Is Loan Quality an Integral Part of Your Lending Process?

Richard L. Sandenaw
December 29, 2008 | COMMENTS

Every credit union has a loan quality assurance program. However, one facet of lending that sometimes gets less attention than it should is loan quality. Loan quality is always assumed in lending discussions, but loan quality may not always be given the same emphasis as loan volume throughout the lending process. In one recent example, a consumer lending manager at a mid-sized credit union was given a goal of growing loan volume. The goal evidently did not include the specific objective of maintaining satisfactory loan quality. Perhaps the CEO in this example expected that quality was inherent in the credit union's lending process. A year and a half later, the credit union had achieved noteworthy loan growth. Indirect auto loan production had grown by over 50 percent in one year. However there was also an increase in the credit union's delinquency statistics and charge-off activity.

The example above is not uncommon. One would expect more loans in need of attention from the collection department with growth in loan volume. There is a correlation. More loans in the portfolio will mean more collection activity. But what if the number of problem loans is statistically higher than it was before? Is it possible that loan quality is an issue? The following is a short list of possible loan quality factors that may lead to collection problems:

• Lending to a larger percentage of high-risk and sub-prime borrowers
• Buying more indirect loans with high loan-to-value ratios and loans with borrowers who have higher debt ratios
• Not using a bankruptcy indicator or otherwise overlooking the borrowers who have significantly increased their unsecured debts
• Dealer misrepresentations about who is the real owner of the vehicle securing the auto loan (i.e. straw purchases)
• Lending employees who have skirted the credit union's underwriting guidelines

The last point above is difficult to imagine. Employees know the credit union's loan policies and lending procedures. Would they skirt those guidelines and make poor-quality loans? If it did happen, how soon would the lending manager know? What if the lending staff incorrectly interpreted a managers' emphasis on loan growth to outweigh the emphasis on loan quality? Does a credit union's loan quality process provide timely information so management can make mid-course corrections in lending procedures, underwriting, and training? Is there a quality control feedback loop in your credit union as a part of the lending process?

Many types of loan quality problems are possible. Most seasoned lending managers have experienced different types of problem loans. Unfortunately the list includes auto loans with factual misrepresentations because of individual lenders who succumbed to loan volume or dealer pressures. This type of problem can begin simply—a dealer representative pressuring a lender to take one more marginal loan in return for all the good ones that have been sent to the credit union. Or, employees at a weekend car sale who get pressed into taking several poor-quality loans as part of the joint dealer-credit union loan promotion. But, the list also includes a few lenders that crossed an ethical line and accepted personal favors from auto dealerships in return for making bad auto-lending decisions.

Loan problems can also be linked to staff incentives. In one credit union, a group of the lending staff got recognized for monthly loan volume. Over time the subtle message to the group was loan volume was more important than loan quality. In that credit union the majority of charged-off loans came from just one consumer lender who had been focused on loan volume for nearly two years. If a CEO is concerned about these possibilities, what can be done to ensure solid loan quality measures are integrated in the lending program?

There is no single answer to that loan quality question. In many ways, it depends. For example, is the credit union doing indirect lending? If so, what are the ways that loan quality problems can creep into the portfolio? In another example, who do the individual lenders report to in the organization and what priorities have they been given? Is there a robust and ongoing lending training program? Do the lenders know that their loans are being monitored? Is there any type of formal feedback to senior management about how well or how poorly individual lenders are doing monthly?

There are several techniques for managing loan quality. And there is plenty of room for customization. However, the best approach is for the chosen steps to be implemented as an ongoing process, and not simply an event. The approach must also be incorporated into the lending process, and administered routinely and timely. The reader might use the following list as a scorecard. If all of these activities are performed regularly, then the credit union lending manager and CEO can slap high-fives. If not, there might be room for improvement.

Loan quality steps and assessment questions:

• Loan policy documentation. The credit union's loan policy should be clear and well understood. Have lending procedures been documented and updated regularly? Are procedures for using the lending system documented and understood?
• Staff training. The lending staff should be trained regularly. Do they understand loan policy, loan procedure, credit reports, underwriting, loan documentation, loan funding, system usage, and loan setup?
• Loan file check-in . The credit union should have a standard in business days following funding by which loan files must be submitted for check-in review. What happens if loan files sit in a lender's desk drawer for several days or weeks in need of one more detail such as the borrower's signature?
• Loan file review. The credit union should have a thorough review of every loan file within one week of funding to ensure all required documents are present in the file and completed. If there are missing documents or unsigned forms, what is done to complete the loan file? Who follows up on loan file completeness and accuracy with each lender?
• Loan quality assurance sampling . The credit union should have an independent quality review of a randomly selected sample of all funded loans, and the sample size should be at least 10 percent to 15 percent. Are other higher-risk loans sampled in addition? Are employee loans reviewed? When the monthly loan reviews are completed, is there a report to the credit union's senior management? Does the report include a summary of loan errors by lender and branch office? Is there a method for tracking trends over time by lender and branch office?
• Collateral tracking. The credit union should routinely track receipt of missing documents, such as auto titles. Is someone checking the setup of loans on the loan servicing system to verify that pledged shares have been frozen? If errors have been made, does the individual lender or loan disburser get involved in the correction process? Has the branch manager been made aware of the types of errors being made by his/her lending staff?
• Loan charge-off report. The credit union should have a report listing each charge-off monthly with enough detail to know who originated each loan and what caused each to go bad. Is each loan reviewed to determine whether the loan would be made again today with the credit union's current underwriting guidelines? If patterns are detected, is someone given the responsibility to follow-up?
• Loan review committee . The credit union should have a monthly meeting to go over the reports generated in steps 3 through 7 above. If not, who knows what needs mid-course correction and who ensures that corrective actions are being taken? If so, are the CEO, lending manager, QC auditor, branch managers, and collections manager all participants in the meeting? Does the collections manager have the ability to speak about current collections problems and possible trends? Does the collections manager have the responsibility to check repossessed loan collateral against the description of the collateral at the time the charged-off loan was originated? For example, does the repossessed vehicle have the sunroof and leather upholstery it did when the loan was made? Are there monthly reports in the meeting packet that track loan quality factors by lender and auto dealer?
• Loan underwriting review. As a part of the committee referenced above, or as a separate step, the credit union should have a formal process for discussing recent loan underwriting decisions in a group setting. Does this step include projecting loan and credit report details on a screen with the CEO, lending manager, QC auditor, branch managers and collections manager present? Does the discussion in the meeting focus on underwriting decisions and whether there is general agreement? Does the discussion allow for differences in judgment? Does the review lead to discussions on the caliber of decisions being made and whether changes should be made to lending training or other aspects of the loan program?
• Loan underwriting authority. The credit union's lending program should include a formal process for changing lending authority levels up and down. Are there a defined number of steps, in addition to time-in-grade that states how a lender will be considered for a higher lending level? Does the program include completing lending courses with knowledge testing? Does it include training time with the QC auditor or in the collections department? Can an individual's lending authority be reduced if his/her loans have a higher number of errors than permitted or if a high number of loans go delinquent?

These loan quality steps and assessment questions may sound imposing to those who have not developed this type of process. In general, many of these steps can be incorporated in the current duties of the quality control auditor and collections manager. For larger organizations, this type of loan quality program may require more resources. In either case, it is the routine implementation of the steps and the regular administration of the process that make it effective. In each of the examples cited above, the credit unions solved their quality problems and subsequently achieved excellent external audits. The process works.

Richard L. Sandenaw is managing partner for Strategic Mark LLC, a business consulting firm specializing in credit unions. Contact him at 915-588-9024 or rsandenaw@strategicmark.org.