Pub. 4 2015 Issue 1

The CommunityBanker 12 here’s no doubt that the loans your bank made in the post-recession years are going to change down the road, when interest rates rise and the economy swings yet again. But will your loan review process spot that shift in time? Odds are it won’t. And that will cause big trouble when it comes to a bank’s strategic and capital planning. Any bank that relies solely on their existing loan classification system (whether supported or not with a loan review process) will end up with unanticipated losses and charge-offs. Regulators who have had the benefit of seeing the impact of the 2008 recession across the entire banking land- scape have recognized this limitation. They no longer look at historical performance to assess how your bank will fare in the future. Instead, they now want to see how your capital will perform under a two-year severe economic downturn. The loans your bank has made will each react differently to such a downturn, depending on loan vintages and their concurrent economic conditions. In essence, capital adequacy ground rules are changing as regulators react to shifts in banking and the economy. While most community banks have worked out of their pre-recession loans, their replacement loans have different risk return trade-offs that will have considerable impact on a bank’s operations, profitability and capital adequacy over the next few years. These changes must be recognized and quantified. Seem- ingly identically classified loans with different vintages will have substantially different probability of default (PD) and loss given default (LGD) levels in the future. Estimating PDs and LGDs is important for a bank for its own internal use, but it is also vital in M&A analysis. M&A is nothing more than a compressed contribution to a bank’s long- term strategic plan. Having the correct assumptions about loan performance becomes even more critical in the evaluation of potential targets. Traditional loan review worked well in a stable environ- ment and was reflected in the regulatory Basel 1 and Basel 2 structures. But after the 2008 recession, it has become more of a checkbox exercise that measures and validates a bank’s inter- nal classification system, based on pre-recession criteria. “In this new world, the value of the loan review process has become fairly limited, not just for regulatory action, but also for helping a bank with its strategic planning,” said Invic- tus Consulting Group Chairman Kamal Mustafa. “The point is that the traditional loan review process that ignores vintage is useless. Two loans within the same classification level but with different vintages would have dramatically different PDs and LGDs. Banks that ignore these issues –and there are many because community banks are not required to stress test T Warning: Traditional Loan Review May Cause Banks Trouble in the Future ByAdam Mustafa and Lisa Getter F E A T U R E