Understanding the Problem Loan Process in Banking
Successful discovery and depositions require an understanding of the problem loan process in banking. Once a bank has designated a loan as a problem, it takes on a new set of regulatory and policy requirements. Problem loans are sometimes also designated as "Workout Loans." Virtually all problem loans have an adverse classification per regulatory guidelines. I will explain these adverse classifications as well as other banking terms and procedures associated with problem credits. Understanding these classifications may help in assessing how the bank is monitoring, reviewing, analyzing, collecting the loan, and approaching litigation. All of my discussion will pertain to larger loans of banks and not consumer type credit. Some banks, normally larger banks, transfer problem loans to specialized departments for handling. Typically these are designated with special names such as; "Problem Loan Departments," "Work-out Departments," "Special Assets," or "Credit Services."
Special Mention: Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date.
Substandard Assets: A Substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful Assets: An asset classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weakness make collection or liquidation in full, on the basis of current existing facts, conditions, and values, highly questionable and improbable.
Loss Assets:Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.
Based on the sample numerical system as outlined above, the pass credits and adversely classified loans would be designated as follows:
The risk rating quality of the pass credits usually go from the best; 1 to the higher risk 4, before reaching the regulatory guidelines for problem credits. As an example, a risk rating of 1 might be a savings secured loan or loan of such a high quality that there is virtually no possibility of loss. A risk rating of 4 might be a loan that is on the banks "Watch List," meaning it is being highly monitored, and could become a problem but has not yet been downgraded to Special Mention or worse. Some banks designate a 5 (Special Mention) as their Watch List risk category. Loans are typically risk rated by the loan officer designated to handle the credit but the ratings are verified by the appropriate approving body. This could include an Officer Loan Committee, Chief Credit Officer, Board Loan Committee, or Board of Directors depending on how each bank has authorized loan approval/review authority. When regulators examine the bank's loan portfolios, they check the risk ratings of loans reviewed to make sure the appropriate risk rating has been assigned. At each credit examination by regulators, a random sampling of loans is reviewed, but all existing adversely classified loans are reviewed.
At a minimum, the adversely classified definitions, as outlined above, should appear in the bank's loan policy but may be expanded to include more detail. Such detail might suggest when a loan is to be charged off, placed on nonaccrual, or what corrective action may be required.
Bank Expert Witnesses examine this information to determine the amount of impairment that has been calculated on each loan. This impairment calculation determines the ALLL dollar amount that has been allocated (reserved) on each loan. This information should be helpful in mediation or settlement negotiations.
Once a bank places a loan on nonaccrual, all accrued unpaid interest is reversed from current earnings of the bank. The placing of a loan on nonaccrual has no affect on the balance or accrual of interest that is owed by the customer. Simply stated, the bank discontinues showing any interest income on its income statement until the loan is fully paid or reaches criteria for restoration to accrual status.
Michael F. Richards, is a Banking Expert Witness and Consultant with more than 34 years of experience. His experience as a Founder, President, and Director of two De-Novo banks and the head of a work-out department for a regional bank give clients and attorneys a crucial behind-the-scene understanding of all aspects of banking.
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