Lending is a risky business. Of course, that’s why you do your best to evaluate applicants to reduce the risks you take on as an institution. Asset quality is one of the most critical factors in determining a bank’s health. The quality of your loan portfolio has a substantial effect on asset quality as loans are ordinarily the largest bank-held asset and carry the greatest amount of potential risk to capital.
Asset quality at the customer level is what we think of as underwriting and ability-to-repay requirements. This is looking at the fundamentals of each credit, including, at a minimum:
- the overall financial condition and resources of the borrower;
- borrower credit history;
- the borrower’s character;
- the purpose of the credit relative to the source of repayment; and
- the types of secondary sources of repayment available, such as guarantor support and the collateral’s value.
When assessing asset quality you’re reviewing the totality of the loan portfolio and other assets and classifying its risk as a whole. When a bank makes a significant number of loans that cannot be repaid, this would expose the bank to higher write-offs and, in turn, erode earnings and capital. Because of the importance of asset quality—especially for a community bank—examiners pay close attention to the distribution, severity, and trend of poor-performing assets. When reviewing asset quality, one of the first considerations will be risk management practices of the bank, including:
- the ability of personnel to monitor, manage and control risks under current and stressed market conditions;
- internal review processes that help catch problems;
- policies, procedures and risk limits that guide lending decisions and are reflective of risk appetite; and
- active monitoring of credit quality accompanied by actions taken to address any weaknesses.
Examiners then test bank processes by reviewing a statistical sample of assets. These reviews are central to any exam, but asset quality ratings also depend on the level of funds from earnings that are redirected to cover potential or known losses on assets, which is now calculated pursuant to the CECL methodology. Without going into detail on CECL, examiners review your processes—making sure they are proportionate to the level of credit risk in the portfolio—and the methodology used to determine them. When loans go bad, the bank forecloses, and any losses are offset by the reserve.
Examiners also consider asset concentration, such as unusually high volumes of lending in commercial real estate. Losses from unexpected changes in economic or geographic conditions are heightened when concentrations exist.
For community banks—where loan portfolios are the primary bank asset—good lending practices are essential but sound asset quality practices ensure community banks remain diligent and protect themselves against market pressures and post-consummation lending issues. Please feel free to reach out to us on the hotline with any additional questions you may have.