payout can come from rentals, estimated furniture, television and stereophonic equipment, boats,
tax benefits, and estimated residual value of the mobile homes and other types of merchandise usually sold
property. under a sales finance contract. Drafting agreements are a
Leveraged Lease, in which the bank as lessor relatively common approach utilized in conjunction with
purchases and becomes the equipment owner by floor plan financing. Under this arrangement, the bank
providing a relatively small percentage (20-40%) of establishes a line of credit for the borrower and authorizes
the capital needed. Balance of the funds is borrowed the goods manufacturer to draw drafts on the bank in
by the lessor from long-term lenders who hold a first payment for goods shipped. The bank agrees to honor
lien on the equipment and assignments of the lease these drafts, assuming proper documentation (such as
and lease rental payments. This specialized and invoices, manufacturer's statement of origin, etc.) is
complex form of leasing is prompted mainly by a provided. The method facilitates inventory purchases by,
desire on the part of the lessor to shelter income from in effect, guaranteeing payment to the manufacturer for
taxation. Creditworthiness of the lessee is paramount merchandise supplied. Floor plan loans involve all the
and the general rule is a bank should not enter into a basic risks inherent in any form of inventory financing.
leveraged lease transaction with any party to whom it However, because of the banker's inability to exercise full
would not normally extend unsecured credit. control over the floored items, the exposure to loss may be
Rentals, which include only those payments greater than in other similar types of financing. Most
reasonably anticipated by the bank at the time the dealers have minimal capital bases relative to debt. As a
lease is executed. result, close and frequent review of the dealer's financial
information is necessary. As with all inventory financing,
Bank management should carefully evaluate all lease collateral value is of prime importance. Control requires
variables, including the estimate of the residual value. the bank to determine the collateral value at the time the
Banks may be able to realize unwarranted lease income in loan is placed on the books, frequently inspect the
the early years of a contract by manipulating the lease collateral to determine its condition, and impose a

RMS Manual of Examination Policies 3.2-29 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

curtailment requirement sufficient to keep collateral value percentage of each sales draft and a maximum dollar
in line with loan balances. amount per transaction. Amounts exceeding that limit
require prior approval by the bank. Merchants also may
Handling procedures for floor plan lines will vary greatly be assessed a fee for imprinters or promotional materials.
depending on bank size and location, dealer size and the The merchant deposits the bank credit card sales draft at
type of merchandise being financed. In many cases, the the bank and receives immediate credit for the discounted
term "trust receipt" is used to describe the debt instrument amount. The bank assumes the credit risk and charges the
existing between the bank and the dealer. Trust receipts nonrecourse sales draft to the individual customer's credit
may result from drafting agreements between a bank and a card account. Monthly statements are rendered by the
manufacturer for the benefit of a dealer. In other bank to the customer who may elect to remit the entire
instances, the dealer may order inventory, bring titles or amount, generally without service charge, or pay in
invoices to the bank, and then obtain a loan secured or to monthly installments, with an additional percentage
be secured by the inventory. Some banks may use master charged on the outstanding balance each month. A
debt instruments, and others may use a trust receipt or note cardholder also may obtain cash advances from the bank
for each piece of inventory. The method of perfecting a or dispensing machines. Those advances accrue interest
security interest also varies from state to state. The from the transaction date. A bank may be involved in a
important point is that a bank enacts realistic handling credit card plan in three ways:
policies and ensures that its collateral position is properly
protected. Agent Bank, which receives credit card applications
from customers and sales drafts from merchants and
Examination procedures and examiner considerations for forwards such documents to banks described below,
reviewing floor plan lending activities are included in the and is accountable for such documents during the
ED Modules in the Loan References section. process of receiving and forwarding.
Sublicensee Bank, which maintains accountability for
Check Credit and Credit Card Loans credit card loans and merchant's accounts; may
maintain its own center for processing payments and
Check credit is defined as the granting of unsecured drafts; and may maintain facilities for embossing
revolving lines of credit to individuals or businesses. credit cards.
Check credit services are provided by the overdraft Licensee Bank, which is the same as sublicensee
system, cash reserve system, and special draft system. The bank, but in addition may perform transaction
most common is the overdraft system. In that method, a processing and credit card embossing services for
transfer is made from a preestablished line of credit to a sublicensee banks, and also acts as a regional or
customer's demand deposit account when a check which national clearinghouse for sublicensee banks.
would cause an overdraft position is presented. Transfers
normally are made in stated increments, up to the Check credit and credit card loan policies should address
maximum line of credit approved by the bank, and the procedures for careful screening of account applicants;
customer is notified that the funds have been transferred. establishment of internal controls to prevent interception
In a cash reserve system, customers must request that the of cards before delivery, merchants from obtaining control
bank transfer funds from their preestablished line of credit of cards, or customers from making fraudulent use of lost
to their demand deposit account before negotiating a check or stolen card; frequent review of delinquent accounts,
against them. A special draft system involves the accounts where payments are made by drawing on
customer negotiating a special check drawn directly reserves, and accounts with steady usage; delinquency
against a preestablished line of credit. In that method, notification procedures; guidelines for realistic
demand deposit accounts are not affected. In all three charge-offs; removal of accounts from delinquent status
systems, the bank periodically provides its check credit (curing) through performance not requiring a catch-up of
customers with a statement of account activity. Required delinquent principal; and provisions that preclude
minimum payments are computed as a fraction of the automatic reissuance of expired cards to obligors with
balance of the account on the cycle date and may be made charged-off balances or an otherwise unsatisfactory credit
by automatic charges to a demand deposit account. history with the bank.

Most bank credit card plans are similar. The bank solicits Examination procedures for reviewing these activities are
retail merchants, service organizations and others who included in the ED Modules. Also, the FDIC has separate
agree to accept a credit card in lieu of cash for sales or manuals on Credit Card Specialty Bank Examination
services rendered. The parties also agree to a discount Guidelines and Credit Card Securitization Activities.

Loans (8-16) 3.2-30 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Credit Card-related Merchant Activities services of agents, such as an independent sales

organization (ISO). ISOs solicit merchants' credit card
Merchant credit card activities basically involve the transactions for a clearing institution. In some cases, the
acceptance of credit card sales drafts for clearing by a ISOs actually contract with merchants on behalf of
financial institution (clearing institution). For the clearing clearing institutions. Some of these contracts are entered
institution, these activities are generally characterized by into by the ISOs without the review and approval of the
thin profit margins amidst high transactional and sales clearing institutions. At times, clearing institutions
volumes. Typically, a merchant's customer will charge an unfortunately rely too much on the ISOs to oversee
item on a credit card, and the clearing institution will give account activity. In some cases, clearing institutions have
credit to the merchant's account. Should the customer permitted ISOs to contract with disreputable merchants.
dispute a charge transaction, the clearing institution is Because of the poor condition of the merchant, or ISO, or
obligated to honor the customer's legitimate request to both, these clearing institutions can ultimately incur heavy
reverse the transaction. The Clearing Institution must then losses.
seek reimbursement from the merchant. Problems arise
when the merchant is not creditworthy and is unable, or A financial institution with credit card clearing activities
unwilling, to reimburse the clearing institution. In these should develop its own internal controls and procedures to
instances, the clearing institution will incur a loss. ensure sound agent selection standards before engaging an
Examiners should review for the existence of any such ISO. ISOs that seek to be compensated solely on the basis
contingent liabilities. of the volume of signed-up merchants should be carefully
In order to avoid losses and to ensure the safe and scrutinized. A clearing institution should adequately
profitable operation of a clearing institution's credit card supervise the ISO's activities, just as the institution should
activities, the merchants with whom it contracts for supervise any third party engaged to perform services for
clearing services should be financially sound and honestly any aspect of the institution's operations. Also, it should
operated. To this end, safe and sound merchant credit card reserve the right to ratify or reject any merchant contract
activities should include clear and detailed acceptance that is initiated by an ISO.
standards for merchants. These standards include the
following: Examination procedures for reviewing credit card related
merchant activities are included in the Examination
A clearing institution should scrutinize prospective Documentation Modules in the Supplemental Modules
merchants with the same care and diligence that it Section and in the Credit Card Specialty Bank
uses in evaluating prospective borrowers. Examination Guidelines.
Financial institutions engaging in credit card clearing
operations must closely monitor their merchants.
Controls should be in place to ensure that early OTHER CREDIT ISSUES
warning signs are recognized so that problem
merchants can be removed from a clearing institution's Appraisals
program promptly to minimize loss exposure.
In cases of merchants clearing large dollar volumes, a Appraisals are professional judgments of the market value
clearing institution should establish an account of real property. Three basic valuation approaches are
administration program that, at a minimum, used by professional appraisers in estimating the market
incorporates periodic reviews of the merchants' value of real property; the cost approach, the market data
financial statements and business activities. or direct sales comparison approach, and the income
A clearing institution should establish an internal approach. The principles governing the three approaches
periodic reporting system of merchant account are widely known in the appraisal field and are referenced
activities regardless of the amount or number of in parallel regulations issued by each of the Federal bank
transactions cleared, and these reports should be and thrift regulatory agencies. When evaluating collateral,
reviewed for irregularities so that the Clearing the three valuation approaches are not equally appropriate.
Institution alerts itself quickly to problematic
merchant activity. Cost Approach - In this approach, the appraiser
Clearing institutions should follow the guidelines that estimates the reproduction cost of the building and
are established by the card issuing networks. improvements, deducts estimated depreciation, and
adds the value of the land. The cost approach is
Another possible problem with merchant activities particularly helpful when reviewing draws on
involves clearing institutions that sometimes engage the construction loans. However, as the property

RMS Manual of Examination Policies 3.2-31 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

increases in age, both reproduction cost and discounted income stream to arrive at the total present
depreciation become more difficult to estimate. market value of the property.
Except for special purpose facilities, the cost approach
is usually inappropriate in a troubled real estate Valuation of Troubled Income-Producing Properties
market because construction costs for a new facility
normally exceed the market value of existing When an income property is experiencing financial
comparable properties. difficulties due to general market conditions or due to its
Market Data or Direct Sales Comparison own characteristics, data on comparable property sales is
Approach - This approach examines the price of often difficult to obtain. Troubled properties may be hard
similar properties that have sold recently in the local to market, and normal financing arrangements may not be
market, estimating the value of the subject property available. Moreover, forced and liquidation sales can
based on the comparable properties' selling prices. It dominate market activity. When the use of comparables is
is very important that the characteristics of the not feasible (which is often the case for commercial
observed transactions be similar in terms of market properties), the net present value of the most reasonable
location, financing terms, property condition and use, expectation of the property's income-producing capacity -
timing, and transaction costs. The market approach not just in today's market but over time - offers the most
generally is used in valuing owner-occupied appropriate method of valuation in the supervisory
residential property because comparable sales data is process.
typically available. When adequate sales data is
available, an analyst generally will give the most Estimates of the property's value should be based upon
weight to this type of estimate. Often, however, the reasonable and supportable projections of the determinants
available sales data for commercial properties is not of future net operating income: rents (or sales), expenses,
sufficient to justify a conclusion. and rates of occupancy. The primary considerations for
The Income Approach - The economic value of an these projections include historical levels and trends, the
income-producing property is the discounted value of current market performance achieved by the subject and
the future net operating income stream, including any similar properties, and economically feasible and
"reversion" value of property when sold. If defensible projections of future demand and supply
competitive markets are working perfectly, the conditions. If current market activity is dominated by a
observed sales price should be equal to this value. For limited number of transactions or liquidation sales, high
unique properties or in depressed markets, value capitalization and discount rates implied by such
based on a comparable sales approach may be either transactions should not be used. Rather, analysts should
unavailable or distorted. In such cases, the income use rates that reflect market conditions that are neither
approach is usually the appropriate method for highly speculative nor depressed.
valuing the property. The income approach converts
all expected future net operating income into present Appraisal Regulation
value terms. When market conditions are stable and
no unusual patterns of future rents and occupancy Title XI of the Financial Institutions Reform, Recovery,
rates are expected, the direct capitalization method is and Enforcement Act of 1989 requires that appraisals
often used to estimate the present value of future prepared by certified or licensed appraisers be obtained in
income streams. For troubled properties, however, the support of real estate lending and mandates that the
more explicit discounted cash flow (net present value) Federal financial institutions regulatory agencies adopt
method is more typically utilized for analytical regulations regarding the preparation and use of appraisals
purposes. In the rent method, a time frame for in certain real estate related transactions by financial
achieving a "stabilized", or normal, occupancy and institutions under their jurisdiction. In addition, Title XI
rent level is projected. Each year's net operating created the Appraisal Subcommittee (Subcommittee) of
income during that period is discounted to arrive at the Federal Financial Institutions Examination Council
present value of expected future cash flows. The (FFIEC) to provide oversight of the real estate appraisal
property's anticipated sales value at the end of the process as it relates to federally related real estate
period until stabilization (its terminal or reversion transactions. The Subcommittee is composed of six
value) is then estimated. The reversion value members, each of whom is designated by the head of their
represents the capitalization of all future income respective agencies. Each of the five financial institution
streams of the property after the projected occupancy regulatory agencies which comprise the FFIEC and the
level is achieved. The terminal or reversion value is U.S. Department of Housing and Urban Development are
then discounted to its present value and added to the represented on Subcommittee. A responsibility of the
Subcommittee is to monitor the state certification and

Loans (8-16) 3.2-32 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

licensing of appraisers. It has the authority to disapprove a The transaction is a business loan that: (i) has a
state appraiser regulatory program, thereby disqualifying transaction value of $1 million or less; and (ii) is not
the state's licensed and certified appraisers from dependent on the sale of, or rental income derived
conducting appraisals for federally related transactions. from, real estate as the primary source of repayment;
The Subcommittee gets its funding by charging state A lease of real estate is entered into, unless the lease is
certified and licensed appraisers an annual registration fee. the economic equivalent of a purchase or sale of the
The fee income is used to cover Subcommittee leased real estate;
administrative expenses and to provide grants to the The transaction involves an existing extension of
Appraisal Foundation. credit at the lending institution, provided that: (i)
There has been no obvious and material change in the
Formed in 1987, the Appraisal Foundation was established market conditions or physical aspects of the property
as a private not for profit corporation bringing together that threatens the adequacy of the institutions real
interested parties within the appraisal industry, as well as estate collateral protection after the transaction, even
users of appraiser services, to promote professional with the advancement of new monies; or (ii) There is
standards within the appraisal industry. The Foundation no advancement of new monies, other than funds
sponsors two independent boards referred to in Title XI, necessary to cover reasonable closing costs;
The Appraiser Qualifications Board (AQB) and The The transaction involves the purchase, sale,
Appraisal Standards Board (ASB). Title XI specifies that investment in, exchange of, or extension of credit
the minimum standards for state appraiser certification are secured by, a loan or interest in a loan, pooled loans,
to be the criteria for certification issued by the AQB. Title or interests in real property, including mortgage-
XI does not set specific criteria for the licensed backed securities, and each loan or interest in a loan,
classification. These are individually determined by each pooled loan, or real property interest met FDIC
state. Additionally, Title XI requires that the appraisal regulatory requirements for appraisals at the time of
standards prescribed by the Federal agencies, at a origination;
minimum, must be the appraisal standards promulgated by The transaction is wholly or partially insured or
the ASB. The ASB has issued The Uniform Standards of guaranteed by a United States government agency or
Professional Appraisal Practice (USPAP) which set the United States government sponsored agency;
appraisal industry standards for conducting an appraisal of The transaction either; (i) Qualifies for sale to a
real estate. To the appraisal industry, USPAP is analogous United States government agency or United States
to generally accepted accounting principles for the government sponsored agency; or (ii) Involves a
accounting profession. residential real estate transaction in which the
appraisal conforms to the Federal National Mortgage
In conformance with Title XI, Part 323 of the FDIC Association or Federal Home Loan Mortgage
regulations identifies which real estate related transactions Corporation appraisal standards applicable to that
require an appraisal by a certified or licensed appraiser and category of real estate;
establishes minimum standards for performing appraisals. The regulated institution is acting in a fiduciary
Substantially similar regulations have been adopted by capacity and is not required to obtain an appraisal
each of the Federal financial institutions regulatory under other law; or
agencies.
The FDIC determines that the services of an appraiser
are not necessary in order to protect Federal financial
Real estate-related transactions include real estate loans,
and public policy interests in real estate-related
mortgage-backed securities, bank premises, real estate
financial transaction or to protect the safety and
investments, and other real estate owned. All real estate-
soundness of the institution.
related transactions by FDIC-insured institutions not
specifically exempt are, by definition, "federally related
Section 323.4 establishes minimum standards for all
transactions" subject to the requirements of the regulation.
appraisals in connection with federally related
Exempt real estate-related transactions include:
transactions. Appraisals performed in conformance with
the regulation must conform to the requirements of the
The transaction value is $250,000 or less; USPAP and certain other listed standards. The applicable
A lien on real estate has been taken as collateral in an sections of USPAP are the Preamble (ethics and
abundance of caution; competency), Standard 1 (appraisal techniques), Standard
The transaction is not secured by real estate; 2 (report content), and Standard 3 (review procedures).
A lien on real estate has been taken for purposes other USPAP Standards 4 through 10 concerning appraisal
than the real estates value;

RMS Manual of Examination Policies 3.2-33 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

services and appraising personal property do not apply to An institution's real estate appraisal and evaluation policies
federally related transactions. and procedures will be reviewed as part of the examination
of the institution's overall real estate-related activities. An
An appraisal satisfies the regulation if it is performed in institution's policies and procedures should be
accordance with all of its provisions and it is still current incorporated into an effective appraisal and evaluation
and meaningful. In other words, a new appraisal does not program. Examiners will consider the institution's size and
necessarily have to be done every time there is a the nature of its real estate-related activities when
transaction, provided the institution has an acceptable assessing the appropriateness of its program.
process in place to review existing appraisals.
When analyzing individual transactions, examiners should
Adherence to the appraisal regulation and appraisal review an appraisal or evaluation to determine whether the
guidelines should be part of the examiner's overall review methods, assumptions, and findings are reasonable and in
of the lending function. An institution's written appraisal compliance with the agencies' appraisal regulations,
program should contain specific administrative review policies, supervisory guidelines, and internal policies.
procedures that provide some evidence, such as a staff Examiners also will review the steps taken by an
member's signature on an appraisal checklist that indicates institution to ensure that the individuals who perform its
the appraisal was reviewed and that all standards were appraisals and evaluations are qualified and are not subject
met. In addition, the regulation requires that the appraisal to conflicts of interest. Institutions that fail to maintain a
contain the appraiser's certification that it was prepared in sound appraisal or evaluation program or to comply with
conformance with USPAP. When analyzing individual the agencies' appraisal regulations, policies, or these
transactions, examiners should review appraisal reports to supervisory guidelines will be cited in examination reports
determine the institution's conformity to its own internal and may be criticized for unsafe and unsound banking
appraisal policies and for compliance with the regulation. practices. Deficiencies will require corrective action.
Examiners may need to conduct a more detailed review if
the appraisal does not have sufficient information, does Appraisal and Evaluation Program - An institution's board
not explain assumptions, is not logical, or has other major of directors is responsible for reviewing and adopting
deficiencies that cast doubt as to the validity of its opinion policies and procedures that establish an effective real
of value. Examination procedures regarding appraisal estate appraisal and evaluation program. The program
reviews are included in the Examination Documentation should:
Modules.
Establish selection criteria and procedures to evaluate
Loans in a pool such as an investment in mortgage- backed and monitor the ongoing performance of individuals
securities or collateralized mortgage obligations should who perform appraisals or evaluations;
have some documented assurance that each loan in the Provide for the independence of the person
pool has an appraisal in accordance with the regulation. performing appraisals or evaluations;
Appropriate evidence could include an issuer's Identify the appropriate appraisal for various lending
certification of compliance. transactions;
Establish criteria for contents of an evaluation;
All apparent violations of Part 323 should be listed in the Provide for the receipt of the appraisal or evaluation
examination report in the usual manner. Significant report in a timely manner to facilitate the underwriting
systemic failures to meet standards and procedures could decision;
call for formal corrective measures. Assess the validity of existing appraisals or
evaluations to support subsequent transactions;
Interagency Appraisal and Evaluation Guidelines Establish criteria for obtaining appraisals or
evaluations for transactions that are otherwise exempt
These Interagency Appraisal and Evaluation Guidelines from the agencies' appraisal regulations; and
dated October 27, 1994 address supervisory matters
Establish internal controls that promote compliance
relating to real estate-related financial transactions and
with these program standards.
provide guidance to examining personnel and federally
regulated institutions about prudent appraisal and
Selection of Individuals Who May Perform Appraisals and
evaluation policies, procedures, practices, and standards.
Evaluations - An institution's program should establish
The guidelines were reiterated and clarified in a Statement
criteria to select, evaluate, and monitor the performance of
issued by the regulatory agencies on October 27, 2003.
the individual(s) who performs a real estate appraisal or
evaluation. The criteria should ensure that:

Loans (8-16) 3.2-34 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Transactions That Require Appraisals - Although the

The institution's selection process is non-preferential agencies' appraisal regulations exempt certain categories
and unbiased; of real estate-related financial transactions from the
The individual selected possesses the requisite appraisal requirements, most real estate transactions over
education, expertise and competence to complete the $250,000 are considered federally related transactions and
assignment; thus require appraisals. A "federally related transaction"
The individual selected is capable of rendering an means any real estate-related financial transaction, in
unbiased opinion; and which the agencies engage, contract for, or regulate and
The individual selected is independent and has no that requires the services of an appraiser. An agency also
direct or indirect interest, financial or otherwise, in the may impose more stringent appraisal requirements than the
property or the transaction. appraisal regulations require, such as when an institution's
troubled condition is attributable to real estate loan
Under the agencies' appraisal regulations, the appraiser underwriting problems.
must be selected and engaged directly by the institution or
its agent. The appraiser's client is the institution, not the Minimum Appraisal Standards - The agencies' appraisal
borrower. Also, an institution may not use an appraisal regulations include five minimum standards for the
that has been readdressed appraisal reports that are preparation of an appraisal. The appraisal must:
altered by the appraiser to replace any references to the
original client with the institutions name. An institution Conform to generally accepted appraisal standards as
may use an appraisal that was prepared by an appraiser evidenced by the Uniform Standards of Professional
engaged directly by another financial services institution, Appraisal Practice (USPAP) promulgated by the
as long as the institution determines that the appraisal Appraisal Standards Board (ASB) of the Appraisal
conforms to the agencies' appraisal regulations and is Foundation unless principles of safe and sound
otherwise acceptable. banking require compliance with stricter standards.
Although allowed by USPAP, the agencies' appraisal
Independence of the Appraisal And Evaluation Function - regulations do not permit an appraiser to appraise any
Because the appraisal and evaluation process is an integral property in which the appraiser has an interest, direct
component of the credit underwriting process, it should be or indirect, financial or otherwise;
isolated from influence by the institution's loan production Be written and contain sufficient information and
process. An appraiser and an individual providing analysis to support the institution's decision to engage
evaluation services should be independent of the loan and in the transaction. As discussed below, appraisers
collection functions of the institution and have no interest, have available various appraisal development and
financial or otherwise, in the property or the transaction. report options; however, not all options may be
In addition, individuals independent from the loan appropriate for all transactions. A report option is
production area should oversee the selection of appraisers acceptable under the agencies' appraisal regulations
and individuals providing evaluation services. If absolute only if the appraisal report contains sufficient
lines of independence cannot be achieved, an institution information and analysis to support an institution's
must be able to clearly demonstrate that it has prudent decision to engage in the transaction.
safeguards to isolate its collateral evaluation process from Analyze and report appropriate deductions and
influence or interference from the loan production process. discounts for proposed construction or renovation,
That is, no single person should have sole authority to partially leased buildings, non-market lease terms, and
render credit decisions on loans which they ordered or tract developments with unsold units. This standard is
reviewed 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 actual physical condition and subject to the zoning in
some cases, such as in a small or rural institution or effect as of the date of the appraisal. For properties
branch, the only individual qualified to analyze the real where improvements are to be constructed or
estate collateral may also be a loan officer, other officer, or rehabilitated, the regulated institution may also
director of the institution. To ensure their independence, request a prospective market value based on stabilized
such lending officials, officers, or directors should abstain occupancy or a value based on the sum of retail sales.
from any vote or approval involving loans on which they However, the sum of retail sales for a proposed
performed an appraisal or evaluation. development is not the market value of the
development for the purpose of the agencies' appraisal

RMS Manual of Examination Policies 3.2-35 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

regulations. For proposed developments that involve the use of a Limited Appraisal for a federally related
the sale of individual houses, units, or lots, the transaction, but the agencies believe that institutions
appraiser must analyze and report appropriate should be cautious in their use of a Limited Appraisal
deductions and discounts for holding costs, marketing because it will be less thorough than a Complete
costs and entrepreneurial profit. For proposed and Appraisal.
rehabilitated rental developments, the appraiser must Complete and Limited Appraisal assignments may be
make appropriate deductions and discounts for items reported in three different report formats: a Self-
such as leasing commission, rent losses, and tenant Contained Report, a Summary Report, or a Restricted
improvements from an estimate based on stabilized Report. The major difference among these three reports
occupancy; relates to the degree of detail presented in the report by the
Be based upon the definition of market value set forth appraiser. The Self-Contained Appraisal Report provides
in the regulation. Each appraisal must contain an the most detail, while the Summary Appraisal Report
estimate of market value, as defined by the agencies' presents the information in a condensed manner. The
appraisal regulations; and, Restricted Report provides a capsulated report with the
Be performed by state licensed or certified appraisers supporting details maintained in the appraiser's files.
in accordance with requirements set forth in the
regulation. The agencies believe that the Restricted Report format will
not be appropriate to underwrite a significant number of
Appraisal Options - An appraiser typically uses three federally related transactions due to the lack of sufficient
market value approaches to analyze the value of a property supporting information and analysis in the appraisal report.
cost, income, and sales market. The appraiser reconciles However, it might be appropriate to use this type of
the results of each approach to estimate market value. An appraisal report for ongoing collateral monitoring of an
appraisal will discuss the property's recent sales history institution's real estate transactions and under other
and contain an opinion as to the highest and best use of the circumstances when an institution's program requires an
property. An appraiser must certify that he/she has evaluation.
complied with USPAP and is independent. Also, the
appraiser must disclose whether the subject property was Moreover, since the institution is responsible for selecting
inspected and whether anyone provided significant the appropriate appraisal report to support its underwriting
assistance to the person signing the appraisal report. decisions, its program should identify the type of appraisal
report that will be appropriate for various lending
An institution may engage an appraiser to perform either a transactions. The institution's program should consider the
Complete or Limited Appraisal. When performing a risk, size, and complexity of the individual loan and the
Complete Appraisal assignment, an appraiser must comply supporting collateral when determining the level of
with all USPAP standards - without departing from any appraisal development and the type of report format that
binding requirements - and specific guidelines when will be ordered. When ordering an appraisal report,
estimating market value. When performing a Limited institutions may want to consider the benefits of a written
Appraisal, the appraiser elects to invoke the Departure engagement letter that outlines the institution's
Provision which allows the appraiser to depart, under expectations and delineates each party's responsibilities,
limited conditions, from standards identified as specific especially for large, complex, or out-of-area properties.
guidelines. For example, in a Limited Appraisal, the
appraiser might not utilize all three approaches to value; Transactions That Require Evaluations - A formal opinion
however, departure from standards designated as binding of market value prepared by a state licensed or certified
requirements is not permitted. There are numerous appraiser is not always necessary. Instead, less formal
binding requirements which are detailed in the USPAP. evaluations of the real estate may suffice for transactions
Use of the USPAP Standards publication as a reference is that are exempt from the agencies' appraisal requirements.
recommended. The book provides details on each
appraisal standard and advisory opinions issued by the Institutions should also establish criteria for obtaining
Appraisal Standards Board. appraisals or evaluations for safety and soundness reasons
for transactions that are otherwise exempt from the
An institution and appraiser must concur that use of the agencies' appraisal regulations.
Departure Provision is appropriate for the transaction
before the appraiser commences the appraisal assignment. Evaluation Content - An institution should establish
The appraiser must ensure that the resulting appraisal prudent standards for the preparation of evaluations. At a
report will not mislead the institution or other intended minimum, an evaluation should:
users of the appraisal report. The agencies do not prohibit

Loans (8-16) 3.2-36 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Be written;
Include the preparer's name, address, and signature, Valid Appraisals and Evaluations - The agencies allow an
and the effective date of the evaluation; institution to use an existing appraisal or evaluation to
Describe the real estate collateral, its condition, its support a subsequent transaction, if the institution
current and projected use; documents that the existing estimate of value remains
Describe the source(s) of information used in the valid. Therefore, a prudent appraisal and evaluation
analysis; program should include criteria to determine whether an
Describe the analysis and supporting information, existing appraisal or evaluation remains valid to support a
and; subsequent transaction. Criteria for determining whether
Provide an estimate of the real estate's market value, an existing appraisal or evaluation remains valid will vary
with any limiting conditions. depending upon the condition of the property and the
marketplace, and the nature of any subsequent transaction.
An evaluation report should include calculations, Factors that could cause changes to originally reported
supporting assumptions, and, if utilized, a discussion of values include: the passage of time; the volatility of the
comparable sales. Documentation should be sufficient to local market; the availability of financing; the inventory of
allow an institution to understand the analysis, competing properties; improvements to, or lack of
assumptions, and conclusions. An institution's own real maintenance of, the subject property or competing
estate loan portfolio experience and value estimates surrounding properties; changes in zoning; or
prepared for recent loans on comparable properties might environmental contamination. The institution must
provide a basis for evaluations. document the information sources and analyses used to
conclude that an existing appraisal or evaluation remains
An evaluation should provide an estimate of value to assist valid for subsequent transactions.
the institution in assessing the soundness of the
transaction. Prudent practices also require that as an Renewals, Refinancings, and Other Subsequent
institution engages in more complex real estate-related Transactions - The agencies' appraisal regulations
financial transactions, or as its overall exposure increases, generally allow appropriate evaluations of real estate
a more detailed evaluation should be performed. For collateral in lieu of an appraisal for loan renewals and
example, an evaluation for a home equity loan might be refinancings; however, in certain situations an appraisal is
based primarily on information derived from a sales data required. If new funds are advanced in excess of
services organization or current tax assessment reasonable closing costs, an institution is expected to
information, while an evaluation for an income-producing obtain a new appraisal for the renewal of an existing
real estate property should fully describe the current and transaction when there is a material change in market
expected use of the property and include an analysis of the conditions or in the physical aspects of the property that
property's rental income and expenses. threatens the institution's real estate collateral protection.

Qualifications of Evaluation Providers - Individuals who The decision to reappraise or reevaluate the real estate
prepare evaluations should have real estate-related training collateral should be guided by the exemption for renewals,
or experience and knowledge of the market relevant to the refinancings, and other subsequent transactions. Loan
subject property. Based upon their experience and workouts, debt restructurings, loan assumptions, and
training, professionals from several fields may be qualified similar transactions involving the addition or substitution
to prepare evaluations of certain types of real estate of borrowers may qualify for the exemption for renewals,
collateral. Examples include individuals with appraisal refinancings, and other subsequent transactions. Use of
experience, real estate lenders, consultants or sales this exemption depends on the condition and quality of the
persons, agricultural extension agents, or foresters. loan, the soundness of the underlying collateral and the
Institutions should document the qualifications and validity of the existing appraisal or evaluation.
experience level of individuals whom the institution deems
acceptable to perform evaluations. An institution might A reappraisal would not be required when an institution
also augment its in-house expertise and hire an outside advances funds to protect its interest in a property, such as
party familiar with a certain market or a particular type of to repair damaged property, because these funds should be
property. Although not required, an institution may use used to restore the damaged property to its original
state licensed or certified appraisers to prepare evaluations. condition. If a loan workout involves modification of the
As such, Limited Appraisals reported in a Summary or terms and conditions of an existing credit, including
Restricted format may be appropriate for evaluations of acceptance of new or additional real estate collateral,
real estate-related financial transactions exempt from the which facilitates the orderly collection of the credit or
agencies' appraisal requirements. reduces the institution's risk of loss, a reappraisal or

RMS Manual of Examination Policies 3.2-37 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

reevaluation may be prudent, even if it is obtained after the Portfolio Monitoring - The institution should also develop
modification occurs. criteria for obtaining reappraisals or reevaluations as part
of a program of prudent portfolio review and monitoring
An institution may engage in a subsequent transaction techniques, even when additional financing is not being
based on documented equity from a valid appraisal or contemplated. Examples of such types of situations
evaluation, if the planned future use of the property is include large credit exposures and out-of-area loans.
consistent with the use identified in the appraisal or
evaluation. If a property, however, has reportedly Referrals - Financial institutions are encouraged to make
appreciated because of a planned change in use of the referrals directly to state appraiser regulatory authorities
property, such as rezoning, an appraisal would be required when a state licensed or certified appraiser violates
for a federally related transaction, unless another USPAP, applicable State law, or engages in other
exemption applied. unethical or unprofessional conduct. Examiners finding
evidence of unethical or unprofessional conduct by
Program Compliance - An institution's appraisal and appraisers will forward their findings and
evaluation program should establish effective internal recommendations to their supervisory office for
controls that promote compliance with the program's appropriate disposition and referral to the State, as
standards. An individual familiar with the appropriate necessary.
agency's appraisal regulation should ensure that the
institution's appraisals and evaluations comply with the Examination Treatment
agencies' appraisal regulations, these guidelines, and the
institution's program. Loan administration files should All apparent violations of the appraisal regulation should
document this compliance review, although a detailed be described in the schedule of violations of laws and
analysis or comprehensive analytical procedures are not regulations. Management's comments and any
required for every appraisal or evaluation. For some commitments for correcting the practices that led to the
loans, the compliance review may be part of the loan apparent violation should be included. Violations that are
officer's overall credit analysis and may take the form of technical in nature and do not impact the value conclusion
either a narrative or a checklist. Corrective action should generally should not require a new appraisal. (These
be undertaken for noted deficiencies by the individual who technical violations should not be relisted in subsequent
prepared the appraisal or evaluation. examinations.) Since the point of an appraisal is to help
make sound loan underwriting decisions, getting an
An institution's appraisal and evaluation program should appraisal on a loan already made simply to fulfill the
also have comprehensive analytical procedures that focus requirements of the appraisal regulation, would be of little
on certain types of loans, such as large-dollar credits, loans benefit. However, an institution should be expected to
secured by complex or specialized properties, non- obtain a new appraisal on a loan in violation of the
residential real estate construction loans, or out-of-area appraisal regulation when there is a safety and soundness
real estate. These comprehensive analytical procedures reason for such action. For example, construction loans
should be designed to verify that the methods, and lines of credit need to have the value of the real estate
assumptions, and conclusions are reasonable and reviewed frequently in order for the institution to properly
appropriate for the transaction and the property. These manage the credit relationship. A new appraisal might
procedures should provide for a more detailed review of also be needed to determine the proper classification for
selected appraisals and evaluations prior to the final credit examination purposes of a collateral dependent loan.
decision. The individual(s) performing these reviews
should have the appropriate training or experience, and be Loan Participations
independent of the transaction.
A loan participation is a sharing or selling of ownership
Appraisers and persons performing evaluations should be interests in a loan between two or more financial
responsible for any deficiencies in their reports. Deficient institutions. Normally, a lead bank originates the loan and
reports should be returned to them for correction. sells ownership interests to one or more participating
Unreliable appraisals or evaluations should be replaced banks at the time the loan is closed. The lead (originating)
prior to the final credit decision. Changes to an appraisal's bank retains a partial interest in the loan, holds all loan
estimate of value are permitted only as a result of a review documentation in its own name, services the loan, and
conducted by an appropriately qualified state licensed or deals directly with the customer for the benefit of all
certified appraiser in accordance with Standard III of participants. Properly structured, loan participations allow
USPAP. selling banks to accommodate large loan requests which
would otherwise exceed lending limits, diversify risk, and

Loans (8-16) 3.2-38 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

improve liquidity. Participating banks are able to recourse provision affect the accounting for the
compensate for low local loan demand or invest in large transaction. Formal recourse provisions may affect the
loans without servicing burdens and origination costs. If accounting treatment of a participation depending upon the
not appropriately structured and documented, a date that the participation is transferred to another
participation loan can present unwarranted risks to both institution. Implicit recourse provisions would not affect
the seller and purchaser of the loan. Examiners should the financial reporting treatment of a participation because
determine the nature and adequacy of the participation the accounting standards look to the contractual terms of
arrangement as well as analyze the credit quality of the asset transfers in determining whether or not the criteria
loan. necessary for sales accounting treatment have been met.
Although implicit recourse provisions would not affect the
Accounting and Capital Treatment - The proper accounting treatment of a loan participation, they may
accounting treatment for loan participations is governed by affect the risk-based capital treatment of a participation.
FAS 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. FAS Loan participations transferred prior to April 1, 2001, are
applies to both the transferor (seller) of assets and the accounted for based on FAS 125, Accounting for Transfers
transferee (purchaser). and Servicing of Financial Assets and Extinguishments of
Liabilities. The sales criteria contained in FAS 125 are
Loan participations are accounted for as sales provided the very similar to those contained in FAS 140, which are
sales criteria in FAS 140 are met. If the sales criteria are summarized above. However, for FDIC-insured
not met, participations are accounted for as secured institutions, the first of the sales criteria in FAS 140,
borrowings. The sales criteria focus on whether or not known as the isolation test, applies to transfers occurring
control is effectively transferred to the purchaser. To after December 31, 2001. As a result, loan participations
qualify for sales treatment three criteria must be met: transferred from April 1 through December 31, 2001, are
subject to the isolation test in FAS 125, but are otherwise
The purchaser's interest in the loan must be isolated accounted for based on FAS 140. Based upon the FASB's
from the seller, meaning that the purchaser's interest initial understanding of the nature of the FDIC's
in the loan is presumptively beyond the reach of the receivership power to reclaim certain assets sold by
seller and its creditors, even in bankruptcy or other institutions that subsequently failed when it was drafting
receivership; FAS 125, the FASB deemed assets sold by FDIC-insured
Each purchaser has the right to pledge or exchange its institutions to be beyond the reach of creditors in an FDIC
interest in the loan, and there are no conditions that receivership. Therefore in FAS 125, the FASB concluded
both constrain the purchaser from taking advantage of that assets transferred by an FDIC-insured institution,
that right and provide more than a trivial benefit to the including participations, generally met the isolation test for
seller; and sales accounting treatment with respect to receiverships.
The agreement does not both entitle and obligate the (Depending on the terms of the transfer, the transferred
seller to repurchase or redeem the purchaser's interest assets might not meet the isolation test for other reasons.)
in the loan prior to the loan's maturity, and it does not As a result, the mere existence of formal (written,
provide the seller with the ability to unilaterally cause contractual) recourse provisions would not, in and of
the purchaser to return its interest in the loan to the themselves, preclude loan participations transferred prior
seller (other than through a cleanup call). to January 1, 2002, from being accounted for as sales
provided all other criteria necessary for sales accounting
Right to Repurchase - Some loan participation treatment are met. However, participations transferred
agreements may give the seller a contractual right to prior to January 1, 2002, which are subject to formal
repurchase the participated interest in the loan at any time. recourse provisions, as well as those subject to implicit
In this case, the seller's right to repurchase the (unwritten, noncontractual) recourse provisions in which
participation effectively provides the seller with a call the seller demonstrates intent to repurchase participations
option on a specific asset and precludes sale accounting. in the event of default even in the absence of a formal
If a loan participation agreement contains such a obligation to do so, would be considered assets sold with
provision, the participation should be accounted for as a recourse when calculating the seller's risk-based capital
secured borrowing. ratios.

Recourse Arrangements - Recourse arrangements may, After the issuance of FAS 125, the FASB further clarified
or may not, preclude loan participations from being its understanding of the FDIC's ability to reclaim certain
accounted for as sales for financial reporting purposes. assets in a receivership, and the FDIC clarified when it
The date of the participation and the formality of the would not seek to reclaim loan participations sold in Part

RMS Manual of Examination Policies 3.2-39 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

360 of the FDIC Rules and Regulations. Section 360.6 from its books. The participated portion of the loan is
limits the FDIC's ability to reclaim certain loan reported as both Loans and Other Borrowed Money in the
participations sold without recourse, but does not limit the Report of Condition. The purchaser would report its
FDIC's ability to reclaim loan participations sold with interest in the loan as Loans in the Report of Condition,
recourse. For purposes of Section 360.6, the phrase and as Loans to depository institutions and acceptances of
"without recourse" means that the participation is not other banks in Schedule RC-C. More detailed guidance on
subject to any agreement which requires the lead bank accounting for transfers of financial assets, including loan
(seller) to repurchase the participant's (purchaser's) interest participations, is contained in the Transfers of Financial
in the loan or to otherwise compensate the participant due Assets entry in the Glossary of the Call Report
to a default on the underlying loan. The FASB's new Instructions.
understanding of the FDIC's receivership powers,
including Part 360, is addressed in FAS 140. Independent Credit Analysis - A bank purchasing a
participation loan is expected to perform the same degree
Loan participations transferred after December 31, 2001, of independent credit analysis on the loan as if it were the
must be accounted for pursuant to all of the provisions of originator. To determine if a participation loan meets its
FAS 140, including its isolation test. In accordance with credit standards, a participating bank must obtain all
FAS 140, loan participations sold by FDIC-insured relevant credit information and details on collateral values,
institutions with recourse generally will not be considered lien status, loan agreements and participation agreements
isolated from creditors in the event of receivership due to before a commitment is made to purchase. The absence of
the FDIC's power to reclaim the participated assets. As a such information may be evidence that the participating
result, loan participations transferred after December 31, bank has not been prudent in its credit decision.
2001, which are subject to formal (written, contractual)
recourse provisions should be accounted for as secured During the life of the participation, the participant should
borrowings by both the seller and the purchaser for monitor the servicing and the status of the loan. In order
financial reporting purposes. This means that the seller to exercise control of its ownership interest, a purchasing
must not reduce the loan assets on its balance sheet for the bank must ascertain that the selling bank will provide
participation, and that the entire amount of the loan must complete and timely credit information on a continuing
be included in the seller's assets for both leverage and risk- basis.
based capital purposes. Participations transferred after
December 31, 2001, which are subject to implicit The procedures for purchasing loan participations should
(unwritten, noncontractual) recourse provisions may be be provided for in the bank's formal lending policy. The
accounted for as sales by both the seller and the purchaser criteria for participation loans should be consistent with
for financial reporting purposes, provided the other sales that for similar direct loans. The policy would normally
criteria addressed above are met. However, if the seller require the complete analysis of the credit quality of
demonstrates intent to repurchase participations sold in the obligations to be purchased, determination of value and
event of default even in the absence of a formal obligation lien status of collateral, and the maintenance of full credit
to do so, then these participations will be treated as assets information for the life of the participation.
sold with recourse when calculating the seller's risk-based
capital ratios. Consistent with an AICPA auditing Participation Agreements - A participation loan can
interpretation, FDIC-insured institutions which account for present unique problems if the borrower defaults, the lead
loan participations transferred after December 31, 2001, as bank becomes insolvent, or a party to the participation
sales rather than as secured borrowings for financial arrangement does not perform as expected. These
reporting purposes should generally do so only if the contingencies should be considered in a written
participation agreement is supported by a legal opinion participation agreement. The agreement should clearly
explaining how the isolation test for sales accounting state the limitations the originating and participating banks
treatment is met given the FDIC's receivership powers. impose on each other and the rights all parties retain. In
addition to the general terms of the participation
Call Report Treatment - When a loan participation is transaction, participation agreements should specifically
accounted for as a sale, the seller removes the participated include the following considerations:
interest in the loan from its books. The purchaser reports
its interest in the loan as Loans in the Report of Condition, The obligation of the lead bank to furnish timely
and in Call Report Schedule RC-C - Loans and Lease credit information and to provide notification of
Financing Receivables, based upon collateral, borrower, or material changes in the borrower's status;
purpose. If a loan participation is accounted for as a Requirements that the lead bank consult with
secured borrowing, the seller does not remove the loan participants prior to modifying any loan, guaranty, or

Loans (8-16) 3.2-40 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

security agreements and before taking any action on criteria are not strictly met, the loan participation could be
defaulted loans; subject to the qualitative and/or quantitative restrictions of
The specific rights and remedies available to the lead Section 23A. Refer to the Related Organizations Section
and participating banks upon default of the borrower; of this Manual which describes transactions with affiliates.
Resolution procedures when the lead and participating
banks cannot agree on the handling of a defaulted Sales of 100 Percent Loan Participations - In some
loan; cases, depository institutions structure loan originations
Resolution of any potential conflicts between the lead and participations with the intention of selling off 100
bank and participants in the event that more than one percent of the underlying loan amount. Certain 100
loan to the borrower defaults; and percent loan participation programs raise unique safety and
Provisions for terminating the agency relationship soundness issues that should be addressed by an
between the lead and participating banks upon such institutions policies, procedures and practices.
events as insolvency, breach of duty, negligence, or
misappropriation by one of the parties. If not appropriately structured, these 100 percent
participation programs can present unwarranted risks to
In some loan participation agreements, the participation the originating institution including legal, reputation and
agreement provides for the allocation of loan payments on compliance risks. While this statement applies only to a
some basis other than in proportion to ownership interest. small number of mostly very large insured depository
For example, principal payments may be applied first to institutions, the agreements should clearly state the
the participants ownership interest and all remaining limitations the originating and participating institutions
payments to the lead banks ownership interest. In these impose on each other and the rights all parties retain. The
instances, the participation agreement must also specify originating institution should state that loan participants
that in case of loan default, participants will share in all are participating in loans and are not investing in a
subsequent payments and collections in proportion to their business enterprise. The policies of an institution engaged
respective ownership interest at the time of default. in these originations should address safety and soundness
Without such a provision, the banks would not have a pro- concerns and include criteria to address:
rata sharing of credit risk. Provided the sales criteria
contained in FAS 140 are met, loan participations sold in The programs objectives these should be of a
which the participation agreements provide for the commercial nature (structured as commercial
allocation of loan payments, absent default, on some basis undertakings and not as investments in securities).
other than proportional ownership interests, may be treated The plan of distribution participants should be
as sold and removed from the balance sheet for financial limited to sophisticated financial and commercial
reporting purposes. However, if the participation entities and sophisticated persons and the
agreements do not also contain a provision requiring that participations should not be sold directly to the public.
all payments and collections received subsequent to The credit requirements applicable to the borrower -
default be allocated based on ownership interests in the the originating institution should structure 100% loan
loan as of the date of default, those participations will be participation programs only for borrowers who meet
treated as loans sold with recourse for risk-based capital the originating institutions credit requirements.
purposes regardless of the financial reporting treatment. Access afforded program participants to financial
Further discussion of loans sold with recourse is contained information on the borrower - the originating
in the Sales of Assets for Risk-Based Capital Purposes institution should allow potential loan participants to
entry in the glossary of the Call Report Instructions. obtain and review appropriate credit and other
information to enable the participants to make an
Participations Between Affiliated Institutions - informed credit decision.
Examiners should ascertain that banks do not relax their
credit standards when dealing with affiliated institutions Environmental Risk Program
and that participation loans between affiliated institutions
are in compliance with Section 23A of the Federal Reserve A lending institution should have in place appropriate
Act. The Federal Reserve Board Staff has interpreted that safeguards and controls to limit exposure to potential
the purchase of a participation loan from an affiliate is environmental liability associated with real property held
exempt from Section 23A provided that the commitment to as collateral. The potential adverse effect of
purchase is obtained by the affiliate before the loan is environmental contamination on the value of real property
consummated by the affiliate, and the decision to and the potential for liability under various environmental
participate is based upon the bank's independent laws have become important factors in evaluating real
evaluation of the creditworthiness of the loan. If these

RMS Manual of Examination Policies 3.2-41 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

estate transactions and making loans secured by real estate.

Environmental contamination, and liability associated with
environmental contamination, may have a significant
adverse effect on the value of real estate collateral, which LOAN PROBLEMS
may in certain circumstances cause an insured institution
to abandon its right to the collateral. It is also possible for It would be impossible to list all sources and causes of
an institution to be held directly liable for the problem loans. They cover a multitude of mistakes a bank
environmental cleanup of real property collateral acquired may permit a borrower to make, as well as mistakes
by the institution. The cost of such a cleanup may exceed directly attributable to weaknesses in the bank's credit
by many times the amount of the loan made to the administration and management. Some well-constructed
borrower. A loan may be affected adversely by potential loans may develop problems due to unforeseen
environmental liability even where real property is not circumstances on the part of the borrower; however, bank
taken as collateral. For example, a borrower's capacity to management must endeavor to protect a loan by every
make payments on a loan may be threatened by means possible. One or more of the items in the following
environmental liability to the borrower for the cost of a list is often basic to the development of loan problems.
hazardous contamination cleanup on property unrelated to Many of these items may also be indicative of potential
the loan with the institution. The potential for bank fraud and/or insider abuse. Additional information
environmental liability may arise from a variety of Federal on the warning signs and suggested areas for investigation
and State environmental laws and from common law tort are included in the Bank Fraud and Insider Abuse Section
liability. of this Manual.

Guidelines for an Environmental Risk Program Poor Selection of Risks

As part of the institution's overall decision-making Problems in this area may reflect the absence of sound
process, the environmental risk program should establish lending policies, and/or management's lack of sound credit
procedures for identifying and evaluating potential judgment in advancing certain loans. The following are
environmental concerns associated with lending practices general types of loans which may fall within the category
and other actions relating to real property. The board of of poor risk selection. It should be kept in mind that these
directors should review and approve the program and examples are generalizations, and the examiner must
designate a senior officer knowledgeable in environmental weigh all relevant factors in determining whether a given
matters responsible for program implementation. The loan is indeed a poor risk.
environmental risk program should be tailored to the needs
of the lending institution. That is, institutions that have a Loans to finance new and untried business ventures
heavier concentration of loans to higher risk industries or which are inadequately capitalized.
localities of known contamination may require a more Loans based more upon the expectation of
elaborate and sophisticated environmental risk program successfully completing a business transaction than on
than institutions that lend more to lower risk industries or sound worth or collateral.
localities. The environmental risk program should provide Loans for the speculative purchase of securities or
for staff training, set environmental policy guidelines and goods.
procedures, require an environmental review or analysis Collateral loans made without adequate margin of
during the application process, include loan documentation security.
standards, and establish appropriate environmental risk Loans made because of other benefits, such as the
assessment safeguards in loan workout situations and control of large deposit balances, and not based upon
foreclosures. sound worth or collateral.
Loans made without adequate owner equity in
Examination Procedures underlying real estate security.
Loans predicated on collateral which has questionable
Examiners should review an institution's environmental liquidation value.
risk program as part of the examination of its lending and Loans predicated on the unmarketable stock of a local
investment activities. When analyzing individual credits, corporation when the bank is at the same time lending
examiners should review the institution's compliance with directly to the corporation. Action which may be
its own environmental risk program. Failure to establish beneficial to the bank from the standpoint of the one
or comply with an appropriate environmental program loan may be detrimental from the standpoint of the
should be criticized and corrective action required. other loan.

Loans (8-16) 3.2-42 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

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 bank situations and in banks which fail.
out-of-territory borrowers (excluding large banks Such practices with regard to loans are found in the form
properly staffed to handle such loans). of overextensions of unsound credit to insiders, or their
Loans involving brokered deposits or link financing. interests, who have improperly used their positions to
obtain unjustified loans. Active officers, who serve at the
Overlending pleasure of the ownership interests, are at times subjected
to pressures which make it difficult to objectively evaluate
It is almost as serious, from the standpoint of ultimate such loans. Loans made for the benefit of ownership
losses, to lend a sound financial risk too much money as it interests that are carried in the name of a seemingly
is to lend to an unsound risk. Loans beyond the unrelated party are sometimes used to conceal self-dealing
reasonable capacity of the borrower to repay invariably loans.
lead to the development of problem loans.
Technical Incompetence
Failure to Establish or Enforce Liquidation
Technical incompetence usually is manifested in
Agreements management's inability to obtain and evaluate credit
information or put together a well-conceived loan package.
Loans granted without a well-defined repayment program Management weaknesses in this area are almost certain to
violate a fundamental principle of sound lending. lead to eventual loan losses. Problems can also develop
Regardless of what appears to be adequate collateral when management, technically sound in some forms of
protection, failure to establish at inception or thereafter lending, becomes involved in specialized types of credit in
enforce a program of repayment almost invariably leads to which it lacks expertise and experience.
troublesome and awkward servicing problems, and in
many instances is responsible for serious loan problems
including eventual losses. This axiom of sound lending is
Lack of Supervision
important not only from the lender's standpoint, but also
Loan problems encountered in this area normally arise for
the borrower's.
one of two reasons:
Incomplete Credit Information Absence of effective active management supervision
of loans which possessed reasonable soundness at
Lending errors frequently result because of management's inception. Ineffective supervision almost invariably
failure to obtain and properly evaluate credit information. results from lack of knowledge of a borrower's affairs
Adequate comparative financial statements, income over the life of the loan. It may well be coupled with
statements, cash flow statements and other pertinent one or more of the causes and sources of loan
statistical support should be available. Other essential problems previously mentioned.
information, such as the purpose of the borrowing and
Failure of the board and/or senior management to
intended plan or sources of repayment, progress reports,
properly oversee subordinates to determine that sound
inspections, memoranda of outside information and loan
policies are being carried out.
conferences, correspondence, etc., should be contained in
the bank's credit files. Failure of a bank's management to
give proper attention to credit files makes sound credit Lack of Attention to Changing Economic
judgment difficult if not impossible. Conditions

Overemphasis on Loan Income Economic conditions, both national and local, are
continuously changing, management must be responsive to
Misplaced emphasis upon loan income, rather than these changes. This is not to suggest that lending policies
soundness, almost always leads to the granting of loans should be in a constant state of flux, nor does it suggest
possessing undue risk. In the long run, unsound loans that management should be able to forecast totally the
results of economic changes. It does mean, however, that

RMS Manual of Examination Policies 3.2-43 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

bankers should realistically evaluate lending policies and other payments without adequate or reasonable
individual loans in light of changing conditions. earnings retention; and net worth enhancements
Economic downturns can adversely affect borrowers' resulting solely from reappraisal in the value of fixed
repayment potential and can lessen a bank's collateral assets.
protection. Reliance on previously existing conditions as Cash Flow Documentation - Absence of cash flow
well as optimistic hopes for economic improvement can, statements or projections, particularly as related to
particularly when coupled with one or more of the causes newly established term borrowers; projections
and sources of loan problems previously mentioned, lead indicating an inability to meet required interest and
to serious loan portfolio deterioration. principal payments; and statements reflecting that
cash flow is being provided by the sale of fixed assets
Competition or nonrecurring situations.
Correspondence and Credit Files - Missing and/or
Competition among financial institutions for growth, inadequate collateral or loan documentation, such as
profitability, and community influence sometimes results financial statements, security agreements, guarantees,
in the compromise of sound credit principles and assignments, hypothecation agreements, mortgages,
acquisition of unsound loans. The ultimate cost of appraisals, legal opinions and title insurance, property
unsound loans outweighs temporary gains in growth, insurance, loan applications; evidence of borrower
income and influence. credit checks; corporate or partnership borrowing
authorizations; letters indicating that a borrower has
suffered financial difficulties or has been unable to
Potential Problem Indicators by Document
meet established repayment programs; and documents
that reveal other unfavorable factors relative to a line
The preceding discussions describe various practices or
of credit.
conditions which may serve as a source or cause of weak
loans. Weak loans resulting from these practices or Collateral - Collateral evidencing a speculative loan
conditions may manifest themselves in a variety of ways. purpose or collateral with inferior marketability
While it is impossible to provide a complete detailing of characteristics (single purpose real estate, restricted
potential "trouble indicators", the following list, by stock, etc.) which has not been compensated for by
document, may aid the examiner in identifying potential other reliable repayment sources; and collateral of
problem loans during the examination process. questionable value acquired subsequent to the
extension of the credit.
Debt Instrument - Delinquency; irregular payments
or payments not in accordance with terms; unusual or
frequently modified terms; numerous renewals with LOAN APPRAISAL AND
little or no principal reduction; renewals that include CLASSIFICATION
interest; and extremely high interest rate in relation to
comparable loans granted by the bank or the going
Loan Appraisal
rate for such loans in the bank's market area.
Liability Ledger - Depending on the type of debt,
In order to properly analyze any credit, an examiner must
failure to amortize in a regular fashion over a
acquire certain fundamental information about a
reasonable period of time, e.g., on an annual basis,
borrower's financial condition, purpose and terms of the
seasonally, etc.; and a large number of out-of-territory
borrowing, and prospects for its orderly repayment. The
borrowers, particularly in cases where these types of
process involved in acquiring the foregoing information
loans have increased substantially since the previous
will necessarily vary with the size of the bank under
examination.
examination and the type and sophistication of records
Financial and Operating Statements - Inadequate or utilized by the bank.
declining working capital position; excessive volume
or negative trend in receivables; unfavorable level or Because of the sheer volume of loans, it is necessary to
negative trend in inventory; no recent aging of focus attention on the soundness of larger lines of credit.
receivables, or a marked slowing in receivables; Relatively smaller loans that appear to be performing
drastic increase in volume of payables; repeated and satisfactorily may ordinarily be omitted from individual
increasing renewals of carry-over operating debt; appraisal. The minimum size of the loan to be appraised
unfavorable trends in sales and profits; rapidly depends upon the characteristics of the individual bank.
expanding expenses; heavy debt-to-worth level and/or The cut-off point should be low enough to permit an
deterioration in this relationship; large dividend or accurate appraisal of the loan portfolio as a whole, yet not

Loans (8-16) 3.2-44 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

so high as to preclude a thorough analysis of a should be scrutinized to acquire the necessary descriptive
representative portion of total loans. This procedure does information and to ascertain that the collateral held to
not prevent an examiner from analyzing smaller loans secure the notes is as transcribed.
which do not show adequate amortization for long periods
of time, are overdue, are deficient in collateral coverage, Gathering credit information is an important process and
or otherwise possess characteristics which would cause should be done with care to obtain the essential
them to be subject to further scrutiny. In most instances, information, which will enable the examiner to appraise
there should be direct correlation between the cut-off point the loans accurately and fairly. Failure to obtain and
utilized, the percentage of loans lined, and the asset quality record pertinent information contained in the credit files
and management ratings assigned at the previous can reflect unfavorably on examiners, and a good deal of
examination. examiner and loan officer time can be saved by carefully
analyzing the files. Ideally, credit files will also contain
The following types of loans or lines of credit should be important correspondence between the bank and the
analyzed at each examination: borrower. However, this is not universally the case; in
some instances, important correspondence is deliberately
Loans or lines of credit listed for Special Mention or lodged in separate files because of its sensitive character.
adversely classified at the previous FDIC examination Correspondence between the bank and the borrower can
or State examination, if applicable as a result of an be especially valuable to the examiner in developing added
alternating examination program; insight into the status of problem credits.
Loans reflected on the bank's problem loan list, if
such a list exists, or identified as problem loans by the Verification of loan proceeds is one of the most valuable
banks credit grading system; and effective loan examining techniques available to the
Significant overdue loans as determined from the examiner and often one of the most ignored. This
bank's delinquency list; verification process can disclose fraudulent or fictitious
Other significant loans which exhibit a high degree of notes, misapplication of funds, loans made for the benefit
risk that have come to the examiner's attention in the or accommodation of parties other than the borrower of
review of minutes, audit reports or other sources; and record, or utilization of loans for purposes other than those
Loans to the bank's insiders, and their related interests reflected in the bank's files. Verification of the
and insiders of other banks. disbursement of a selected group of large or unusual loans,
particularly those subject to classification or Special
The degree of analysis and/or time devoted to the above Mention and those granted under circumstances which
loans may vary. For example, the time devoted to a appear illogical or incongruous is important. However, it
previously classified loan which has been substantially is more important to carry the verification process one step
reduced or otherwise improved may be significantly less further to the apparent utilization of loan proceeds as
than other loans. Watch list loans should initially be reflected by the customer's deposit account or other related
sampled to assess if managements ratings are accurate. bank records. The examiner should also determine the
The reworking of certain loan files, such as seasoned real purpose of the credit and the expected source of
estate mortgages, which are not subject to significant repayment.
change, should be kept to a minimum or omitted. This
does not mean that an examiner should not briefly review Examination Procedures regarding loan portfolio analysis
new file information (since the previous examination) to are included in the Examination Documentation Modules.
determine any adverse trends with respect to significant
loans. In addition, the examiner should review a sufficient Loan Discussion
volume of different types of loans offered by the bank to
determine that bank policies are adequate and being The examiner must comprehensively review all data
followed. collected on the individual loans. In most banks, this
review should allow the majority of loans to be passed
Review of Files and Records without criticism, eliminating the need for discussing these
lines with the appropriate bank officer(s). No matter how
Commercial loan liability ledgers or comparable thoroughly the supporting loan files have been reviewed,
subsidiary records vary greatly in quality and detail. there will invariably be a number of loans which will
Generally, they will provide the borrower's total require additional information or discussion before an
commercial loan liability to the bank, and the postings appropriate judgment can be made as to their credit
thereto will depict a history of the debt. Collateral records quality, relationship to other loans, proper documentation,
or other circumstances related to the overall examination

RMS Manual of Examination Policies 3.2-45 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

of the loan portfolio. Such loans require discussion with quality deterioration may occur. Therefore, the examiner
the appropriate bank officer(s) as do other loans for which should not only identify problem loans, but also ascertain
adequate information has been assembled to indicate that the cause(s) of these problems. Weaknesses in lending
classification or Special Mention is warranted. policies or practices should be stressed, along with
possible corrective measures, in discussions with the
Proper preparation for the loan discussion is essential, and bank's senior management and/or the directorate and in the
the following points should be given due consideration by Report of Examination.
the examiner. Loans which have been narrowed down for
discussion should be reviewed in depth to insure a Loan Classification
comprehensive grasp of all factual material. Careful
advance preparation can save time for all concerned. To quantify and communicate the results of the loan
Particularly with regard to large, complicated lines, undue appraisal, the examiner must arrive at a decision as to
reliance should not be placed on memory to cover which loans are to be subjected to criticism and/or
important points in loan discussion. Important weaknesses comment in the examination report. Adversely classified
and salient points to be covered in discussion, questions to loans are allocated on the basis of risk to three categories:
be asked, and information to be sought should be noted. Substandard; Doubtful; and Loss.
The loan discussion should not involve discussion of
trivialities since the banker's time is valuable, and it is no Other loans of questionable quality, but involving
place for antagonistic remarks and snide comments insufficient risk to warrant classification, are designated as
directed at loan officers. The examiner should listen Special Mention loans. Loans lacking technical or legal
carefully to what the banker has to say, and concisely and support, whether or not adversely classified, should be
accurately note this information. Failure to do so can brought to the attention of the bank's management. If the
result in inaccuracies and make follow-up at the next deficiencies in documentation are severe in scope or
examination more difficult. volume, a schedule of such loans should be included in the
Report of Examination.
Loan Analysis
Loan classifications are expressions of different degrees of
In the appraisal of individual loans, the examiner should a common factor, risk of nonpayment. All loans involve
weigh carefully the information obtained and arrive at a some risk, but the degree varies greatly. It is incumbent
judgment as to the credit quality of the loans under review. upon examiners to avoid classification of sound loans.
Each loan is appraised on the basis of its own The practice of lending to sound businesses or individuals
characteristics. Consideration is given to the risk involved for reasonable periods is a legitimate banking function.
in the project being financed; the nature and degree of Adverse classifications should be confined to those loans
collateral security; the character, capacity, financial which are unsafe for the investment of depositors' funds.
responsibility, and record of the borrower; and the
feasibility and probability of its orderly liquidation in If the internal grading system is determined to be accurate
accordance with specified terms. The willingness and and reliable, examiners can use the institutions data for
ability of a debtor to perform as agreed remains the preparing the applicable examination report pages and
primary measure of a loans risk. This implies that the schedules, for determining the overall level of
borrower must have earnings or liquid assets sufficient to classifications, and for providing supporting comments
meet interest payments and provide for reduction or regarding the quality of the loan portfolio. If the internal
liquidation of principal as agreed at a reasonable and classifications are overly conservative, examiners should
foreseeable date. However, it does not mean that make appropriate adjustments and include explanations in
borrowers must at all times be in a position to liquidate the reports comments.
their loans, for that would defeat the original purpose of
extending credit. A uniform agreement on the classification of assets and
appraisal of securities in bank examinations was issued
Following analysis of specific credits, it is important that jointly on June 15, 2004, by the Office of the Comptroller
the examiner ascertain whether troublesome loans result of the Currency, the FDIC, the Federal Reserve Board, and
from inadequate lending and collection policies and the Office of Thrift Supervision. This interagency
practices or merely reflect exceptions to basically sound statement provides definitions of Substandard, Doubtful,
credit policies and practices. In instances where and Loss categories used for adversely classifying bank
troublesome loans exist due to ineffective lending assets. Amounts classified Loss should be promptly
practices and/or inadequate supervision, it is quite possible eliminated from the bank's books.
that existing problems will go uncorrected and further loan

Loans (8-16) 3.2-46 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Uniform guidelines have been established by the FDIC

regarding the Report of Exam treatment of assets classified Definition - A Special Mention asset has potential
Doubtful. The general policy is not to require charge-off weaknesses that deserve management's close attention. If
or similar action for Doubtful classifications. Examiners left uncorrected, these potential weaknesses may result in
should make a statement calling for a bank to charge-off a deterioration of the repayment prospects for the asset or in
portion of loans classified Doubtful only when State law the institution's credit position at some future date. Special
or policy requires. Further, any such statement should be Mention assets are not adversely classified and do not
clear as to the intended purpose of bringing the bank into expose an institution to sufficient risk to warrant adverse
conformity with those State requirements. An exception is classification.
made for formal actions under Section 8 of the FDI Act.
Use of Special Mention - The Special Mention category is
A statement addressing the chargeoff of loans classified not to be used as a means of avoiding a clear decision to
Loss is a required comment Report of Examination when classify a loan or pass it without criticism. Neither should
the amount is material. Amounts classified Loss should be it include loans listed merely "for the record" when
promptly eliminated from the bank's books. uncertainties and complexities, perhaps coupled with large
size, create some reservations about the loan. If
Definitions weaknesses or evidence of imprudent handling cannot be
identified, inclusion of such loans in Special Mention is
Substandard - Substandard loans are inadequately not justified.
protected by the current sound worth and paying
capacity of the obligor or of the collateral pledged, if Ordinarily, Special Mention credits have characteristics
any. Loans so classified must have a well-defined which corrective management action would remedy.
weakness or weaknesses that jeopardize the Often weak origination and/or servicing policies are the
liquidation of the debt. They are characterized by the cause for the Special Mention designation. Examiners
distinct possibility that the bank will sustain some loss should not misconstrue the fact that most Special Mention
if the deficiencies are not corrected. loans contain management correctable deficiencies to
Doubtful - Loans classified Doubtful have all the mean that loans involving merely technical exceptions
weaknesses inherent in those classified Substandard belong in this category. However, instances may be
with the added characteristic that the weaknesses encountered where technical exceptions are a factor in
make collection or liquidation in full, on the basis of scheduling loans for Special Mention.
currently known facts, conditions and values, highly
questionable and improbable. Careful identification of loans which properly belong in
Loss - Loans classified Loss are considered this category is important in determining the extent of risk
uncollectible and of such little value that their in the loan portfolio and providing constructive criticism
continuance as bankable assets is not warranted. This for bank management. While Special Mention Assets
classification does not mean that the loan has should not be combined with adversely classified assets,
absolutely no recovery or salvage value but rather it is their total should be considered in the analysis of asset
not practical or desirable to defer writing off this quality and management, as appropriate.
basically worthless asset even though partial recovery
may be effected in the future. The nature of this category precludes inclusion of smaller
lines of credit unless those loans are part of a large
There is a close relationship between classifications, and grouping listed for related reasons. Comments on loans
no classification category should be viewed as more listed for Special Mention in the Report of Examination
important than the other. The uncollectibility aspect of should be drafted in a fashion similar to those for
Doubtful and Loss classifications makes their segregation adversely classified loans. There is no less of a
of obvious importance. The function of the Substandard requirement upon the examiner to record clearly the
classification is to indicate those loans which are unduly reasons why the loan is listed. The major thrust of the
risky and, if unimproved, may be a future hazard. comments should be towards achieving correction of the
deficiencies identified.
A complete list of adversely classified loans is to be
provided to management, either during or at the close of Troubled Commercial Real Estate Loan
an examination. Classification Guidelines
Special Mention Assets

RMS Manual of Examination Policies 3.2-47 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

Additional classification guidelines have been developed certain circumstances. Refer to the Report of Examination
to aid the examiner in classifying troubled commercial real Instructions for further guidance.
estate loans. These guidelines are intended to supplement
the uniform guidelines discussed above. After performing Past Due and Nonaccrual
an analysis of the project and its appraisal, the examiner
must determine the classification of any exposure. Overdue loans are not necessarily subject to adverse
criticism. Nevertheless, a high volume of overdue loans
The following guidelines are to be applied in instances almost always indicates liberal credit standards, weak
where the obligor is devoid of other reliable means of servicing practices, or both. Because loan renewal and
repayment, with support of the debt provided solely by the extension policies vary among banks, comparison of their
project. If other types of collateral or other sources of delinquency ratios may be misleading. A more significant
repayment exist, the project should be evaluated in light of method of evaluating this factor lies in determination of
these mitigating factors. the trend within the bank under examination, keeping in
mind the distortion resulting from seasonal influences,
Substandard - Any such troubled real estate loan or economic conditions, or the timing of examinations. It is
portion thereof should be classified Substandard when important for the examiner to carefully consider the
well-defined weaknesses are present which jeopardize makeup and reasons for the volume of overdue loans.
the orderly liquidation of the debt. Well-defined Only then can it be determined whether the volume of past
weaknesses include a project's lack of marketability, due paper is a significant factor reflecting adversely on the
inadequate cash flow or collateral support, failure to quality or soundness of the overall loan portfolio or the
complete construction on time or the project's failure efficiency and quality of management. It is important that
to fulfill economic expectations. They are overdue loans be computed on a uniform basis. This
characterized by the distinct possibility that the bank allows for comparison of overdue totals between
will sustain some loss if the deficiencies are not examinations and/or with other banks.
corrected.
Doubtful - Doubtful classifications have all the The Report of Examination includes information on
weaknesses inherent in those classified Substandard overdue and nonaccrual loans. Loans which are still
with the added characteristic that the weaknesses accruing interest but are past their maturity or on which
make collection or liquidation in full, on the basis of either interest or principal is due and unpaid (including
currently known facts, conditions and values, highly unplanned overdrafts) are separated by loan type into two
questionable and improbable. A Doubtful distinct groupings: 30 to 89 days past due and 90 days or
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
near term. Examiners should attempt to identify Loss estate mortgage loans, term loans or any other loans
in the credit where possible thereby limiting the payable on regular monthly installments of principal and
excessive use of the Doubtful classification. interest.
Loss - Advances in excess of calculated current fair
value which are considered uncollectible and do not Some modification of the overdue criteria may be
warrant continuance as bankable assets. There is little necessary because of applicable State law, joint
or no prospect for near term improvement and no examinations, or unusual circumstances surrounding
realistic strengthening action of significance pending. certain kinds of loans or in individual loan situations. It
will always be necessary for the examiner to ascertain the
Technical Exceptions bank's renewal and extension policies and procedures for
collecting interest prior to determining which loans are
Deficiencies in documentation of loans should be brought overdue, since such practices often vary considerably from
to the attention of management for remedial action. bank to bank. This is important not only to validate which
Failure of management to effect corrections may lead to loans are actually overdue, but also to evaluate the
the development of greater credit risk in the future. soundness of such policies. Standards for renewal should
Moreover, an excessive number of technical exceptions be aimed at achieving an orderly liquidation of loans and
may be a reflection on management's quality and ability. not at maintaining a low ratio of past due paper through
Inclusion of the schedule "Assets With Credit Data or unwarranted extensions or renewals.
Collateral Documentation Exceptions" and various
comments in the Report of Examination is appropriate in

Loans (8-16) 3.2-48 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

In larger departmentalized banks or banks with large the borrower may have demonstrated sustained
branch systems, it may be informative to analyze performance over a period of time in accordance with the
delinquencies by determining the source of overdue loans contractual terms. Such loans to be returned to accrual
by department or branch. This is particularly true if a status, even though the loans have not been brought fully
large volume of overdue loans exist. The production of current, provided two criteria are met:
schedules delineating overdue loans by department or
branch is encouraged if it will aid in pinpointing the source All principal and interest amounts contractually due
of a problem or be otherwise informative.. (including arrearage) are reasonably assured of
repayment within a reasonable period, and
Continuing to accrue income on assets which are in default There is a sustained period of repayment performance
as to principal and interest overstates a bank's assets, (generally a minimum of six months) by the borrower,
earnings and capital. Call Report Instructions indicate that in accordance with the contractual terms involving
where the period of default of principal or interest equals payments of cash or cash equivalents.
or exceeds 90 days, the accruing of income should be
discontinued unless the asset is well-secured and in When the regulatory reporting criteria for restoration to
process of collection. A debt is well-secured if accrual status are met, previous charge-offs taken would
collateralized by liens on or pledges of real or personal not have to be fully recovered before such loans are
property, including securities that have a realizable value returned to accrual status. Loans that meet the above
sufficient to discharge the debt in full; or by the guarantee criteria would continue to be disclosed as past due, as
of a financially responsible party. A debt is in process of appropriate, until they have been brought fully current.
collection if collection is proceeding in due course either
through legal action, including judgment enforcement Troubled Debt Restructuring - Multiple Note
procedures, or, in appropriate circumstances, through
Structure
collection efforts not involving legal action which are
reasonably expected to result in repayment of the debt or
The basic example of a trouble debt restructure (TDR)
its restoration to a current status. Banks are strongly
multiple note structure is a troubled loan that is
encouraged to follow this guideline not only for reporting
restructured into two notes where the first or "A" note
purposes but also bookkeeping purposes. There are
represents the portion of the original loan principal amount
several exceptions, modifications and clarifications to this
which is expected to be fully collected along with
general standard. First, consumer loans and real estate
contractual interest. The second part of the restructured
loans secured by one-to-four family residential properties
loan, or "B" note, represents the portion of the original
are exempt from the nonaccrual guidelines. Nonetheless,
loan that has been charged-off.
these exempt loans should be subject to other alternative
methods of evaluation to assure the bank's net income is
Such TDRs generally may take any of three forms. In
not materially overstated. Second, any State statute,
certain TDRs, the "B" note may be a contingent receivable
regulation or rule which imposes more stringent standards
that is payable only if certain conditions are met (e.g.,
for nonaccrual of interest should take precedence over
sufficient cash flow from property). For other TDRs, the
these instructions. Third, reversal of previously accrued
"B" note may be contingently forgiven (e.g., note "B" is
but uncollected interest applicable to any asset placed in a
forgiven if note "A" is paid in full). In other instances, an
nonaccrual status, and treatment of subsequent payments
institution would have granted a concession (e.g., rate
as either principal or interest, should be handled in
reduction) to the troubled borrower but the "B" note would
accordance with generally accepted accounting principles.
remain a contractual obligation of the borrower. Because
Acceptable accounting treatment includes reversal of all
the "B" note is not reflected as an asset on the institution's
previously accrued but uncollected interest against
books and is unlikely to be collected, for reporting
appropriate income and balance sheet accounts.
purposes the "B" note could be viewed as a contingent
receivable.
Nonaccrual Loans That Have Demonstrated
Sustained Contractual Performance Institutions may return the "A" note to accrual status
provided the following conditions are met:
The following guidance applies to borrowers who have
resumed paying the full amount of scheduled contractual The restructuring qualifies as a TDR as defined by
interest and principal payments on loans that are past due FAS 15 and there is economic substance to the
and in nonaccrual status. Although a prior arrearage may restructuring.
not have been eliminated by payments from a borrower,

RMS Manual of Examination Policies 3.2-49 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

The portion of the original loan represented by the

"B" note has been charged-off. The charge-off must In general, retail credit should be classified based on the
be supported by a current, well-documented credit following criteria:
evaluation of the borrower's financial condition and
prospects for repayment under the revised terms. The Open-end and closed-end retail loans past due 90
charge-off must be recorded before or at the time of cumulative days from the contractual due date should
the restructuring. be classified Substandard.
The "A" note is reasonably assured of repayment and Closed-end retail loans that become past due 120
of performance in accordance with the modified cumulative days and open-end retail loans that
terms. become past due 180 cumulative days from the
In general, the borrower must have demonstrated contractual due date should be charged-off. The
sustained repayment performance (either immediately charge-off should be taken by the end of the month in
before or after the restructuring) in accordance with which the 120-or 180-day time period elapses.
the modified terms for a reasonable period prior to the Unless the institution can clearly demonstrate and
date on which the "A" note is returned to accrual document that repayment on accounts in bankruptcy is
status. A sustained period of payment performance likely to occur, accounts in bankruptcy should be
generally would be a minimum of six months and charged off within 60 days of receipt of notification of
involve payments in the form of cash or cash filing from the bankruptcy court or within the
equivalents. delinquency time frames specified in this
classification policy, whichever is shorter. The
Under existing reporting requirements, the "A" note would charge-off should be taken by the end of the month in
be disclosed as a TDR. In accordance with these which the applicable time period elapses. Any loan
requirements, if the "A" note yields a market rate of balance not charged-off should be classified
interest and performs in accordance with the restructured Substandard until the borrower re-establishes the
terms, such disclosures could be eliminated in the year ability and willingness to repay (with demonstrated
following restructuring. To be considered a market rate of payment performance for six months at a minimum)
interest, the interest rate on the "A" note at the time of or there is a receipt of proceeds from liquidation of
restructuring must be equal to or greater than the rate that collateral.
the institution is willing to accept for a new receivable Fraudulent loans should be charged off within 90 days
with comparable risk. of discovery or within the delinquency time frames
specified in this classification policy, whichever is
Interagency Retail Credit shorter. The charge-off should be taken by the end of
Classification Policy the month in which the applicable time period elapses.
Loans of deceased persons should be charged off
The quality of consumer credit soundness is best indicated when the loss is determined or within the delinquency
by the repayment performance demonstrated by the time frames adopted in this classification policy,
borrower. Because retail credit generally is comprised of a whichever is shorter. The charge-off should be taken
large number of relatively small balance loans, evaluating by the end of the month in which the applicable time
the quality of the retail credit portfolio on a loan-by-loan period elapses.
basis is burdensome for the institution being examined and One-to four-family residential real estate loans and
examiners. To promote an efficient and consistent credit home equity loans that are delinquent 90 days or more
risk evaluation, the FDIC, the Comptroller of Currency, with loan-to-value ratios greater than 60 percent,
the Federal Reserve and the Office of Thrift Supervision should be classified Substandard.
adopted the Uniform Retail Credit Classification and
Account Management Policy (Retail Classification When a residential or home equity loan is 120 days past
Policy.) due for closed-end credit and 180 days past due for open-
end credit, a current assessment of value should be made
Retail credit includes open-end and closed-end credit and any outstanding loan balance in excess of the fair
extended to individuals for household, family, and other value of the property, less cost to sell, should be classified
personal expenditures. It includes consumer loans and Loss.
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
residence, including home equity and home improvement not classified based solely on delinquency status. Home
loans. equity loans to the same borrower at the same institution
as the senior mortgage loan with a combined loan-to-value

Loans (8-16) 3.2-50 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

ratio equal to or less than 60 percent should not be rewritten, including the number of times such action has
classified. However, home equity loans where the been taken. Documentation normally shows that
institution does not hold the senior mortgage, that are institution personnel communicated with the borrower, the
delinquent 90 days or more should be classified borrower agreed to pay the loan in full, and the borrower
Substandard, even if the loan-to-value ratio is equal to, or shows the ability to repay the loan.
less than, 60 percent.
Institutions that re-age open-end accounts should establish
If an institution can clearly document that the delinquent a reasonable written policy and adhere to it. An account
loan is well secured and in the process of collection, such eligible for re-aging, extension, deferral, renewal, or
that collection will occur regardless of delinquency status, rewrite should exhibit the following:
then the loan need not be classified. A well secured loan is
collateralized by a perfected security interest in, or pledges The borrower should show a renewed willingness and
of, real or personal property, including securities, with an ability to repay the loan.
estimated fair value, less cost to sell, sufficient to recover The account should exist for at least nine months
the recorded investment in the loan, as well as a reasonable before allowing a re-aging, extension, renewal,
return on that amount. In the process of collection means referral, or rewrite.
that either a collection effort or legal action is proceeding The borrower should make at least three minimum
and is reasonably expected to result in recovery of the loan consecutive monthly payments or the equivalent lump
balance or its restoration to a current status, generally sum payment before an account is re-aged. Funds may
within the next 90 days. not be advanced by the institution for this purpose.
No loan should be re-aged, extended, deferred,
This policy does not preclude an institution from adopting renewed, or rewritten more than once within any
an internal classification policy more conservative than the twelve-month period; that is, at least twelve months
one detailed above. It also does not preclude a regulatory must have elapsed since a prior re-aging. In addition,
agency from using the Doubtful or Loss classification in no loan should be re-aged, extended, deferred,
certain situations if a rating more severe than Substandard renewed, or rewritten more than two times within any
is justified. Loss in retail credit should be recognized when five-year period.
the institution becomes aware of the loss, but in no case For open-end credit, an over limit account may be re-
should the charge-off exceed the time frames stated in this aged at its outstanding balance (including the over
policy. limit balance, interest, and fees). No new credit may
be extended to the borrower until the balance falls
Re-aging, Extensions, Deferrals, Renewals, or Rewrites below the designated predelinquency credit limit.
Re-aging is the practice of bringing a delinquent account Partial Payments on Open-End and Closed-End Credit
current after the borrower has demonstrated a renewed
willingness and ability to repay the loan by making some, Institutions should use one of two methods to recognize
but not all, past due payments. Re-aging of open-end partial payments. A payment equivalent to 90 percent or
accounts, or extensions, deferrals, renewals, or rewrites of more of the contractual payment may be considered a full
closed-end accounts should only be used to help borrowers payment in computing delinquency. Alternatively, the
overcome temporary financial difficulties, such as loss of institution may aggregate payments and give credit for any
job, medical emergency, or change in family partial payment received. For example, if a regular
circumstances like loss of a family member. A permissive installment payment is $300 and the borrower makes
policy on re-agings, extensions, deferrals, renewals, or payments of only $150 per month for a six-month period,
rewrites can cloud the true performance and delinquency the loan would be $900, or three full months delinquent.
status of the portfolio. However, prudent use of a policy is An institution may use either or both methods in its
acceptable when it is based on recent, satisfactory portfolio, but may not use both methods simultaneously
performance and the true improvement in a borrower's with a single loan.
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 Examiners should ensure that institutions adhere to the
of contractual terms, should be supported in the Retail Classification Policy. Nevertheless, there may be
institution's management information systems. Adequate instances that warrant exceptions to the general
management information systems usually identify and classification policy. Loans need not be classified if the
document any loan that is extended, deferred, renewed, or institution can document clearly that repayment will occur

RMS Manual of Examination Policies 3.2-51 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

regardless of delinquency status. Examples might include will be essentially the same as for direct paper. If there is
loans well secured by marketable collateral and in the direct debt, comments will necessarily have to be more
process of collection, loans for which claims are filed extensive and probably will help form a basis for the
against solvent estates, and loans supported by valid indirect classification.
insurance claims. Conversely, the Retail Classification
Policy does not preclude examiners from reviewing and No general rule can be established as to the proper
classifying individual large dollar retail credit loans that application of dealers' reserves to the examiner's
exhibit signs of credit weakness regardless of delinquency classifications. Such a rule would be impractical because
status. of the many methods used by banks in setting up such
reserves and the various dealer agreements utilized.
In addition to reviewing loan classifications, the examiner Generally, where the bank is handling a dealer who is not
should ensure that the ALLL provides adequate coverage financially responsible, weak contracts warrant
for inherent losses. Sound risk and account management classification irrespective of any balance in the dealer's
systems, including a prudent retail credit lending policy, reserve. Fair and reasonable judgment on the part of the
measures to ensure and monitor adherence to stated policy, examiner will determine application of dealer reserves.
and detailed operating procedures, should also be
implemented. Internal controls should be in place to ensure If the amount involved would have a material impact on
that the policy is followed. Institutions lacking sound capital, consumer loans should be classified net of
policies or failing to implement or effectively follow unearned income. Large business-type loans placed in
established policies will be subject to criticism. consumer installment loan departments should receive
individual appraisal and, in all cases, the applicable
Examination Treatment unearned income discount should be deducted when such
loans are classified.
Use of the formula classification approach can result in
numerous small dollar adversely classified items. Impaired Loans, Troubled Debt
Although these classification details are not always Restructurings, Foreclosures and
included in the Report of Examination, an itemized list is
to be left with management. A copy of the listing should
Repossessions
also be retained in the examination work papers.
Loan Impairment - A loan is impaired when, based on
Examiner support packages are available which have built current information and events, it is likely that an
in parameters of the formula classification policy, and institution will be unable to collect all amounts due
which generate a listing of delinquent consumer loans to according to the contractual terms of the loan agreement
be classified in accordance with the policy. Use of this (i.e., principal and interest). The accounting standard for
package may expedite the examination in certain cases, impaired loans is set forth in FAS 114, Accounting by
especially in larger banks. Creditors for Impairment of a Loan as amended by FAS
118, Accounting by Creditors for Impairment of a Loan -
Losses are one of the costs of doing business in consumer Income Recognition and Disclosures. FAS 114 applies to
installment credit departments. It is important for the all loans, except large groups of smaller-balance
examiner to give consideration to the amount and severity homogenous loans that are collectively evaluated for
of installment loan charge-offs when examining the impairment and loans that are measured at fair value or the
department. Excessive loan losses are the product of weak lower of cost or fair value.
lending and collection policies and therefore provide a When a loan is impaired under FAS 114, the amount of
good indication of the soundness of the consumer impairment should be measured based on the present value
installment loan operation. The examiner should be alert of expected future cash flows discounted at the loans
also to the absence of installment loan charge-offs, which effective interest rate (i.e., the contractual interest rate
may indicate that losses are being deferred or concealed adjusted for any net deferred loan fees or costs and
through unwarranted rewrites or extensions. premium or discount existing at the origination or
acquisition of the loan). As a practical expedient,
Dealer lines should be scheduled in the report under the impairment may also be measured based on a loans
dealer's name regardless of whether the contracts are observable market price, or the fair value of the collateral,
accepted with or without recourse. Any classification or if the loan is collateral dependent. A loan is collateral
totaling of the nonrecourse line can be separately dependent if repayment is expected to be provided solely
identified from the direct or indirect liability of the dealer. by the underlying collateral and there are no other
Comments and format for scheduling the indirect contracts available and reliable sources of repayment.

Loans (8-16) 3.2-52 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

If the measure of a loan calculated in accordance with FAS To illustrate, assume a bank forecloses on a defaulted
114 is less than the book value of that loan, impairment mortgage loan of $100,000 and takes title to the property.
should be recognized as a valuation allowance against the If the fair value of the realty at the time of foreclosure is
loan. For regulatory reporting and examination report $90,000 and costs to sell are estimated at $10,000, a
purposes, this valuation allowance is included as part of $20,000 loss should be immediately recognized by a
the general allowance for loan and lease losses. In charge to the ALLL. The cost of the foreclosed asset
general, when the excess amount of the loans book value becomes $80,000. If the bank is on an accrual basis of
is determined to be uncollectible, this excess amount accounting, there may also be adjusting entries necessary
should be promptly charged-off against the ALLL. When to reduce both the accrued interest receivable and loan
a loan is collateral dependent, any portion of the loan interest income accounts. Assume further that in order to
balance in excess of the fair value of the collateral (or fair effect sale of the realty to a third party, the bank is willing
value less cost to sell) should similarly be charged-off. to offer a new mortgage loan (e.g., of $100,000) at a
concessionary rate of interest (e.g., 10 percent while the
Troubled Debt Restructuring - Troubled debt market rate for new loans with similar risk is 20 percent).
restructuring takes placed when a bank grants a concession Before booking this new transaction, the bank must
to a debtor in financial difficulty. The accounting establish its "economic value". Pursuant to Accounting
standards for troubled debt restructurings are set forth in Principles Board Opinion No. 21 (APB 21, Interest on
FAS 15, Accounting by Debtors and Creditors for Receivables and Payables), the value is represented by the
Troubled Debt Restructurings, as amended by FAS 114. sum of the present value of the income stream to be
In certain situations FASB 144, Accounting for the received from the new loan, discounted at the current
Impairment or Disposal of Long-Lived Assets, also market rate for this type of credit, and the present value of
applies. It is the FDICs policy that restructurings be the principal to be received, also discounted at the current
reflected in examination reports in accordance with this market rate. This economic value is the proper carrying
accounting guidance. In addition, banks are expected to value for the asset at its origination date, and if less than
follow these principles when filing the Call Report. the fair value less cost to sell at time of foreclosure (e.g.,
$78,000 vs. $80,000), an additional loss has been incurred
Troubled debt restructurings may be divided into two and should be immediately recognized. This additional
broad groups: those where the borrower transfers assets to loss should be reflected in the allowance if a relatively
the creditor to satisfy the claim, which would include brief period has elapsed between foreclosure and
foreclosures; and those in which the terms of a debtors subsequent resale of the property. However, the loss
obligation are modified, which may include reduction in should be treated as "other operating expenses" if the asset
the interest rate to an interest rate that is less than the has been held for a longer period. The new loan would be
current market rate for new obligations with similar risk , placed on the books at its face value ($100,000) and the
extension of the maturity date, or forgiveness of principal difference between the new loan amount and the
or interest. A third type of restructuring combines a "economic value" ($78,000) is treated as unearned
receipt of assets and a modification of loan terms. A loan discount ($22,000). For examination and Call Report
extended or renewed at an interest rate equal to the current purposes, the asset would be shown net of the unearned
interest rate for new debt with similar risk is not reported discount which is reduced periodically as it is earned over
as a restructured loan for examination purposes. the life of the new loan. Interest income is earned on the
restructured loan at the previously established market rate.
Transfer of Assets to the Creditor - A bank that receives This is computed by multiplying the carrying value (i.e.,
assets (except long-lived assets that will be sold) from a face amount of the loan reduced by any principal
borrower in full satisfaction of the book value of a loan payments, less unearned discount) by that rate (20
should record those assets at fair value. If the fair value of percent).
the assets received is less than the institutions recorded
investment in the loan, a loss is charged to the ALLL. The basis for this accounting approach is the assumption
When property is received in full satisfaction of an asset that financing the resale of the property at a concessionary
other than a loan (e.g., a debt security), the loss should be rate exacts an opportunity cost which the bank must
reflected in a manner consistent with the balance sheet recognize. That is, unearned discount represents the
classification of the asset satisfied. When long-lived assets present value of the "imputed" interest differential between
that will be sold, such as real estate, are received in full the concessionary and market rates of interest. Present
satisfaction of a loan, the real estate is recorded at its fair value accounting also assumes that both the bank and the
value less cost to sell. This fair value (less cost to sell) third party who purchased the property are indifferent to a
becomes the cost of the foreclosed asset.

RMS Manual of Examination Policies 3.2-53 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

cash sales price at the "economic value" or a higher the book value of the loan over its fair value (or fair value
financed price repayable over time. less cost to sell, as appropriate) is recognized by creating a
valuation allowance which is included in the ALLL.
Modification of Terms - When the terms of a TDR However, when available information confirms that loans
provide for a reduction of interest or principal, the and leases (including any recorded accrued interest, net
institution should measure any loss on the restructuring in deferred loan fees or costs, and unamortized premium or
accordance with the guidance for impaired loans as set discount) other than collateral dependent loans, or portions
forth in FAS 114 unless the loans are measured at fair thereof, are uncollectible, these amounts should be
value or the lower of cost or fair value. If the fair value of promptly charged-off against the ALLL, regardless of
the restructured loan is less than the book value of that whether an allowance was established to recognize
loan, FAS 114 requires impairment to be recognized as a impairment under FAS 114.
valuation allowance against the loan. For regulatory
reporting and examination report purposes, this valuation An examiner should not automatically require an
allowance should be included as part of ALLL. If the additional allowance for credit losses of impaired loans
excess amount of the loans book value is determined to be over and above what is calculated in accordance with these
uncollectible, this excess amount should be promptly standards. However, an additional allowance on impaired
charged-off against the ALLL. loans may be necessary based on consideration of
institution-specific factors, such as historical loss
For example, in lieu of foreclosure, a bank chooses to experience compared with estimates of such losses and
restructure a $100,000 loan to a borrower which had concerns about the reliability of cash flow estimates, the
originally been granted with an interest rate of 10 percent quality of an institutions loan review function, and
for 10 years. The bank and the borrower have agreed to controls over its process for estimating its FAS 114
capitalize the accrued interest ($10,000) into the note allowance.
balance, but the restructured terms will permit the
borrower to repay the debt over 10 years at a six percent Other Considerations - Examiners may encounter
interest rate. The bank does not believe the loan is situations where impaired loans and restructured debts are
collateral dependent. In this situation, the bank would identified, but the bank has not properly accounted for the
record the restructured loan at the present value of the new transactions. Where incorrect accounting treatment
note amount ($110,000) discounted at the 10 percent rate resulted in an overstatement of earnings, capital and assets,
specified in the original contract. This amount becomes it will be necessary to determine the proper carrying values
the loans fair value. The difference between the for these assets, utilizing the best available information
calculated fair value and the book value of the banks developed by the examiner after consultation with bank
restructured loan (which includes accrued interest, net management. Nonetheless, proper accounting for
deferred loan fees or costs, and unamortized premium or impaired and restructured loans is the responsibility of
discount) is recognized by creating a valuation allowance bank management. Examiners should not spend a
with a corresponding charge to the provision for loan and disproportionate amount of time developing the
lease losses. As a result, the net book value of the appropriate accounting entries, but instead discuss with
restructured loan is reflected at fair value. and require corrective action by bank management when
the banks treatment is not in accordance with accepted
Combination Approach - In some instances, the bank accounting guidelines. It must also be emphasized that
may receive assets in partial rather than full satisfaction of collectability and proper accounting and reporting are
a loan or security and may also agree to alter the original separate matters; restructuring a borrowers debt does not
repayment terms. In these cases, the recorded investment ensure collection of the loan or security. As with all other
should be reduced by the fair value of the assets received assets, adverse classification should be assigned if analysis
and the remaining investment accounted for as a indicates there is risk of loss present. Examiners should
restructuring involving only modification of terms. take care, however, not to discourage or be critical of bank
managements legitimate and reasonable attempts to
Examination Report Treatment - Examiners should achieve debt settlements through concessionary terms. In
continue to classify troubled loans, including any troubled many cases, restructurings offer the only realistic means
collateral dependent loans, based on the definitions of for a bank to bring about collection of weak or nonearning
Loss, Doubtful, and Substandard. When a loan is assets. Finally, the volume of impaired loans and
collateral dependent, any portion of the loan balance restructured debts having concessionary interest rates
which exceeds the fair value of the collateral should be should be considered when evaluating the banks earnings
promptly charged-off against the ALLL. For other loans performance and assigning the earnings performance
that are impaired or have been restructured, the excess of rating.

Loans (8-16) 3.2-54 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

must exercise judgment as to whether a statement

Examination procedures for reviewing TDRs are included should be detailed in its entirety. When the statement
in the ED Modules. is relevant to the classification, it is generally more
effective to summarize weaknesses with the entire
Report of Examination Treatment of statement presented. On the other hand, if the
Classified Loans statement does not significantly support or detract
from the loan, a very brief summarization of the
The Items Subject to Adverse Classification page allows statement is in order.
an examiner to present pertinent and readily Summarize the Problem - The examiner's comments
understandable comments related to loans which are should explicitly point out reasons for the
adversely classified. In addition, the Analysis of Loans classification. Where portions of the line are accorded
Subject to Adverse Classification page permits analysis of different classifications or are not subject to
present and previous classifications from the standpoint of classification, comments should clearly set forth the
source and disposition. These loan schedules should be reasoning for the split treatment.
prepared in accordance with the Report of Examination
Instructions. Management's Intentions - Comments should
include any corrective program contemplated by
An examiner must present, in writing, relevant and readily management.
understandable comments related to criticized loans.
Therefore, a thorough understanding of all factors Examiners should avoid arbitrary or penalty
surrounding the loan is required and only those germane to classifications, nor should "conceded" or "agreed" be
description, collectability, and management plans should given as the principal reason for adverse classifications.
be included in the comments. Comments should be Management's opinions and ideas should not have to be
concise, but brevity is not to be accomplished by omission emphasized; if a classification is well-founded, the facts
of adequate information. Comments should be will speak for themselves. If well-written, there is little
informative and factual data emphasized. The important need for long summary comments reemphasizing major
weaknesses of the loan should not be overshadowed by points of the loan write-up.
extraneous information which might well have been
omitted. An ineffective presentation of a classified loan When the volume of loan classifications reaches the point
weakens the value of a Report of Examination and of causing supervisory concern, analysis of present and
frequently casts doubt on the accuracy of the previous classifications from the standpoint of source and
classifications. The essential test of loan comments is disposition becomes very important. For this reason, the
whether they justify the classification. Analysis of Loans Subject to Adverse Classification page
should be completed in banks possessing characteristics
Careful organization is an important ingredient of good which present special supervisory problems; when the
loan comments. Generally, loan comments should include volume or composition of adversely classified loans has
the following items: changed significantly since the previous examination,
including both upward and downward movements; and, in
Identification - Indicate the name and occupation or such other special or unusual situations as examiners deem
type of business of the borrower. Cosigners, appropriate. Generally, the page should not include
endorsers and guarantors should be identified and in consumer loans and overdrafts and it should be footnoted
the case of business loans, it should be clear whether to indicate that these assets are not included.
the borrower is a corporation, partnership, or sole
proprietorship. Issuance of "Express Determination" Letters
Description - The make-up of the debt should be to Banks for Federal Income Tax Purposes
concisely described as to type of loan, amount, origin
and terms. The history, purpose, and source of Tax Rules - The Internal Revenue Code and tax
repayment should also be indicated. regulations allow a deduction for a loan that becomes
Collateral - Describe and evaluate any collateral, wholly or partially worthless. All pertinent evidence is
indicating the marketability and/or condition thereof. taken into account in determining worthlessness. Special
If values are estimated, note the source. tax rules permit a federally supervised depository
Financial Data - Current balance sheet information institution to elect a method of accounting under which it
along with operating figures should be presented, if conforms its tax accounting for bad debts to its regulatory
such data are considered necessary. The examiner accounting for loan charge-offs, provided certain

RMS Manual of Examination Policies 3.2-55 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

conditions are satisfied. Under these rules, loans that are examinations that cover their loan review process, i.e.,
charged-off pursuant to specific orders of the institution's during safety and soundness examinations. Examiners
supervisory authority or that are classified by the should not alter the scope or frequency of examinations
institution as Loss assets under applicable regulatory merely to permit banks to use the tax-book conformity
standards are conclusively presumed to have become method.
worthless in the taxable year of the charge-offs. These
special tax rules are effective for taxable years ending on When requested by a bank that has made or intends to
or after December 31, 1991. make the election under Section 1.166-2(d)(3) of the tax
regulations, the examiner-in-charge should issue an
To be eligible for this accounting method for tax purposes, "express determination" letter, provided the bank does
an institution must file a conformity election with its maintain and apply loan loss classification standards that
Federal income tax return. The tax regulations also are consistent with the FDIC's regulatory standards. The
require the institution's primary Federal supervisory letter should only be issued at the completion of a safety
authority to expressly determine that the institution and soundness examination at which the examiner-in-
maintains and applies loan loss classification standards charge has concluded that the issuance of the letter is
that are consistent with the regulatory standards of its appropriate.
supervisory authority.
An "express determination" letter should be issued to a
For taxable years ending before the completion of the first bank only if:
examination of an institution's loan review process that is
after October 1, 1992, transition rules allow an institution The examination indicates that the bank maintains and
to make the conformity election without the determination applies loan loss classification standards that are
letter from its primary supervisory authority. However, consistent with the FDIC's standards regarding the
the letter must be obtained at the first examination identification and charge-off of such loans; and
involving the loan review process after October 1, 1992. There are no material deviations from the FDIC's
If the letter is not issued by the supervisory authority at the standards.
examination, the election is revoked retroactively.
Minor criticisms of the bank's loan review process as it
Once the first examination of the loan review process after relates to loan charge-offs or immaterial individual
October 1, 1992, has been performed by an institution's deviations from the FDIC's standards should not preclude
primary Federal supervisory authority, the transition rules the issuance of an "express determination" letter.
no longer apply and the institution must have the "express
determination" letter before making the election. To An "express determination" letter should not be issued if:
continue using the tax-book conformity method, the
institution must request a new letter at each subsequent The bank's loan review process relating to charge-offs
examination that covers the loan review process. If the is subject to significant criticism;
examiner does not issue an "express determination" letter Loan charge-offs reported in the Report of Condition
at the end of such an examination, the institution's election and Income (Call Reports) are consistently overstated
of the tax-book conformity method is revoked or understated; or
automatically as of the beginning of the taxable year that
includes the date of examination. However, that There is a pattern of loan charge-offs not being
examiner's decision not to issue an "express recognized in the appropriate year.
determination" letter does not invalidate an institution's
election for any prior years. The supervisory authority is When the issuance of an "express determination" letter is
not required to rescind any previously issued "express appropriate, it should be prepared on FDIC letterhead
determination" letters. using the following format. The letter should be signed
and dated by the examiner-in-charge and provided to the
When an examiner does not issue an "express bank for its files. The letter is not part of the Report of
determination" letter, the institution is still allowed tax Examination.
deductions for loans that are wholly or partially worthless.
However, the burden of proof is placed on the institution
to support its tax deductions for loan charge-offs. Express Determination Letter for IRS Regulation 1.166-
2(d)(3)
Examination Guidelines - Banks are responsible for
requesting "express determination" letters during

Loans (8-16) 3.2-56 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

In connection with the most recent examination of [Name that factors such as location and economic environment of
of Bank], by the Federal Deposit Insurance Corporation, as the area limit some institutions' ability to diversify. Where
of [examination date], we reviewed the institutions loan reasonable diversification realistically cannot be achieved,
review process as it relates to loan charge-offs. Based on the resultant concentration calls for capital levels higher
our review, we concluded that the bank, as of that date, than the regulatory minimums.
maintained and applied loan loss classification standards
that were consistent with regulatory standards regarding Concentrations generally are not inherently bad, but do
loan charge-offs. add a dimension of risk which the management of the
institution should consider when formulating plans and
This statement is made on the basis of a review that was policies. In formulating these policies, management
conducted in accordance with our normal examination should, at a minimum, address goals for portfolio mix and
procedures and criteria. It does not in any way limit or limits within the loan and other asset categories. The
preclude any formal or informal supervisory action institution's business strategy, management expertise and
(including enforcement actions) by this supervisory location should be considered when reviewing the policy.
authority relating to the institutions loan review process Management should also consider the need to track and
or the level at which it maintains its allowance for loan and monitor the economic and financial condition of specific
lease losses. geographic locations, industries and groups of borrowers
in which the bank has invested heavily. All concentrations
[signature] should be monitored closely by management and receive a
Examiner-in-charge more in-depth review than the diversified portions of the
[date signed] institution's assets. Failure to monitor concentrations can
result in management being unaware how significant
When an "express determination" letter is issued to a bank, economic events might impact the overall portfolio. This
a copy of the letter as well as documentation of the work will also allow management to consider areas where
performed by examiners in their review of the bank's loan concentration reductions may be necessary. Management
loss classification standards should be maintained in the and the board can monitor any reduction program using
workpapers. A copy of the letter should also be forwarded accurate concentration reports. If management is not
to the Regional Office with the Report of Examination. properly monitoring concentration levels and limits,
The issuance of an express determination letter should examiners may consider criticizing management.
be noted in the Report of Examination according to
procedure in the Report of Examination Instructions. To establish a meaningful tracking system for
concentrations of credit, financial institutions should be
When an examiner-in-charge concludes that the conditions encouraged to consider the use of codes to track individual
for issuing a requested "express determination" letter have borrowers, related groups of borrowers, industries, and
not been met, the examiner-in-charge should discuss the individual foreign countries. Financial institutions should
reasons for this conclusion with the Regional Office. The also be encouraged to use the standard industrial
examiner-in-charge should then advise bank management classification (SIC) or similar code to track industry
that the letter cannot be issued and explain the basis for concentrations. Any monitoring program should be
this conclusion. A comment indicating that a requested reported regularly to the board of directors.
"express determination" letter could not be issued, together
with a brief statement of the reasons for not issuing the Refer to the Report of Examination Instructions for
letter are addressed in the Report of Examination guidance in identifying and listing concentrations in the
Instructions. examination report.

FEDERAL FUNDS SOLD AND

CONCENTRATIONS REPURCHASE AGREEMENTS
Generally a concentration is a significantly large volume Federal funds sold and securities purchased under
of economically-related assets that an institution has agreement for resale represent convenient methods to
advanced or committed to one person, entity, or affiliated employ excess funds to enhance earnings. Federal funds
group. These assets may in the aggregate present a are excess reserve balances and take the form of a one-day
substantial risk to the safety and soundness of the transfer of funds between banks. These funds carry a
institution. Adequate diversification of risk allows the specified rate of interest and are free of the risk of loss due
institution to avoid the excessive risks imposed by credit to fluctuations in market prices entailed in buying and
concentrations. It should also be recognized, however,

RMS Manual of Examination Policies 3.2-57 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

selling securities. However, these transactions are usually of Federal funds are normally unsecured unless otherwise
unsecured and therefore do entail potential credit risk. regulated by State statutes, and while collateral protection
Securities purchased under agreement for resale represent is no substitute for thorough credit review, the selling bank
an agreement between the buying and selling banks that should consider the possibility of requiring security if sales
stipulates the selling bank will buy back the securities sold agreements are entered into on a continuing basis for
at an agreed price at the expiration of a specified period of specific but extended periods of time, or for overnight
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 bank should be able to present
and the examiner will need to recognize the elements of logical reasons for such action based on conclusions
risk involved in such transactions. While the selling of drawn from its credit analysis of the buyer and bearing in
funds is on a one-day basis, these transactions may evolve mind the potential risk involved.
into a continuing situation. This development is usually
the result of liability management techniques whereby the A review of Federal funds sold between examinations may
buying bank attempts to utilize the acquired funds to prompt examiners to broaden the scope of their analysis of
support a rapid expansion of its loan-investment posture such activity if the transactions are not being handled in
and as a means of enhancing profits. Of particular concern accordance with sound practices as outlined above. Where
to the examiner is that, in many cases, the selling bank will the bank has not developed a formal policy regarding the
automatically conclude that the buying bank's financial sale of Federal funds or fails to conduct a credit analysis of
condition is above reproach without proper investigation the buyer prior to a sale and during a continuous sale of
and analysis. If this becomes the case, the selling bank such funds, the matter should be discussed with
may be taking an unacceptable risk unknowingly. management. In such discussion, it is incumbent upon
examiners to inform management that their remarks are
Another area of potential risk involves selling Federal not intended to cast doubt upon the financial strength of
funds to a bank which may be acting as an intermediary any bank to whom Federal funds are sold. Rather, the
between the selling bank and the ultimate buying bank. In intent is to advise the banker of the potential risks of such
this instance, the intermediary bank is acting as agent with practices unless safeguards are developed. The need for
the true liability for repayment accruing to the third bank. policy formulation and credit review on all Federal funds
Therefore, it is particularly important that the original sold should be reinforced via a comment in the Report of
selling bank be aware of this situation, ascertain the Examination. Also, if Federal funds sold to any one buyer
ultimate disposition of its funds, and be satisfied as to the equals or exceeds 100 percent of the selling bank's Tier 1
creditworthiness of the ultimate buyer of the funds. Capital, it should be listed on the Concentrations schedule
unless secured by U.S. Government securities. Based on
Clearly, the "risk free" philosophy regarding the sale of the circumstances, the examiner should determine the
Federal funds is inappropriate. Selling banks must take appropriateness of additional comments regarding risk
the necessary steps to assure protection of their position. diversification.
The examiner is charged with the responsibility of
ascertaining that selling banks have implemented and Securities purchased under an agreement to resell are
adhered to policy directives in this regard to forestall any generally purchased at prevailing market rates of interest.
potentially hazardous situations. The purchasing bank must keep in mind that the
transaction merely represents another form of lending.
Examiners should encourage management of banks Therefore, considerations normally associated with
engaged in selling Federal funds to implement a policy granting secured credit should be made. Repayment or
with respect to such activity. This policy should include repurchases by the selling bank is a major consideration,
consideration of such matters as the aggregate sum to be and the buying bank should satisfy itself that the selling
sold at any one time, the maximum amount to be sold to bank will be able to generate the necessary funds to
any one buyer, the maximum duration of time the bank repurchase the securities on the prescribed date. Policy
will sell to any one buyer, a list of acceptable buyers, and guidelines should limit the amount of money extended to
the terms under which a sale will be made. As in any form one seller. Collateral coverage arrangements should be
of lending, thorough credit evaluation of the prospective controlled by procedures similar to the safeguards used to
purchaser, both before granting the credit extension and on control any type of liquid collateral. Securities held under
a continuing basis, is a necessity. Such credit analysis such an arrangement should not be included in the bank's
should emphasize the borrower's ability to repay, the investment portfolio but should be reflected in the Report
source of repayment, and alternative sources of repayment of Examination under the caption Securities Purchased
should the primary source fail to materialize. While sales Under Agreements to Resell. Transactions of this nature

Loans (8-16) 3.2-58 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

do not require entries to the securities account of either

bank with the selling bank continuing to collect all interest Grant of Security Interest
and transmit such payments to the buying bank.
For a security interest to be enforceable against the debtor
or third party with respect to the collateral, the collateral
must be in the possession of the secured party pursuant to
FUNDAMENTAL LEGAL CONCEPTS agreement, or the debtor must sign a security agreement
AND DEFINITIONS which covers the description of the collateral.

Laws and regulations that apply to credit extended by Collateral

banks are more complicated and continually in a state of Any description of personal property or real estate is a
change. However, certain fundamental legal principles sufficient description of the collateral whether or not it is
apply no matter how complex or innovative a lending specific if it reasonably identifies what is described. If the
transaction. To avoid needless litigation and ensure that parties seek to include property acquired after the signing
each loan is a legally enforceable claim against the of the security agreement as collateral, additional
borrower or collateral, adherence to certain rules and requirements must be met.
prudent practices relating to loan transactions and
documentation is essential. An important objective of the Unless otherwise agreed a security agreement gives the
examiner's analysis of collateral and credit files is not only secured party the rights to proceeds from the sale,
to obtain information about the loan, but also to determine exchange, collection or disposition of the collateral.
if proper documentation procedures and practices are
being utilized. While examiners are not expected to be In some cases, the collateral that secures an obligation
experts on legal matters, it is important they be familiar under one security agreement can be used to secure a new
with the Uniform Commercial Code (UCC) adopted by loan, too. This can be done by using a cross-
their respective states as well as other applicable State collateralization clause in the security agreement.
laws governing credit transactions. A good working
knowledge of the various documents necessary to attain Perfecting the Security Interest
the desired collateral or secured position, and how those
documents are to be used or handled in the jurisdiction Three terms basic to secured transactions are attachment,
relevant to the bank under examination, is also essential. security agreement and security interest. Attachment
refers to that point when the creditor's legal rights in the
Uniform Commercial Code debtor's property come into existence or "attach. This
Secured Transactions does not mean the creditor necessarily takes physical
possession of the property, or does it mean acquisition of
Article 9 of the UCC governs secured transactions; i.e., ownership of the property. Rather, it means that before
those transactions which create a security interest in attachment, the borrower's property is free of any legal
personal property or fixtures including goods, documents, encumbrance, but after attachment, the property is legally
instruments, general intangibles, chattel paper or accounts. bound by the creditor's security interest. In order for the
Article 9 was significantly revised effective July 1, 2001, creditor's security interest to attach, there must be a
but each individual state must adopt the changes for it to security agreement in which the debtor authenticates and
become law. Because some states have enacted modified provides a description of the collateral. A creditor's
versions of the UCC and subsequent revisions, each security interest can be possessory or nonpossessory, a
applicable State statute should be consulted. secured party with possession pursuant to agreement
means that the agreement for possession has to be an
General Provisions agreement that the person will have possession for
purposes of security. The general rule is a bank must take
A Security Agreement is an agreement between a debtor possession of deposit accounts (proprietary), letter of
and a secured party that creates or provides for a security credit rights, electronic chattel, paper, stocks and bonds to
interest. The Debtor is the person that has an interest in perfect a security interest therein. In a transaction
the collateral other than a security interest. The term involving a nonpossessory security interest, the debtor
Debtor also includes a seller of payment intangibles or retains possession of the collateral. A security interest in
promissory notes. The obligor is the person who owes on collateral automatically attaches to the proceeds of the
a secured transaction. The Secured Party is the lender, collateral and is automatically perfected in the proceeds if
seller or other person in whose favor there is a security the credit was advanced to enable the purchase
interest.

RMS Manual of Examination Policies 3.2-59 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

A party's security interest in personal property is not The lien secures payment or performance of an
protected against a debtor's other creditors unless it has obligation for goods or services furnished in
been perfected. A security interest is perfected when it has connection with a debtors farming operation or rent
attached and when all of the applicable steps required for on real property leased by a debtor in connection with
perfection, such as the filing of a financing statement or its farming operation.
possession of the collateral, have been taken. These The lien is created by statute in favor of a person that
provisions are designed to give notice to others of the in the ordinary course of its business furnished goods
secured party's interest in the collateral, and offer the or services to a debtor in connection with a debtors
secured party the first opportunity at the collateral if the farming operation or leased property to a debtor in
need to foreclose should arise. If the security interest is not connection with the debtors farming operation.
perfected, the secured party loses its secured status. The liens effectiveness does not depend on the
persons possession of the personal property.
Right to Possess and Dispose of Collateral
An agricultural lien is therefore non-possessory. Law
Unless otherwise agreed, when a debtor defaults on a outside of UCC-9 governs creation of agricultural liens
secured loan, a secured party has the right to take and their attachment to collateral. An agricultural lien
possession of the collateral without going to court if this cannot be created or attached under Article 9. Article 9,
can be done without breaching the peace. Alternatively, if however, does govern perfection. In order to perfect an
the security agreement so provides, the secured party may agricultural lien, a financing statement must be filed. A
require the debtor to assemble the collateral and make it perfected agricultural lien on collateral has priority over a
available to the secured party at a place to be designated conflicting security interest in or agricultural lien on the
by the secured party which is reasonably convenient to same collateral if the statute creating the agricultural lien
both parties. provides for such priority. Otherwise, the agricultural lien
is subject to the same priority rules as security interests
A secured party may then sell, lease or otherwise dispose (for example, date of filing).
of the collateral with the proceeds applied as follows: (a)
foreclosure expenses, including reasonable attorneys' fees A distinction is made with respect to proceeds of collateral
and legal expenses; (b) the satisfaction of indebtedness for security interests and agricultural liens. For security
secured by the secured party's security interest in the interests, collateral includes the proceeds under Article 9.
collateral; and (c) the satisfaction of indebtedness secured For agricultural liens, the collateral does not include
by any subordinate security interest in the collateral if the proceeds unless State law creating the agricultural lien
secured party receives written notification of demand gives the secured party a lien on proceeds of the collateral
before the distribution of the proceeds is completed. If subject to the lien.
requested by the secured party, the holder of a subordinate
security interest must furnish reasonable proof of his Special Filing Requirements There is a national
interest, and unless he does so, the secured party need not uniform Filing System form. Filers, however are not
comply with his demand. required to use them. If permitted by the filing office,
parties may file and otherwise communicate by means of
Examiners should determine bank policy concerning the records communicated and stored in a media other than
verification of lien positions prior to advancing funds. paper. A peculiarity common to all states is the filing of a
Failure to perform this simple procedure may result in the lien on aircraft; the security agreement must be submitted
bank unknowingly assuming a junior lien position and, to the Federal Aviation Administration in Oklahoma City,
thereby, greater potential loss exposure. Management may Oklahoma.
check filing records personally or a lien search may be
performed by the filing authority or other responsible Default and Foreclosure - As a secured party, a bank's
party. This is especially important when the bank grants rights in collateral only come into play when the obligor is
new credit lines. in default. What constitutes default varies according to the
specific provisions of each promissory note, loan
Agricultural Liens agreement, security agreement, or other related documents.
After an obligor has defaulted, the creditor usually has the
An agricultural lien is generally defined as an interest, right to foreclose, which means the creditor seizes the
other than a security interest, in farm products that meets security pledged to the loan, sells it and applies the
the following three conditions: proceeds to the unpaid balance of the loan. For consumer
transactions, there are strict consumer notification
requirements prior to disposition of the collateral. For

Loans (8-16) 3.2-60 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

consumer transactions, the lender must provide the debtor value who buys in the normal manner, cuts off a prior
with certain information regarding the surplus or perfected security interest in the collateral.
deficiency in the disposition of collateral. There may be
more than one creditor claiming a right to the sale The second exception to the rule of priority concerns the
proceeds in foreclosure situations. When this occurs, vulnerability of security interests perfected by doing
priority is generally established as follows: (1) Creditors nothing. While these interests are perfected automatically,
with a perfected security interest (in the order in which with the date of perfection being the date of attachment,
lien perfection was attained); (2) Creditors with an they are extremely vulnerable at the hands of subsequent
unperfected security interest; and (3) General creditors. bona fide purchasers. Suppose, for example, a dealer sells
a television set on a secured basis to an ultimate consumer.
Under the UCC procedure for foreclosing security Since the collateral is consumer goods, the security interest
interests, four concepts are involved. First is repossession is perfected the moment if attaches. But if the original
or taking physical possession of the collateral, which may buyer sells the television set to another person who buys it
be accomplished with judicial process or without judicial in good faith and in ignorance of the outstanding security
process (known as self-help repossession), so long as the interest, the UCC provides that the subsequent purchase
creditor commits no breach of the peace. The former is cuts off the dealer's security interest. This second
usually initiated by a replevin action in which the sheriff exception is much the same as the first except for one
seizes the collateral under court order. A second important important difference: the dealer (creditor) in this case can
concept of UCC foreclosure procedures is redemption or be protected against purchase of a customer's collateral by
the debtor's right to redeem the security after it has been filing a financing statement with the appropriate public
repossessed. Generally, the borrower must pay the entire official.
balance of the debt plus all expenses incurred by the bank
in repossessing and holding the collateral. The third The third exception regards the after-acquired property
concept is retention that allows the bank to retain the clause that protects the value of the collateral in which the
collateral in return for releasing the debtor from all further creditor has a perfected security interest. The
liability on the loan. The borrower must agree to this after-acquired property clause ordinarily gives the original
action, hence would likely be so motivated only when the creditor senior priority over creditors with later perfected
value of the security is likely to be less than or about equal interests. However, it is waived as regards the creditor
to the outstanding debt. Finally, if retention is not who supplies replacements or additions to the collateral or
agreeable to both borrower and lender, the fourth concept, the artisan who supplies materials and services that
resale of the security, comes into play. Although sale of enhance the value of the collateral as long as a perfected
the collateral may be public or private, notice to the debtor security interest in the replacement or additions, or
and other secured parties must generally be given. The collateral is held.
sale must be commercially reasonable in all respects.
Debtors are entitled to any surplus resulting from sale Borrowing Authorization
price of the collateral less any unpaid debt. If a deficiency
occurs (i.e., the proceeds from sale of the collateral were Borrowing authorizations in essence permit one party to
inadequate to fully extinguish the debt obligation), the incur liability for another. In the context of lending, this
bank has the right to sue the borrower for this shortfall. usually concerns corporations. A corporation may enter
This is a right it does not have under the retention concept. into contracts within the scope of the powers authorized by
its charter. In order to make binding contracts on behalf of
Exceptions to the Rule of Priority - There are three the corporation, the officers must be authorized to do so
exceptions to the general rule that the creditor with the either by the board of directors or by expressed or implied
earliest perfected security interest has priority. The first general powers. Usually a special resolution expressly
concerns a specific secured transaction in which a creditor gives certain officers the right to obligate the corporate
makes a loan to a dealer and takes a security interest in the entity, pledge assets as collateral, agree to other terms of
dealer's inventory. Suppose such a creditor files a the indebtedness and sign all necessary documentation on
financing statement with the appropriate public official to behalf of the corporate entity.
perfect the security interest. While it might be possible for
the dealer's customers to determine if an outstanding Although a general resolution is perhaps satisfactory for
security interest already exists against the inventory, it the short-term, unsecured borrowings of a corporation, a
would be impractical to do so. Therefore, an exception is specific resolution of the corporation's board of directors is
made to the general rule and provides that a buyer in the generally advisable to authorize such transactions as term
ordinary course of business, i.e., an innocent purchaser for loans, loans secured by security interests in the
corporation's personal property, or mortgages on real

RMS Manual of Examination Policies 3.2-61 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

estate. Further, mortgaging or pledging substantially all added to a signature means that if the instrument is not
of the corporation's assets without prior approval of the paid when due, the guarantor will pay it, but only after the
shareholders of the corporation is often prohibited, holder has reduced to judgment a claim against the maker
therefore, a bank may need to seek advice of counsel to and execution has been returned unsatisfied, or after the
determine if shareholder consent is required for certain maker has become insolvent or it is otherwise useless to
contemplated transactions. proceed against such a party.

Loans to corporations should indicate on their face that the Contracts of guarantee are further divided into a limited
corporation is the borrower. The corporate name should guarantee which relates to a specific note (often referred to
appear followed by the name, title and signature of the as an "endorsement") or for a fixed period of time, or a
appropriate officer. If the writing is a negotiable continuing guarantee which, in contrast, is represented by
instrument, the UCC states the party signing is personally a separate instrument and enforceable for future (duration
liable as a general rule. To enforce payment against a depends upon State law) transactions between the bank
corporation, the note or other writing should clearly show and the borrower or until revoked. A well drawn
that the debtor is a corporation. continuing guarantee contains language substantially
similar to the following: "This is an absolute and
Bond and Stock Powers unconditional guarantee of payment, is unconditionally
delivered, and is not subject to the procurement of a
As mentioned previously, a bank generally obtains a guarantee from any person other than the undersigned, or
security interest in stocks and bonds by possession. The to the performance or happening of any other condition."
documents which allow the bank to sell the securities if the The aforementioned unambiguous terms are necessary to
borrower defaults are called stock powers and bond the enforceability of contracts of guarantee, as they are
powers. The examiner should ensure the bank has, for frequently entered into solely as an accommodation for the
each borrower who has pledged stocks or bonds, one borrower and without the guarantor's participation in the
signed stock power for all stock certificates of a single benefits of the loan. Thus, courts tend to construe
issuer, and a separate signed bond power for each bond contracts of guarantee strictly against the party claiming
instrument. The signature must agree with the name on under the contract. Unless the guarantee is given prior to
the actual stock certificate or bond instrument. Refer to or at the time the initial loan is made, the guarantee may
Federal Reserve Board Regulations Part 221 (Reg U) for not be enforceable because of the difficulty of establishing
further information on loans secured by investment that consideration was given. Banks should not disburse
securities. funds on such loans until they have the executed guarantee
agreement in their possession. Banks should also require
Comaker the guarantee be signed in the presence of the loan officer,
or, alternatively, that the guarantor's signature be
Two or more persons who are parties to a contract or notarized. If the proposed guarantor is a partnership, joint
promise to pay are known as comakers. They are a unit to venture, or corporation, the examiner should ensure the
the performance of one act and are considered primarily signing party has the legal authority to enter into the
liable. In the case of default on an unsecured loan, a guarantee agreement. Whenever there is a question
judgment would be obtained against all. A release against concerning a corporation's authority to guarantee a loan,
one is a release against all because there is but one counsel should be consulted and a special corporate
obligation and if that obligation is released as to one resolution passed by the organization's board of directors.
obligor, it is released as to all others.
Subordination Agreement
Loan Guarantee
A bank extending credit to a closely held corporation may
Since banks often condition credit advances upon the want to have the company's officers and shareholders
backup support provided by third party guarantees, subordinate to the bank's loan any indebtedness owed them
examiners should understand the legal fundamentals by the corporation. This is accomplished by execution of
governing guarantees. A guarantee may be a guarantee of a subordination agreement by the officers and
payment or of collection. "Payment guaranteed" or shareholders. Subordination agreements are also
equivalent words added to a signature means that if the commonly referred to as standby agreements. Their basic
instrument is not paid when due, the guarantor will pay it purpose is to prevent diversion of funds from reduction of
according to its terms without resort by the holder to any bank debt to reduction of advances made by the firm's
other party. "Collection guaranteed" or equivalent words owners or officers.

Loans (8-16) 3.2-62 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Hypothecation Agreement borrower is entitled to pay the debt and demand

reconveyance from the lender, as in the case of an ordinary
This is an agreement whereby the owner of property grants mortgage. If the debt is not paid, the grantee must
a security interest in collateral to the bank to secure the foreclose as if a regular mortgage had been made.
indebtedness of a third party. Banks often take possession
of the stock certificates, plus stock powers endorsed in The examiner should ensure the bank has performed a title
blank, in lieu of a hypothecation agreement. Caution, and lien search of the property prior to taking a mortgage
however, dictates that the bank take a hypothecation or advancing funds. Proper procedure calls for an
agreement setting forth the bank's rights in the event of abstractor bringing the abstract up to date, and review of
default. the abstract by an attorney or title insurance company. If
an attorney performs the task, the abstract will be
Real Estate Mortgage examined and an opinion prepared indicating with whom
title rests, along with any defects and encumbrances
A mortgage may be defined as a conveyance of realty disclosed by the abstract. Like an abstractor, an attorney is
given with the intention of providing security for the liable only for damages caused by negligence. If a title
payment of debt. There are several different types of insurance company performs the task of reviewing the
mortgage instruments but those commonly encountered are abstract, it does essentially the same thing; however, when
regular mortgages, deeds of trust, equitable mortgages, and title insurance is obtained, it represents a contract to make
deeds absolute given as security. good, loss arising through defects in title to real estate or
liens or encumbrances thereon. Title insurance covers
Regular Mortgages - The regular mortgage involves only various items not covered in an abstract and title opinion.
two parties, the borrower and the lender. The mortgage Some of the more common are errors by abstractors or
document encountered in many states today is referred to attorneys include unauthorized corporate action, mistaken
as the regular mortgage. It is, in form, a deed or legal interpretations, and unintentional errors in public
conveyance of realty by the borrower to the lender records by public officials. Once the bank determines title
followed or preceded by a description of the debt and the and lien status of the property, the mortgage can be
property, and includes a provision to the effect that the prepared and funds advanced. The bank should record the
mortgage be released upon full payment of the debt. mortgage immediately after closing the loan. Form,
Content of additional paragraphs and provisions varies execution, and recording of mortgages vary from state to
considerably. state and therefore must conform to the requirements of
State law.
Deeds of Trust - In the trust deed, also known as the deed
of trust, the borrower conveys the realty not to the lender Collateral Assignment
but to a third party, a trustee, in trust for the benefit of the
holder of the notes(s) that constitutes the mortgage debt. An assignment is generally considered as the transfer of a
The deed of trust form of mortgage has certain advantages, legal right from one person to another. The rights
the principle being that in a number of states it can be acquired under a contract may be assigned if they relate to
foreclosed by trustee's sale under the power of sale clause money or property, but personal services may not be
without court proceedings. assigned. Collateral assignments are used to establish the
bank's rights as lender in the property or asset serving as
Equitable Mortgages - As a general rule, any instrument collateral. It is generally used for loans secured by savings
in writing by which the parties show their intention that deposits, certificates of deposit or other cash accounts as
realty be held as security for the payment of a debt, well as loans backed by cash surrender value of life
constitutes an equitable mortgage capable of being insurance. In some instances, it is used in financing
foreclosed in a court of equity. accounts receivable and contracts. If a third party holder
of the collateral is involved, such as life insurance
Deeds Absolute Given as Security - Landowners who company or the payor of an assigned contract, an
borrow money may give as security an absolute deed to acknowledgement should be obtained from that party as to
the land. "Absolute deed" means a quitclaim or warranty the bank's assigned interest in the asset for collateral
deed such as is used in an ordinary realty sale. On its face, purposes.
the transaction appears to be a sale of the realty; however,
the courts treat such a deed as a mortgage where the
evidence shows that the instrument was really intended CONSIDERATION OF BANKRUPTCY
only as security for a debt. If such proof is available, the LAW AS IT RELATES TO

RMS Manual of Examination Policies 3.2-63 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

COLLECTABILITY OF A DEBT the repayment plan. In Chapter 13 proceedings, only

secured creditors are so entitled. A majority vote binds the
Introduction minority to the plan, provided the latter will receive
pursuant to the plan at least the amount they would have
Familiarity with the basic terms and concepts of the received in a straight liquidation. The plan is fashioned so
Federal bankruptcy law (formally known as the that it may be carried out in three years although the court
Bankruptcy Reform Act of 1978) is necessary in order for may extend this to five years.
examiners to make informed judgments concerning the
likelihood of collection of loans to bankrupt individuals or Most cases in bankruptcy courts are Chapter 7
organizations. The following paragraphs present an proceedings, but reorganization cases are increasingly
overview of the subject. Complex situations may arise common. From the creditor's point of view, Chapter 11 or
where more in-depth consideration of the bankruptcy 13 filings generally result in greater debt recovery than do
provisions may be necessary and warrant consultation with liquidation situations under Chapter 7. Nonetheless, the
the bank's attorney, Regional Counsel or other member of fact that reorganization plans are tailored to the facts and
the Regional Office staff. For the most part, however, circumstances applicable to each bankrupt situation means
knowledge of the following information when coupled that they vary considerably and the amount recovered by
with review of credit file data and discussion with bank the creditor may similarly vary from nominal to virtually
management should enable examiners to reach sound complete recovery.
conclusions as to the eventual repayment of the bank's
loans. Functions of Bankruptcy Trustees

Forms of Bankruptcy Relief Trustees are selected by the borrower's creditors and are
responsible for administering the affairs of the bankrupt
Liquidation and rehabilitation are the two basic types of debtor's estate. The bankrupt's property may be viewed as
bankruptcy proceedings. Liquidation is pursued under a trust for the benefit of the creditors, consequently it
Chapter 7 of the law and involves the bankruptcy trustee follows the latter should, through their elected
collecting all of the debtor's nonexempt property, representatives, exercise substantial control over this
converting it into cash and distributing the proceeds property.
among the debtor's creditors. In return, the debtor obtains
a discharge of all debts outstanding at the time the petition Voluntary and Involuntary Bankruptcy
was filed which releases the debtor from all liability for
those pre-bankruptcy debts. When a debtor files a bankruptcy petition with the court,
the case is described as a voluntary one. It is not
Rehabilitation (sometimes known as reorganization) is necessary the individual or organization be insolvent in
effected through Chapter 11 or Chapter 13 of the law and order to file a voluntary case. Creditors may also file a
in essence provides that creditors' claims are satisfied not petition, in which case the proceeding is know as an
via liquidation of the obligor's assets but rather from future involuntary bankruptcy. However, this alternative applies
earnings. That is, debtors are allowed to retain their assets only to Chapter 7 cases and the debtor generally must be
but their obligations are restructured and a plan is insolvent, i.e., unable to pay debts as they mature, in order
implemented whereby creditors may be paid. for an involuntary bankruptcy to be filed.

Chapter 11 bankruptcy is available to all debtors, whether Automatic Stay

individuals, corporations or partnerships. Chapter 13
(sometimes referred to as the "wage earner plan"), on the Filing of the bankruptcy petition requires (with limited
other hand, may be used only by individuals with regular exceptions) creditors to stop or "stay" further action to
incomes and when their unsecured debts are under collect their claims or enforce their liens or judgements.
$100,000 and secured debts less than $350,000. The Actions to accelerate, set off or otherwise collect the debt
aforementioned rehabilitation plan is essentially a contract are prohibited once the petition is filed, as are post-
between the debtor and the creditors. Before the plan may bankruptcy contacts with the obligor. The stay remains in
be confirmed, the bankruptcy court must find it has been effect until the debtor's property is released from the
proposed in good faith and that creditors will receive an estate, the bankruptcy case is dismissed, the debtor obtains
amount at least equal to what would be received in a or is denied a discharge, or the bankruptcy court approves
Chapter 7 proceeding. In Chapter 11 reorganization, all a creditor's request for termination of the stay. Two of the
creditors are entitled to vote on whether or not to accept more important grounds applicable to secured creditors

Loans (8-16) 3.2-64 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

under which they may request termination are as follows: "exception to discharge"). The borrower obviously
(1) The debtor has no equity in the encumbered property, remains liable for all obligations not discharged, and
and the property is not necessary to an effective creditors may pursue customary collection procedures with
rehabilitation plan; or (2) The creditor's interest in the respect thereto. Grounds for an "objection to discharge"
secured property is not adequately protected. In the latter include the following actions or inactions by the bankrupt
case, the law provides three methods by which the debtor (this is not an all-inclusive list): fraudulent
creditor's interests may be adequately protected: the conveyance within 12 months of filing the petition;
creditor may receive periodic payments equal to the unjustifiable failure to keep or preserve financial records;
decrease in value of the creditor's interest in the collateral; false oath or account or presentation of a false claim in the
an additional or substitute lien on other property may be bankruptcy case and estate, respectively; withholding of
obtained; or some other protection is arranged (e.g., a books or records from the trustee; failure to satisfactorily
guarantee by a third party) to adequately safeguard the explain any loss or deficiency of assets; refusal to testify
creditor's interests. If these alternatives result in the when legally required to do so; and receiving a discharge
secured creditor being adequately protected, relief from in bankruptcy within the last six full years. Some of the
the automatic stay will not be granted. If relief from the bases upon which creditors may file "exceptions to
stay is obtained, creditors may continue to press their discharge" are: nonpayment of income taxes for the three
claims upon the bankrupt's property free from interference years preceding the bankruptcy; money, property or
by the debtor or the bankruptcy court. services obtained through fraud, false pretenses or false
representation; debts not scheduled on the bankruptcy
Property of the Estate petition and which the creditor had no notice; alimony or
child support payments (this exception may be asserted
When a borrower files a bankruptcy petition, an "estate" is only by the debtor's spouse or children, property
created and, under Chapter 7 of the law, the property of settlements are dischargeable); and submission of false or
the estate is passed to the trustee for distribution to the incomplete financial statements. If a bank attempts to seek
creditors. Certain of the debtor's property is exempt from an exception on the basis of false financial information, it
distribution under all provisions of the law (not just must prove the written financial statement was materially
Chapter 7), as follows: homeowner's equity up to $7,500; false, it reasonably relied on the statement, and the debtor
automobile equity and household items up to $1,200; intended to deceive the bank. These assertions can be
jewelry up to $500; cash surrender value of life insurance difficult to prove. Discharges are unavailable to
up to $4,000; Social Security benefits (unlimited); and corporations or partnerships. Therefore, after a
miscellaneous items up to $400 plus any unused portion of bankruptcy, corporations and partnerships often dissolve
the homeowner's equity. The bankruptcy code recognizes or become defunct.
a greater amount of exemptions may be available under
State law and, if State law is silent or unless it provides to Reaffirmation
the contrary, the debtor is given the option of electing
either the Federal or State exemptions. Examiners should Debtors sometimes promise their creditors after a
note that some liens on exempt property which would bankruptcy discharge that they will repay a discharged
otherwise be enforceable are rendered unenforceable by debt. An example wherein a debtor may be so motivated
the bankruptcy. A secured lender may thus become involves the home mortgage. To keep the home and
unsecured with respect to the exempt property. The basic discourage the mortgagee from foreclosing, a debtor may
rule in these situations is that the debtor can render reaffirm this obligation. This process of reaffirmation is
unenforceable judicial liens on any exempt property and an agreement enforceable through the judicial system. The
security interests that are both nonpurchase money and law sets forth these basic limitations on reaffirmations: the
nonpossessory on certain household goods, tools of the agreement must be signed before the discharge is granted;
trade and health aids. a hearing is held and the bankruptcy judge informs the
borrower there is no requirement to reaffirm; and the
Discharge and Objections to Discharge debtor has the right to rescind the reaffirmation if such
action is taken within 30 days.
The discharge, as mentioned previously, protects the
debtor from further liability on the debts discharged. Classes of Creditors
Sometimes, however, a debtor is not discharged at all (i.e.,
the creditor has successfully obtained an "objection to The first class of creditors is known as priority creditors.
discharge") or is discharged only as regards to a specific As the name implies, these creditors are entitled to receive
creditor(s) and a specific debt(s) (an action known as payment prior to any others. Priority payments include

RMS Manual of Examination Policies 3.2-65 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

administrative expenses of the debtor's estate, unsecured Preference rules also apply to a transfer of a lien to
claims for wages and salaries up to $2,000 per person, secure past debts, if the transfer has all five elements
unsecured claims for employee benefit plans, unsecured set forth under the first point.
claims of individuals up to $900 each for deposits in There are certain situations wherein a debtor has given
conjunction with rental or lease of property, unsecured a preference to a creditor but the trustee is not
claims of governmental units and certain tax liabilities. permitted to invalidate it. A common example
Secured creditors are only secured up to the extent of the concerns floating liens on inventory under the
value of their collateral. They become unsecured in the Uniform Commercial Code. These matters are subject
amount by which collateral is insufficient to satisfy the to complex rules, however, and consultation with the
claim. Unsecured creditors are of course the last class in Regional Office may be advisable when this issue
terms of priority. arises.

Preferences Setoffs
Certain actions taken by a creditor before or during Setoffs occur when a party is both a creditor and a debtor
bankruptcy proceedings may be invalidated by the trustee of another; amounts which a party owes are netted against
if they result in some creditors receiving more than their amounts which are owed to that party. If a bank exercises
share of the debtor's estate. These actions are called its right of setoff properly and before the bankruptcy
"transfers" and fall into two categories. The first involves filing, the action is generally upheld in the bankruptcy
absolute transfers, such as payments received by a proceedings. Setoffs made after the bankruptcy may also
creditor; the trustee may invalidate this action and require be valid but certain requirements must be met of which the
the payment be returned and made the property of the following are especially important: First, the debts must be
bankrupt estate. A transfer of security, such as the between the same parties in the same right and capacity.
granting of a mortgage, may also be invalidated by the For example, it would be improper for the bank to setoff
trustee. Hence, the trustee may require previously the debtor's loan against a checking account of the estate
encumbered property be made unencumbered, in which of the obligor's father, of which the debtor is executor.
case the secured party becomes an unsecured creditor. Second, both the debt and the deposit must precede the
This has obvious implications as regards loan bankruptcy petition filing. Third, the setoff may be
collectability. disallowed if funds were deposited in the bank within 90
days of the bankruptcy filing and for the purpose of
Preferences are a potentially troublesome area for banks creating or increasing the amount to be set off.
and examiners should have an understanding of basic
principles applicable to them. Some of the more important Transfers Not Timely Perfected or Recorded
of these are listed here.
Under most circumstances, a bank which has not recorded
A preference may be invalidated (also known as its mortgage or otherwise fails to perfect its security
"avoided") if it has all of these elements: the transfer interest in a proper timely manner runs great risk of losing
was to or for the benefit of a creditor; the transfer was its security. This is a complex area of the law but
made for or on account of a debt already outstanding; prudence clearly dictates that liens be properly obtained
the transfer has the effect of increasing the amount a and promptly filed so that the possibility of losing the
creditor would receive in Chapter 7 proceedings; the protection provided by collateral is eliminated.
transfer was made within 90 days of the bankruptcy
filing, or within one year if the transfer was to an SYNDICATED LENDING
insider who had reasonable cause to believe the debtor
was insolvent at the time of transfer; and the debtor
was insolvent at the time of the transfer. Under Overview
bankruptcy law, borrowers are presumed insolvent for
90 days prior to filing the bankruptcy petition. Syndicated loans often represent a substantial portion of
Payment to a fully secured creditor is not a preference the commercial and industrial loan portfolios of large
because such a transfer would not have the effect of banks. A syndicated loan involves two or more banks
increasing the amount the creditor would otherwise contracting with a borrower, typically a large or middle
receive in a Chapter 7 proceeding. Payment to a market corporation, to provide funds at specified terms
partially secured creditor does, however, have the under the same credit facility. The average commercial
effect of increasing the creditor's share and is thus syndicated credit is in excess of $100 million. Syndicated
deemed a preference which the trustee may avoid. credits differ from participation loans in that lenders in a

Loans (8-16) 3.2-66 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

syndication participate jointly in the origination process, as A subset of syndicated lending is leveraged lending which
opposed to one originator selling undivided participation refers to borrowers with an excessive level of debt and
interests to third parties. In a syndicated deal, each debt service compared with cash flow. By their very
financial institution receives a pro rata share of the income nature, these instruments are of higher risk.
based on the level of participation in the credit.
Additionally, one or more lenders take on the role of lead Syndication Process
or "agent" (co-agents in the case of more than one) of the
credit and assume responsibility of administering the loan There are four phases in a loan syndication: Pre-Launch,
for the other lenders. The agent may retain varying Launch, Post-Launch, and Post-Closing.
percentages of the credit, which is commonly referred to
as the "hold level." The Pre-Launch Process - During this phase, the
syndicators identify the borrowers needs and perform
The syndicated market formed to meet basic needs of their initial due diligence. Industry information is gathered
lenders and borrowers, specifically: and analyzed, and background checks may be performed.
Potential pricing and structure of the transaction takes
raising large amounts of money, shape. Formal credit write-ups are sent to credit officers
enabling geographic diversification, for review and to senior members of syndication group for
satisfying relationship banking, pricing approval. Competitive bids are sent to the
obtaining working capital quickly and efficiently, borrower. The group then prepares for the launch.
spreading risk for large credits amongst banks, and
gaining attractive pricing advantages. An information memorandum is prepared by the agent.
This memorandum is a formal and confidential document
The syndicated loan market has grown steadily, and that should address all principal credit issues relating to the
growth in recent years has been extraordinary as greater borrower and to the project being financed. It should, at a
market discipline has lead to uniformity in pricing. In minimum, contain an overview of the transaction
recent years syndicated lending has come to resemble a including a term sheet, an overview of the borrowers
capital market, and this trend is expected to continue as business, and quarterly and annual certified financial
secondary market liquidity for these products continues to statements. This documents acts as both the marketing
grow. The volume of syndicated credits is currently tool and as the source of information for the syndication.
measured in trillions of dollars, and growth is expected to
continue as pricing structures continue to appeal to lenders The Launch Phase - The transaction is launched into the
or "investors. market when banks are sent the information memoranda
mentioned above. Legal counsel commences to prepare
In times of excess liquidity in the marketplace, spreads the documentation. Negotiations take place between the
typically are quite narrow for investment-grade facilities, banks and the borrower over pricing, collateral, covenants,
thus making it a borrowers market. This may be and other terms. Often there is a bank meeting so
accompanied by an easing of the structuring and potential participants can discuss the companys business
covenants. In spite of tightening margins, commercial and industry both with the lead agent and with the
banks are motivated to compete regarding pricing in order company.
to retain other business.
Post-Launch Phase - Typically there is a two-week
Relaxing covenants and pricing may result in lenders period for potential participants to evaluate the transaction
relying heavily on market valuations, or so-called and to decide whether or not to participate in the
"enterprise values" in arriving at credit decisions. These syndication. During this period, banks do their due
values are derived by applying a multiple to cash flow, diligence and credit approval. Often this entails running
which differs, by industry and other factors, to historical or projection models, including stress tests, doing business
projected cash flows of the borrower. This value and industry research; and presenting the transaction for
represents the intangible business value of a company as a the approval process once the decision is made to commit
going concern, which often exceeds its underlying assets. to the transaction.

Many deals involve merger and acquisition financing. After the commitment due date, participating banks
While the primary originators of the syndicated loans are receive a draft credit agreement for their comments.
commercial banks, most of the volume is sold and held by Depending upon the complexity of the agreement, they
other investors. usually have about a week to make comments. The final
credit agreement is then negotiated based on the comments

RMS Manual of Examination Policies 3.2-67 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

and the loan would then close two to five days after the measure cash flow adequacy include EBITDA divided by
credit agreement is finalized. total debt and EBITDA divided by interest expense.

Post-Closing Phase - Post-Closing, there should be Non-financial covenants may include restrictions on other
ongoing dialogue with the borrower about matters such as management changes, provisions of
financial/operating performance as well as quarterly credit information, guarantees, disposal of assets, etc.
agreement covenant compliance checks. Annually, a full
credit analysis should be done as well as annual meetings Credit Ratings
of the participants for updates on financial and operating
performance. Both the agent bank and the participants Over the past several years, large credit rating agencies
need to assess the loan protection level by analyzing the have entered the syndicated loan market (Standard and
business risk as well as the financial risk. Each industry Poors, Moody, Fitch Investor Services). Loan ratings
has particular dominant risks that must be assessed. differ from bond ratings in that bond ratings emphasize the
probability of default of the bond; whereas loan ratings
Loan Covenants emphasize the probability of default as well as the
likelihood of collection upon default. Loan ratings
Loan covenants are special or particular conditions that are emphasize the loans structural characteristics (covenants,
included in a loan agreement and that the borrower is cash flow, collateral, etc.) and the expected loss on the
required to fulfill in order for the loan agreement to remain loan.
valid. Typically, covenants cover several domains but can
broadly be divided into financial and non-financial Overview of the Shared National Credit
categories. The former refers to respecting certain (SNC) Program
financial conditions that can be defined either in absolute
amounts or ratios. Some examples are: The Shared National Credit (SNC) Program is an
interagency initiative administered jointly by the FDIC,
Net worth test: restricts the total amount of debt a Federal Reserve Board, and the Office of the Comptroller
borrower can incur, expressed as a percentage of net of the Currency. The program was established in the
worth. 1970's for the purpose of ensuring consistency among the
three Federal banking regulators in the classification of
Current ratio/ Quick Ratio tests: measures liquidity. large syndicated credits.
Interest, Debt service or Fixed Charges Coverage test: Each SNC is reviewed annually at its agent bank or a
assure that some level of cash flow is generated by a designated review bank and the quality rating assigned by
company above its operating expenses and other fixed examiners is reported to all participating banks. These
obligations. ratings are subsequently used during all examinations of
participating banks, thus avoiding duplicate reviews of the
Profitability test: Particularly important for the nonrated same loan and ensuring consistent treatment with regard to
company; some usual ratios include EBITDA (earnings regulatory credit ratings. Examiners should not change
before interest, taxes, depreciation, and amortization) SNC ratings during risk management examinations. Any
divided by average capital, operating income as a material change in a SNC should be reported to the
percentage of sales and earnings on business segment appropriate regional SNC coordinator so that a
assets. determination can be made as to the appropriate action,
including inclusion in the credit re-review process.
Capital expenditure limitations: Should be set according to Definition of a SNC
the companys business plan and then measured
accordingly. Any loan and/or formal loan commitment, including any
asset such as other real estate, stocks, notes, bonds and
Borrowing Base Limitations: Ascertain that companies are debentures taken for debts previously contracted, extended
not borrowing to overinvest in inventory and provide a to a borrower by a supervised institution, its subsidiaries,
first line of fallback for the lenders if a credit begins to and affiliates which in original amount aggregates $20
deteriorate. million or more and, which is shared by three or more
unaffiliated institutions under a formal lending agreement;
Cash Flow volatility: Actual leverage covenant levels vary or, a portion of which is sold to two or more unaffiliated
by industry segment. Typical ratios that are used to

Loans (8-16) 3.2-68 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

institutions, with the purchasing institution(s) assuming its lead management fees paid in recognition of the lead
pro rata share of the credit risk. managers organization; management fees usually
divided equally between the management group and is
SNC's Include: payable regardless of drawdown; underwriting fees a
percentage of the sum being underwritten; participation
All international credits to borrowers in the private fees expressed as a percentage of each banks
sector, regardless of currency denomination, which participation in the loan; and agency fees levied on most
are administered by a domestic office. loans and provide for the appointment of one or more
Assets taken for debts previously contracted such as agent banks. The fee may be a percentage of the whole
other real estate, stocks, notes, bonds, and debentures. facility or a pre-arranged fixed sum.
Credits or credit commitments which have been
reduced to less than $20 million and were classified or LIBOR London Interbank Offered Rate The interest
criticized during the previous SNC review, provided rate at which major international banks in London lend to
they have not been reduced below $10 million. each other and the rate(s) frequently underlying loan
Any other large credit(s) designated by the interest calculations. LIBOR will vary according to
supervisory agencies as meeting the general intent or market conditions and will of course depend upon the loan
purpose of the SNC program. period as well as the currency in question.
Two or more credits to the same borrower that
aggregate $20 million and each credit has the same Participating Banks a bank that has lent a portion of the
participating lenders outstanding amount to the borrower.

SNCs Do Not Include: Reference Bank A bank that sets the lending rate
(LIBOR) at the moment of each loan rollover period
Credits shared solely between affiliated supervised
institutions. Tranche In a large syndicated loan, different portions of
Private sector credits that are 100 percent guaranteed the facility may be made available at different time
by a sovereign entity. periods, and in different currencies. These separate
components are known as tranches of the facility.
International credits or commitments administered in a
foreign office.
Underwriter - A bank that guarantees the lending of the
Direct credits to sovereign borrowers.
funds to the borrower irrespective of successful
Credits known as "club credits", which include related
syndication or not.
borrowings but are not extended under the same
lending agreement.
Zeta score - There are models which predict bankruptcy
Credits with different maturity dates for different based on the analysis of certain financial ratios. Edward
lenders. Altman of New York University developed a model in
1968 which is used by the regulatory agencies called Zeta.
For additional information regarding the SNC Program The Zeta score methodology is intended to forecast the
examiners can contact the regional SNC coordinator. probability of a company entering bankruptcy within a
twelve month period. It uses five financial ratios from
Glossary of Syndicated Lending Terms reported accounting information to produce an objective
measure of financial strength of a company. The ratios
Agent Entity that assumes the lead role in originating and included in the measurement are: working capital/total
administering the credit facility. assets; retained earnings/total assets; earnings before
interest and taxes/total assets; market value of common
Arranging Banks The banks that arrange a financing on and preferred equity/total liabilities (in non-public
behalf of a corporate borrower. Usually the banks commit organizations, the book value of common and preferred
to underwriting the whole amount only if they are unable equity should be substituted); and sales/total assets (for
to place the deal fully. Typically, however, they place the non-manufacturing companies, this variable is eliminated).
bulk of the facility and retain a portion on their books. For
their efforts in arranging a deal, these banks collect an
arrangement fee. CREDIT SCORING
Front-end costs Commissions, fees or other payments Automated credit scoring systems allow institutions to
that are taken at the outset of a loan. Some examples are: underwrite and price loans more quickly than was possible

RMS Manual of Examination Policies 3.2-69 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

in the past. This efficiency has enabled some banks to each credit bureau varies, and as a consequence, the
expand their lending into national markets and originate quality of scores varies.
loan volumes once considered infeasible. Scoring also
reduces unit-underwriting costs, while yielding a more As a precaution, institutions that rely on credit bureau
consistent loan portfolio that is easily securitized. These scores should sample and compare credit bureau reports to
benefits have been the primary motivation for the determine which credit bureau most effectively captures
proliferation of credit scoring systems among both large data for the market(s) in which the institution does
and small institutions. business. For institutions that acquire credit from multiple
regions, use of multiple scorecards may be appropriate,
Credit scoring systems identify specific characteristics that depending on apparent regional credit bureau strength. In
help define predictive variables for acceptable some instances, it may be worthwhile for institutions to
performance (delinquency, amount owed on accounts, pull scores from each of the major credit bureaus and
length of credit history, home ownership, occupation, establish rules for selecting an average value. By tracking
income, etc.) and assign point values relative to their credit bureau scores over time and capturing performance
overall importance. These values are then totaled to data to differentiate which score seems to best indicate
calculate a credit score, which helps institutions to rank probable performance outcome, institutions can select the
order risk for a given population. Generally, an individual best score for any given market. Efforts to differentiate
with a higher score will perform better relative to an and select the best credit bureau score should be
individual with a lower credit score. documented.

Few, if any, institutions have an automated underwriting Although some institutions develop their own scoring
system where the credit score is used exclusively to make models, most are built by outside vendors and
the credit decision. Some level of human review is usually subsequently maintained by the institution. Vendors build
present to provide the flexibility needed to address scoring models based upon specific information and
individual circumstances. Institutions typically establish a parameters provided by bank management. Therefore,
minimum cut-off score below which applicants are denied management must clearly communicate with the vendor
and a second cutoff score above which applicants are and ensure that the scorecard developer clearly
approved. However, there is usually a range, or gray understands the banks objectives. Bank management
area, in between the two cut-off scores where credits are should also adhere closely to vendor manual specifications
manually reviewed and credit decisions are judgmentally for system maintenance and management, particularly
determined. those that provide guidance for periodically assessing
performance of the system.
Most, if not all, systems also provide for overrides of
established cut-off scores. If the institutions scoring Scoring models generally become less predictive as time
system effectively predicts loss rates and reflects passes. Certain characteristics about an applicant, such as
managements risk parameters, excessive overrides will income, job stability, and age change over time, as do
negate the benefits of an automated scoring system. overall demographics. One-by-one, these changes will
Therefore, it is critical for management to monitor and result in significant shifts in the profile of the population.
control overrides. Institutions should develop acceptable Once a fundamental change in the profile occurs, the
override limits and prepare monthly override reports that model is less able to identify potentially good and bad
provide comparisons over time and against the institutions applicants. As these changes continue, the model loses its
parameters. Override reports should also identify the ability to rank order risk. Thus, institutions must
approving officer and include the reason for the override. periodically validate the systems predictability and refine
scoring characteristics when necessary. These efforts
Although banks often use more than one type of credit should be documented.
scoring methodology in their underwriting and account
management practices, many systems incorporate credit Institutions initially used credit scoring for consumer
bureau scores. Credit bureau scores are updated lending applications such as credit card, auto, and
periodically and validated on an ongoing basis against mortgage lending. However, credit scoring eventually
performance in credit bureau files. Scores are designed to gained acceptance in the small business sector. Depending
be comparable across the major credit bureaus; however, on the manner in which it is implemented, credit scoring
the ability of any score to estimate performance outcome for small business lending may represent a fundamental
probabilities depends on the quality, quantity, and timely shift in underwriting philosophy if institutions view a
submission of lender data to the various credit bureaus. small business loan as more of a high-end consumer loan
Often, the depth and thoroughness of data available to and, thus, grant credit more on the strength of the

Loans (8-16) 3.2-70 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

principals personal credit history and less on the that employs strong risk management practices to identify,
fundamental strength of the business. While this may be measure, monitor, and control the elevated risks that are
appropriate in some cases, it is important to remember that inherent in this activity. Finally, subprime lenders should
the income from small business remains the primary retain additional capital support consistent with the volume
source of repayment for most loans. Banks that do not and nature of the additional risks assumed. If the risks
analyze business financial statements or periodically associated with this activity are not properly controlled,
review their lines of credit may lose an opportunity for subprime lending may be considered an unsafe and
early detection of credit problems. unsound banking practice.

The effectiveness of any scoring system directly depends The term, subprime, refers to the credit characteristics of
on the policies and procedures established to guide and the borrower at the loans origination, rather than the type
enforce proper use. Policies should include an overview of credit or collateral considerations. Subprime borrowers
of the institutions scoring objectives and operations; the typically have weakened credit histories that may include a
establishment of authorities and responsibilities over combination of payment delinquencies, charge-offs,
scoring systems; the use of a chronology log to track judgments, and bankruptcies. They may also display
internal and external events that affect the scoring system; reduced repayment capacity as measured by credit scores,
the establishment of bank officials responsible for debt-to-income ratios, or other criteria. Generally,
reporting, monitoring, and reviewing overrides; as well as subprime borrowers will display a range of credit risk
the provision of a scoring system maintenance program to characteristics that may include one or more of the
ensure that the system continues to rank risk and to predict following:
default and loss under the original parameters.
Two or more 30-day delinquencies in the last 12
Examiners should refer to the Credit Card Specialty Bank months, or one or more 60-day delinquencies in the
Examination Guidelines and the Credit Card Activities last 24 months;
section of the Examination Modules for additional Judgment, foreclosure, repossession, or charge-off in
guidance on credit scoring systems. the prior 24 months;
Bankruptcy in the last 5 years;
Relatively high default probability as evidenced by,
SUBPRIME LENDING for example, a Fair Isaac and Co. risk score (FICO) of
660 or below (depending on the product/collateral), or
Introduction other bureau or proprietary scores with an equivalent
default probability likelihood; and/or
There is not a universal definition of a subprime loan in Debt service-to-income ratio of 50 percent or greater,
the industry, but subprime lending is generally or otherwise limited ability to cover family living
characterized as a lending program or strategy that targets expenses after deducting total monthly debt-service
borrowers who pose a significantly higher risk of default requirements from monthly income.
than traditional retail banking customers. Institutions
often refer to subprime lending by other names such as the This list is illustrative rather than exhaustive and is not
nonprime, nonconforming, high coupon, or alternative meant to define specific parameters for all subprime
lending market. borrowers. Additionally, this definition may not match all
market or institution-specific subprime definitions, but
Well-managed subprime lending can be a profitable should be viewed as a starting point from which examiners
business line; however, it is a high-risk lending activity. should expand their review of the banks lending program.
Successful subprime lenders carefully control the elevated
credit, operating, compliance, legal, market, and reputation Subprime lenders typically use the criteria above to
risks as well as the higher overhead costs associated with segment prospects into subcategories such as, for example,
more labor-intensive underwriting, servicing, and A-, B, C, and D. However, subprime subcategories can
collections. Subprime lending should only be conducted vary significantly among lenders based on the credit
by institutions that have a clear understanding of the grading criteria. What may be an A grade definition at
business and its inherent risks, and have determined these one institution may be a B grade at another bank, but
risks to be acceptable and controllable given the generally each grade represents a different level of credit
institutions staff, financial condition, size, and level of risk.
capital support. In addition, subprime lending should only
be conducted within a comprehensive lending program While the industry often includes borrowers with limited
or no credit histories in the subprime category, these

RMS Manual of Examination Policies 3.2-71 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

borrowers can represent a substantially different risk activities, and for fully documenting the methodology and
profile than those with a derogatory credit history and are analysis supporting the amount specified.
not inherently considered subprime. Rather, consideration
should be given to underwriting criteria and portfolio Examiners will evaluate the capital adequacy of subprime
performance when determining whether a portfolio of lenders on a case-by-case basis, considering, among other
loans to borrowers with limited credit histories should be factors, the institutions own documented analysis of the
treated as subprime for examination purposes. capital needed to support its subprime lending activities.
Examiners should expect capital levels to be risk sensitive,
Subprime lending typically refers to a lending program that is, allocated capital should reflect the level and
that targets subprime borrowers. Institutions engaging in variability of loss estimates within reasonably conservative
subprime lending generally have knowingly and parameters. Examiners should also expect institutions to
purposefully focused on subprime lending through specify a direct link between the estimated loss rates used
planned business strategies, tailored products, and explicit to determine the required ALLL, and the unexpected loss
borrower targeting. An institutions underwriting estimates used to determine capital.
guidelines and target markets should provide a basis for
determining whether it should be considered a subprime The sophistication of this analysis should be
lender. The average credit risk profile of subprime loan commensurate with the size, concentration level, and
programs will exhibit the credit risk characteristics listed relative risk of the institutions subprime lending activities
above, and will likely display significantly higher and should consider the following elements:
delinquency and/or loss rates than prime portfolios. High
interest rates and fees are a common and relatively easily Portfolio growth rates;
identifiable characteristic of subprime lending. However, Trends in the level and volatility of expected losses;
high interest rates and fees by themselves do not constitute The level of subprime loan losses incurred over one or
subprime lending. more economic downturns, if such data/analyses are
available;
Subprime lending does not include traditional consumer The impact of planned underwriting or marketing
lending that has historically been the mainstay of changes on the credit characteristics of the portfolio,
community banking, nor does it include making loans to including the relative levels of risk of default, loss in
subprime borrowers as discretionary exceptions to the the event of default, and the level of classified assets;
institutions prime retail lending policy. In addition, Any deterioration in the average credit quality over
subprime lending does not refer to: prime loans that time due to adverse selection or retention;
develop credit problems after acquisition; loans initially The amount, quality, and liquidity of collateral
extended in subprime programs that are later upgraded, as securing the individual loans;
a result of their performance, to programs targeted to Any asset, income, or funding source concentrations;
prime borrowers; or community development loans as
The degree of concentration of subprime credits;
defined in the CRA regulations.
The extent to which current capitalization consists of
residual assets or other potentially volatile
For supervisory purposes, a subprime lender is defined as
components;
an insured institution or institution subsidiary that has a
subprime lending program with an aggregate credit The degree of legal and/or reputation risk associated
exposure greater than or equal to 25 percent of Tier 1 with the subprime business line(s) pursued; and
capital. Aggregate exposure includes principal The amount of capital necessary to support the
outstanding and committed, accrued and unpaid interest, institutions other risks and activities.
and any retained residual assets relating to securitized
subprime loans. Given the higher risk inherent in subprime lending
programs, examiners should reasonably expect, as a
starting point, that an institution would hold capital against
Capitalization such portfolios in an amount that is one and one half to
three times greater than what is appropriate for non-
The FDICs minimum capital requirements generally
subprime assets of a similar type. Refinements should
apply to portfolios that exhibit substantially lower risk
depend on the factors analyzed above, with particular
profiles than exist in subprime loan programs. Therefore,
emphasis on the trends in the level and volatility of loss
these requirements may not be sufficient to reflect the risks
rates, and the amount, quality, and liquidity of collateral
associated with subprime portfolios. Each subprime
securing the loans. Institutions with subprime programs
lender is responsible for quantifying the amount of capital
affected by this guidance should have capital ratios that are
needed to offset the additional risk in subprime lending

Loans (8-16) 3.2-72 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

well above the averages for their traditional peer groups or Any models are subject to a comprehensive validation
other similarly situated institutions that are not engaged in process.
subprime lending.
The results of the stress test exercises should be a
Some subprime asset pools warrant increased supervisory documented factor in the analysis and determination of
scrutiny and monitoring, but not necessarily additional capital adequacy for the subprime portfolios.
capital. For example, well-secured loans to borrowers
who are slightly below what is considered prime quality Institutions that engage in subprime lending without
may entail minimal additional risks compared to prime adequate procedures to estimate and document the level of
loans, and may not require additional capital if adequate capital necessary to support their activities should be
controls are in place to address the additional risks. On the criticized. Where capital is deemed inadequate to support
other hand, institutions that underwrite higher-risk the risk in subprime lending activities, examiners should
subprime pools, such as unsecured loans or high loan-to- consult with their Regional Office to determine the
value second mortgages, may need significantly higher appropriate course of action.
levels of capital, perhaps as high as 100% of the loans
outstanding depending on the level and volatility of risk. Risk Management
Because of the higher inherent risk levels and the
increased impact that subprime portfolios may have on an
The following items are essential components of a risk
institutions overall capital, examiners should document
management program for subprime lenders.
and reference each institutions subprime capital
evaluation in their comments and conclusions regarding
Planning and Strategy. Prior to engaging in subprime
capital adequacy.
lending, the board and management should ensure that
proposed activities are consistent with the institution's
Stress Testing overall business strategy and risk tolerances, and that all
involved parties have properly acknowledged and
An institutions capital adequacy analysis should include addressed critical business risk issues. These issues
stress testing as a tool for estimating unexpected losses in include the costs associated with attracting and retaining
its subprime lending pools. Institutions should project the qualified personnel, investments in the technology
performance of their subprime loan pools under necessary to manage a more complex portfolio, a clear
conservative stress test scenarios, including an estimation solicitation and origination strategy that allows for after-
of the portfolios susceptibility to deteriorating economic, the-fact assessment of underwriting performance, and the
market, and business conditions. Portfolio stress testing establishment of appropriate feedback and control systems.
should include shock testing of basic assumptions such The risk assessment process should extend beyond credit
as delinquency rates, loss rates, and recovery rates on risk and appropriately incorporate operating, compliance,
collateral. It should also consider other potentially adverse market, liquidity, reputation and legal risks.
scenarios, such as: changing attrition or prepayment rates;
changing utilization rates for revolving products; changes Institutions establishing a subprime lending program
in credit score distribution; and changes in the capital should proceed slowly and cautiously into this activity to
markets demand for whole loans, or asset-backed minimize the impact of unforeseen personnel, technology,
securities supported by subprime loans. or internal control problems and to determine if favorable
initial profitability estimates are realistic and sustainable.
These are representative examples. Actual factors will Strategic plan performance analysis should be conducted
vary by product, market segment, and the size and frequently in order to detect adverse trends or
complexity of the portfolio relative to the institutions circumstances and take appropriate action in a timely
overall operations. Whether stress tests are performed manner.
manually, or through automated modeling techniques, the
Regulatory Agencies will expect that: Management and Staff. Prior to engaging in subprime
lending, the board should ensure that management and
The process is clearly documented, rational, and easily staff possess sufficient expertise to appropriately manage
understood by the board and senior management; the risks in subprime lending and that staffing levels are
The inputs are reliable and relate directly to the adequate for the planned volume of activity. Subprime
subject portfolios; lending requires specialized knowledge and skills that
Assumptions are well documented and conservative; many financial institutions do not possess. Marketing,
and account origination, and collections strategies and

RMS Manual of Examination Policies 3.2-73 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

techniques often differ from those employed for prime

credit; thus it is generally not sufficient to have the same Given the higher credit risk associated with the subprime
staff responsible for both subprime and prime loans. borrower, effective subprime lenders use mitigating
Servicing and collecting subprime loans can be very labor underwriting guidelines and risk-based pricing to reduce
intensive and requires a greater volume of staff with the overall risk of the loan. These guidelines include
smaller caseloads. Lenders should monitor staffing levels, lower loan-to-value ratio requirements and lower
staff experience, and the need for additional training as maximum loan amounts relative to each risk grade within
performance is assessed over time. Compensation the portfolio. Given the high-risk nature of subprime
programs should not depend primarily on volume or lending, the need for thorough analysis and documentation
growth targets. Any targets used should be weighted is heightened relative to prime lending. Compromises in
towards factors such as portfolio quality and risk-adjusted analysis or documentation can substantially increase the
profitability. risk and severity of loss. In addition, subprime lenders
should develop criteria for limiting the risk profile of
Lending Policies and Procedures. Lenders should have borrowers selected, giving consideration to factors such as
comprehensive written policies and procedures, specific to the frequency, recency, and severity of delinquencies and
each subprime lending product, that set limits on the derogatory items; length of time with re-established credit;
amount of risk that will be assumed and address how the and reason for the poor credit history.
institution will control portfolio quality and avoid
excessive exposure. Policies and procedures should be in While the past credit deficiencies of subprime borrowers
place before initiating the activity. Institutions may reflect a higher risk profile, subprime loan programs must
originate subprime loans through a variety of channels, be based upon the borrowers current reasonable ability to
including dealers, brokers, correspondents, and marketing repay and a prudent debt amortization schedule. Loan
firms. Regardless of the source, it is critical that repayment should not be based upon foreclosure
underwriting policies and procedures incorporate the risk proceedings or collateral repossession. Institutions must
tolerances established by the board and management and recognize the additional default risks and determine if
explicitly define underwriting criteria and exception these risks are acceptable and controllable without
processes. Subprime lending policies and procedures resorting to foreclosure or repossession that could have
should, at a minimum, address the items outlined in the been predetermined by the loan structure at inception.
loan reference module of the Examination Documentation
Modules for subprime lending. If the institution elects to Profitability and Pricing. A key consideration for
use scoring systems for approvals or pricing, the model lenders in the subprime market is the ability to earn risk-
should be tailored to address the behavioral and credit adjusted yields that appropriately compensate the
characteristics of the subprime population targeted and the institution for the increased risk and costs assumed. The
products offered. It is not acceptable to rely on models institution must have a comprehensive framework for
developed for standard risk borrowers or products. pricing decisions and profitability analysis that considers
Furthermore, the models should be reviewed frequently all costs associated with each subprime product, including
and updated as necessary to ensure assumptions remain origination, administrative/servicing, expected charge-offs,
valid. funding, and capital. In addition, the pricing framework
should allow for fluctuations in the economic cycle. Fees
often comprise a significant portion of revenue in
subprime lending. Consideration should be given to the
portion of revenues derived from fees and the extent to
which the fees are a recurring and viable source of
revenue. Profitability projections should be incorporated
into the business plan. Management should track actual
performance against projections regularly and have a
process for addressing variances.

Loan Review and Monitoring. Institutions must have

comprehensive analysis and information systems that
identify, measure, monitor and control the risks associated
with subprime lending. Analysis must promote
understanding of the portfolio and early identification of
adverse quality/performance trends. Systems employed
must posses the level of detail necessary to properly

Loans (8-16) 3.2-74 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

evaluate subprime activity. Recommended portfolio outline whether the bank will finance the sale of the
segmentation and trend analyses are fully discussed in the repossessed collateral, and if so, the limitations that apply.
subprime lending loan reference module of the Banks should track the performance of such loans to
Examination Modules. assess the adequacy of these policies.

Analysis should take into consideration the effects of Compliance and Legal Risks. Subprime lenders
portfolio growth and seasoning, which can mask true generally run a greater risk of incurring legal action given
performance by distorting delinquency and loss ratios. the higher fees, interest rates, and profits; targeting
Vintage, lagged delinquency, and lagged loss analysis customers who have little experience with credit or
methods are sometimes used to account for growth, damaged credit records; and aggressive collection efforts.
seasoning, and changes in underwriting. Analysis should Because the risk is dependent, in part, upon the public
also take into account the effect of cure programs on perception of a lenders practices, the nature of these risks
portfolio performance. Refer to the glossary of the Credit is inherently unpredictable. Institutions that engage in
Card Specialty Bank Examination Guidelines for subprime lending must take special care to avoid violating
definitions of vintage, roll rate, and migration analysis. consumer protection laws. An adequate compliance
management program must identify, monitor and control
Servicing and Collections. Defaults occur sooner and in the consumer protection hazards associated with subprime
greater volume than in prime lending; thus a well- lending. The institution should have a process in place to
developed servicing and collections function is essential handle the potential for heightened legal action. In
for the effective management of subprime lending. Strong addition, management should have a system in place to
procedures and controls are necessary throughout the monitor consumer complaints for recurring issues and
servicing process; however, particular attention is ensure appropriate action is taken to resolve legitimate
warranted in the areas of new loan setup and collections to disputes.
ensure the early intervention necessary to properly manage
higher risk borrowers. Lenders should also have well- Audit. The institutions audit scope should provide for
defined written collection policies and procedures that comprehensive independent reviews of subprime
address default management (e.g., cure programs and activities. Audit procedures should ensure, among other
repossessions), collateral disposition, and strategies to things, that a sufficient volume of accounts is sampled to
minimize delinquencies and losses. This aspect of verify the integrity of the records, particularly with respect
subprime lending is very labor intensive but critical to the to payments processing.
program's success.
Third Parties. Subprime lenders may use third parties for
Cure programs include practices such as loan a number of functions from origination to collections. In
restructuring, re-aging, renewal, extension, or consumer dealing with high credit-risk products, management must
credit counseling. Cure programs should be used only take steps to ensure that exposures from third-party
when the institution has substantiated the customers practices or financial instability are minimized. Proper
renewed willingness and ability to pay. Management due diligence should be performed prior to contracting
should ensure that its cure programs are neither masking with a third party vendor and on an ongoing basis
poor initial credit risk selection nor deferring losses. thereafter. Contracts negotiated should provide the
Effective subprime lenders may use short-term loan institution with the ability to control and monitor third
restructure programs to assist borrowers in bringing loans party activities (e.g. growth restrictions, underwriting
current when warranted, but will often continue to report guidelines, outside audits, etc.) and discontinue
past due status on a contractual basis. Cure programs that relationships that prove detrimental to the institution.
alter the contractual past due status may mask actual
portfolio performance and inhibit the ability of Special care must be taken when purchasing loans from
management to understand and monitor the true credit third party originators. Some originators who sell
quality of the portfolio. subprime loans charge borrowers high up-front fees,
which may be financed into the loan. These fees provide
Repossession and resale programs are integral to the incentive for originators to produce a high volume of loans
subprime business model. Policies and procedures for with little emphasis on quality, to the detriment of a
foreclosure and repossession activities should specifically potential purchaser. These fees also increase the
address the types of cost/benefit analysis to be performed likelihood that the originator will attempt to refinance the
before pursuing collateral, including valuation methods loans. Contracts should restrict the originator from the
employed; timing of foreclosure or repossession; and churning of customers. Further, subprime loans,
accounting and legal requirements. Policies should clearly especially those purchased from outside the institution's

RMS Manual of Examination Policies 3.2-75 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

lending area, are at special risk for fraud or deficient. Given the high-risk nature of subprime
misrepresentation. Management must also ensure that portfolios and their greater potential for loan losses, the
third party conflicts of interest are avoided. For example, delinquency thresholds for classification set forth in the
if a loan originator provides recourse for poorly Retail Classification Policy should be considered
performing loans purchased by the institution, the minimums. Well-managed subprime lenders should
originator or related interest thereof should not also be recognize the heightened risk-of-loss characteristics in
responsible for processing and determining the past due their portfolios and, if warranted, internally classify their
status of the loans. delinquent accounts well before the timeframes outlined in
the interagency policy. If examination classifications are
Securitizations. Securitizing subprime loans carries more severe than the Retail Classification Policy suggests,
inherent risks, including interim credit, liquidity, interest the examination report should explain the weaknesses in
rate, and reputation risk, that are potentially greater than the portfolio and fully document the methodology used to
those for securitizing prime loans. The subprime loan determine adverse classifications.
secondary market can be volatile, resulting in significant
liquidity risk when originating a large volume of loans ALLL Analysis
intended for securitization and sale. Investors can quickly
lose their appetite for risk in an economic downturn or The institutions documented ALLL analysis should
when financial markets become volatile. As a result, identify subprime loans as a specific risk exposure
institutions may be forced to sell loan pools at deep separate from the prime portfolio. In addition, the analysis
discounts. If an institution lacks adequate personnel, risk should segment the subprime lending portfolios by risk
management procedures, or capital support to hold exposure such as specific product, vintage, origination
subprime loans originally intended for sale, these loans channel, risk grade, loan to value ratio, or other grouping
may strain an institution's liquidity, asset quality, earnings, deemed relevant.
and capital. Consequently, institutions actively involved
in the securitization and sale of subprime loans should Pools of adversely classified subprime loans (to include, at
develop a contingency plan that addresses back-up a minimum, all loans past due 90 days or more) should be
purchasers of the securities, whole loans, or the attendant reviewed for impairment, and an adequate allowance
servicing functions, alternate funding sources, and should be established consistent with existing interagency
measures for raising additional capital. An institutions policy. For subprime loans that are not adversely
liquidity and funding structure should not be overly classified, the ALLL should be sufficient to absorb at least
dependent upon the sale of subprime loans. all estimated credit losses on outstanding balances over the
current operating cycle, typically 12 months. To the extent
Given some of the unique characteristics of subprime that the historical net charge-off rate is used to estimate
lending, accounting for the securitization process requires expected credit losses, it should be adjusted for changes in
assumptions that can be difficult to quantify reliably, and trends, conditions, and other relevant factors, including
erroneous assumptions can lead to the significant business volume, underwriting, risk selection, account
overstatement of an institution's assets. Institutions should management practices, and current economic or business
take a conservative approach when accounting for these conditions that may alter such experience.
transactions and ensure compliance with existing
regulatory guidance. Refer to outstanding memoranda and
examination instructions for further information regarding
securitizations.

Classification
The Uniform Retail Credit Classification and Account
Management Policy (Retail Classification Policy) governs
the evaluation of consumer loans. This policy establishes
general classification thresholds based on delinquency, but
also grants examiners the discretion to classify individual
retail loans that exhibit signs of credit weakness regardless
of delinquency status. An examiner may also classify
retail portfolios, or segments thereof, where underwriting
standards are weak and present unreasonable credit risk,
and may criticize account management practices that are

Loans (8-16) 3.2-76 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

Subprime Auto Lending Sponsored Agencies, Fannie Mae and Freddie Mac,
participate in the subprime mortgage market to a limited
Underwriting. Subprime auto lenders use risk-based degree through purchases of subprime loans and
pricing of loans in addition to more stringent advance guarantees of subprime securitizations.
rates, discounting, and dealer reserves than those typically
used for prime auto loans to mitigate the increased credit Servicing and Collections. Collection calls begin early,
risk. As credit risk increases, advance rates on collateral generally within the first 10 days of delinquency, within
decrease while interest rates, dealer paper discounts, and the framework of existing laws. Lenders generally send
dealer reserves increase. In addition to lower advance written correspondence of intent to foreclosure or initiate
rates, collateral values are typically based on the wholesale other legal action early, often as early as 31 days
value of the car. Lenders will typically treat a new dealer delinquent. The foreclosure process is generally initiated
with greater caution, using higher discounts and/or as soon as allowed by law. Updated collateral valuations
purchasing the dealers higher quality paper until a are typically obtained early in the collections process to
database and working relationship is developed. assist in determining appropriate collection efforts.
Frequent collateral inspections are often used by lenders to
Servicing and Collections. Repossession is quick, monitor the condition of the collateral.
generally ranging between 30 to 60 days past due and
sometimes earlier. The capacity of a repossession and Subprime Credit Card Lending
resale operation operated by a prime lender could easily be
overwhelmed if the lender begins targeting subprime Underwriting. Subprime credit card lenders use risk-
borrowers, leaving the lender unable to dispose of cars based pricing as well as tightly controlled credit limits to
quickly. Resale methods include wholesale auction, retail mitigate the increased credit risk. In addition, lenders may
lot sale, and/or maintaining a database of retail contacts. require full or partial collateral coverage, typically in the
While retail sale will command a greater price, subprime form of a deposit account at the institution, for the higher-
lenders should consider limiting the time allocated to retail risk segments of the subprime market. Initial credit lines
sales before sending cars to auction in order to ensure are set at low levels, such as $300 to $1,000, and
adequate cash flow and avoid excessive inventory build- subsequent line increases are typically smaller than for
up. Refinancing resales should be limited and tightly prime credit card accounts. Increases in credit lines should
controlled, as this practice can mask losses. Lenders be subject to stringent underwriting criteria similar to that
typically implement a system for tracking the location of required at origination.
the collateral.
Underwriting for subprime credit cards is typically based
Subprime Residential Real Estate Lending upon credit scores generated by sophisticated scoring
models. These scoring models use a substantial number of
Underwriting. To mitigate the increased risk, subprime attributes, including the frequency, severity, and recency
residential real estate lenders use risk-based pricing in of previous delinquencies and major derogatory items, to
addition to more conservative LTV ratio requirements and determine the probability of loss for a potential borrower.
cash-out restrictions than those typically used for prime Subprime lenders typically target particular subprime
mortgage loans. As the credit risk of the borrower populations through prescreening models, such as
increases, the interest rate increases and the loan-to-value individuals who have recently emerged from bankruptcy.
ratio and cash-out limit decreases. Prudent loan-to-value Review of the attributes in these models often reveals the
ratios are an essential risk mitigant in subprime real estate nature of the institutions target population.
lending and generally range anywhere from 85 percent to
90 percent for A- loans, to 65 percent for lower grades. Servicing and Collections. Lenders continually monitor
High loan-to-value (HLTV) loans are generally not customer behavior and credit quality and take proactive
considered prudent in subprime lending. HLTV loans measures to avert potential problems, such as decreasing
should be targeted at individuals who warrant large or freezing credit lines or providing consumer counseling,
unsecured debt, and then only in accordance with before the problems become severe or in some instances
outstanding regulatory guidance. The appraisal process before the loans become delinquent. Lenders often use
takes on increased importance given the greater emphasis sophisticated scoring systems to assist in monitoring credit
on collateral. Prepayment penalties are sometimes used on quality and frequently re-score customers. Collection calls
subprime real estate loans, where allowed by law, given on delinquent loans begin early, generally within the first
that prepayment rates are generally higher and more 10 days delinquent, and sometimes as early as 1-day
volatile for subprime real estate loans. Government delinquent, within the framework of existing laws.
Lenders generally send written correspondence within the

RMS Manual of Examination Policies 3.2-77 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

first 30 days in addition to calling. Account suspensions upon refinancing; they may merely require a current pay
occur early, generally within the first 45 days of stub or proof of a regular income source and evidence that
delinquency or immediately upon a negative event such as the customer has a checking account. Other payday
refusal to pay. Accounts over 90 days past due are lenders use scoring models and consult nationwide
generally subject to account closure and charge-off. In databases that track bounced checks and persons with
addition, account closures based upon a borrowers action, outstanding payday loans. However, payday lenders
such as repeated refusal to pay or broken promises to bring typically do not obtain or analyze information regarding
the account current within a specified time frame, may the borrowers total level of indebtedness or information
occur at any time in the collection process. Account from the major national credit bureaus. The combination
closure practices are generally more aggressive for of the borrowers limited financial capacity, the unsecured
relatively new credit card accounts, such as those nature of the credit, and the limited underwriting analysis
originated in the last six months. of the borrowers ability to repay pose substantial credit
risk for insured depository institutions.
Payday Lending
Legal and Reputation Risk. Federal law authorizes
Payday lending is a particular type of subprime lending. Federal and state-chartered insured depository institutions
Payday loans (also known as deferred deposit advances) making loans to out-of-state borrowers to export
are small dollar, short-term, unsecured loans that favorable interest rates provided under the laws of the
borrowers promise to repay out of their next paycheck or State where the bank is located. That is, a state-chartered
regular income payment (such as social security check). bank is allowed to charge interest on loans to out-of-state
Payday loans are usually priced at a fixed dollar fee, which borrowers at rates authorized by the State where the bank
represents the finance charge. Because these loans have is located, regardless of usury limitations imposed by the
such short terms to maturity, the cost of borrowing, State laws of the borrowers residence. Nevertheless,
expressed as an annual percentage rate is very high. institutions face increased reputation risk when they enter
into certain arrangements with payday lenders, including
In return for the loan, the borrower usually provides the arrangements to originate loans on terms that could not be
lender with a check or debit authorization for the amount offered directly by the payday lender.
of the loan plus the fee. The check is either post-dated to
the borrowers next payday or the lender agrees to defer Transaction Risk. Payday loans are a form of specialized
presenting the check for payment until a future date, lending not typically found in state nonmember
usually two weeks or less. When the loan is due, the institutions, and are most frequently originated by
lender expects to collect the loan by depositing the check specialized nonbank firms subject to State regulation.
or debiting the borrowers account or by having the Payday loans can be subject to high levels of transaction
borrower redeem the check with a cash payment. If the risk given the large volume of loans, the handling of
borrower informs the lender that he or she does not have documents, and the movement of loan funds between the
the funds to repay the loan, the loan is often refinanced institution and any third party originators. Because payday
(payday lenders may use the terms rollover, same day loans may be underwritten off-site, there also is the risk
advance, or consecutive advance) through payment of that agents or employees may misrepresent information
an additional finance charge. If the borrower does not about the loans or increase credit risk by failing to adhere
redeem the check in cash and the loan is not refinanced, to established underwriting guidelines.
the lender normally puts the check or debit authorization
through the payment system. If the borrowers deposit Third-Party Risk. Insured depository institutions may
account has insufficient funds, the borrower typically have payday lending programs that they administer
incurs a NSF charge on this account. If the check or the directly, using their own employees, or they may enter into
debit is returned to the lender unpaid, the lender also may arrangements with third parties. In the latter
impose a returned item fee plus collection charges on the arrangements, the institution typically enters into an
loan. agreement in which the institution funds payday loans
originated through the third party. These arrangements
Significant Risks also may involve the sale to the third party of the loans or
servicing rights to the loans. Institutions also may rely on
Credit Risk. Borrowers who obtain payday loans the third party to provide additional services that the bank
generally have cash flow difficulties and few, if any, would normally provide, including collections, advertising
lower-cost borrowing alternatives. In addition, some and soliciting applications. The existence of third party
payday lenders perform minimal analysis of the arrangements may, when not properly managed,
borrowers ability to repay either at the loans inception or

Loans (8-16) 3.2-78 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation
LOANS Section 3.2

significantly increase institutions transaction, legal, and raising additional capital, or submitting a plan to achieve
reputation risks. compliance.

Arrangements with third parties should be guided by Capital Adequacy

written contract and approved by the institutions board.
At a minimum, the arrangement should: Payday lending is among the highest risk subsets of
subprime lending, and significantly higher levels of capital
Describe the duties and responsibilities of each party, than the starting point for subprime loans - one and a half
including the scope of the arrangement; to three times what is appropriate for nonsubprime assets
Specify that the third party will comply with all of a similar type - should be required. Institutions that
applicable laws and regulations; underwrite payday loans may be required to maintain as
Specify which party will provide consumer high as one hundred percent of the loans outstanding
compliance related disclosures; (dollar-for-dollar capital), depending on the level and
Authorize the institution to monitor the third party and volatility of risk. Risks to consider when determining
periodically review and verify that the third party and capital requirements include the unsecured nature of the
its representatives are complying with its agreement credit, the relative levels of risk of default, loss in the
with the institution; event of default, and the level of classified assets. The
Authorize the institution and the appropriate banking degree of legal or reputation risk associated with payday
agency to have access to such records of the third lending should also be considered, especially as it relates
party and conduct onsite transaction testing and to third party agreements.
operational reviews at the third party locations as
necessary or appropriate to evaluate such compliance; Allowance for Loan and Lease Losses
Require the third party to indemnify the institution for
potential liability resulting from action of the third Institutions should maintain an ALLL that is adequate to
party with regard to the payday lending program; and absorb estimated credit losses with the payday portfolio.
Address customer complaints, including any Although the contractual term of each payday loan may be
responsibility for third-party forwarding and short, institutions methodologies for estimating credit
responding to such complaints. losses on these loans should take into account the fact that
many payday loans remain continuously outstanding for
Bank management should sufficiently monitor the third longer periods because of renewals and rollovers. In
party with respect to its activities and performance. addition, institutions should evaluate the collectibility of
Management should dedicate sufficient staff with the accrued fees and finance charges on payday loans and
necessary expertise to oversee the third party. The banks employ appropriate methods to ensure that income is
oversight program should monitor the third partys accurately measured.
financial condition, its controls, and the quality of its
service and support, including its resolution of consumer Classifications
complaints if handled by the third party. Oversight
programs should be documented sufficiently to facilitate The Retail Classification Policy establishes general
the monitoring and management of the risks associated classification thresholds for consumer loans based on
with third-party relationships. delinquency, but also grants examiners the discretion to
classify individual retail loans that exhibit signs of credit
Concentrations weakness regardless of delinquency status. Examiners
also may classify retail portfolios, or segments thereof,
Given the risk inherent in payday lending, concentrations where underwriting standards are weak and present
of credit in this line of business pose a significant safety unreasonable credit risk, and may criticize account
and soundness concern. In the context payday lending, a management practices that are deficient.
concentration would be defined as a volume of payday
loans totaling 25 percent or more of a banks Tier 1 Most payday loans have well-defined weaknesses that
capital. Where concentrations of payday lending are jeopardize the liquidation of the debt. Weaknesses include
noted, bank management should be criticized for a failure limited or no analysis of repayment capacity and the
to diversify risks. Appropriate supervisory action may be unsecured nature of the credit. In addition, payday loan
necessary to address concentrations, including directing portfolios are characterized by a marked proportion of
the institution to reduce its loans to an appropriate level, obligors whose paying capacity is questionable. As a
result of these weaknesses, payday loan portfolios should
be classified Substandard.

RMS Manual of Examination Policies 3.2-79 Loans (8-16)

Federal Deposit Insurance Corporation
LOANS Section 3.2

Establish the maximum number of loans per customer

Furthermore, payday loans that have been outstanding for that are allowed within one calendar year or other
extended periods of time evidence a high risk of loss. designated time period; and
While such loans may have some recovery value, it is not Provide that no more than one payday loan is
practical or desirable to defer writing off these essentially outstanding with the bank at a time to any one
worthless assets. Payday loans that are outstanding for borrower.
greater than 60 days from origination generally meet the
definition of Loss. In certain circumstances, earlier Accrued Fees and Finance Charges
charge-off may be appropriate (i.e., the bank does not
renew beyond the first payday and the borrower is unable Institutions should evaluate the collectibility of accrued
to pay, the bank closes an account, etc.). The institutions fees and finance charges on payday loans because a
policies regarding consecutive advances also should be portion of accrued interest and fees is generally not
considered when determining Loss classifications. Where collectible. Although regulatory reporting instructions do
the economic substance of consecutive advances is not require payday loans to be placed on nonaccrual based
substantially similar to rollovers without appropriate on delinquency status, institutions should employ
cooling off or waiting periods examiners should treat appropriate methods to ensure that income is accurately
these loans as continuous advances and classify measured. Such methods may include providing loss
accordingly. allowances for uncollectible fees and finance charges or
placing delinquent and impaired receivables on nonaccrual
When classifying payday loans, examiners should status. After a loan is placed on nonaccrual status,
reference the Retail Classification Policy as the source subsequent fees and finance charges imposed on the
document. Examiners would normally not classify loans borrower would not be recognized in income and accrued,
for which the institution has documented adequate paying but unpaid fees and finance charges normally would be
capacity of the obligors and/or sufficient collateral reversed from income.
protection or credit enhancement.

Renewals/Rewrites

The Retail Classification Policy establishes guidelines for

extensions, deferrals, renewals, or rewrites of closed-end
accounts. Despite the short-term nature of payday loans,
borrowers that request an extension, deferral, renewal, or
rewrite should exhibit a renewed willingness and ability to
repay the loan. Examiners should ensure that institutions
adopt and adhere to the Retail Classification Policy
standards that control the use of extensions, deferrals,
renewals, or rewrites of payday loans. Under the Retail
Classification Policy, institutions standards should:

Limit the number and frequency of extensions,

deferrals, renewals, and rewrites;
Prohibit additional advances to finance unpaid interest
and fees and simultaneous loans to the same customer;
and
Ensure that comprehensive and effective risk
management, reporting, and internal controls are
established and maintained.

In addition to the above items, institutions also should:

Establish appropriate cooling off or waiting periods

between the time a payday loan is repaid and another
application is made:

Loans (8-16) 3.2-80 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation