As a member of the Loan Committee or Board, there may be occasions when you are asked to review and approve loan requests. The Harvard Westerman and Sam Wilson loans in this course let you do such a review.

In addition , as a director you'll be asked to review the bank's overall loan quality. Typically, this is done through a review of summary and detailed reports that provide information on the performance of the bank's loan portfolio. Examples of these reports are provided later.

Evaluating credit risk in a loan proposal

Determining the credit risk presented by a loan request is at the core of the bank's lending function. This determination shapes the decision to lend and the terms on which the money will be lent. Ultimately, it determines the bank's overall loan quality and credit risk.

As a director, it would be unusual for you to do the actual analysis that supports a loan recommendation or generate the initial terms and conditions associated with the recommendation. Instead, you will likely be presented with a written summary and an oral briefing on a loan request, which provides the basis for the recommendation on the request's disposition.

It can be tempting to adopt the loan recommendation and forgo the analysis. However, the request is being presented to the board for a reason. You therefore owe it to the bank and its shareholders to do an independent review of the large loan. As an outside board member you bring an independent perspective to the bank and its management because you are not submerged in day-to-day operations. This perspective, coupled with your thoughtful review, makes a difference in the bank's future success or failure.

No one expects you, as an outside director, to be an expert in credit analysis. However, you must know enough to identify possible trouble spots in loan proposals and ask management questions about them.

In your loan review you need to be able to identify any circumstances or problems that may affect repayment and whether these obstacles are temporary or long term. To help uncover these types of issues, consider the following questions:

• Do you know how money from the loan will be used and whether the assumptions regarding repayment are reasonable?
• Is the loan structured properly and the loan payments appropriately scheduled?
• Are enough safeguards in place should the borrower default on principal and/or interest payments to keep the bank from experiencing loss?

Identifying sources of credit risk in a loan request with little or no background can be daunting, causing someone new to the loan review process to ask:

• Where do I start my analysis?
• What factors do I consider in my analysis?
• When is my analysis complete?

There is no single correct answer to these questions. No two analysts will follow exactly the same approach in evaluating a borrower's credit worthiness. Having said this, their analyses will have many things in common simply because history shows some things are more important than others in determining whether or not the lender will receive his or her principal and interest from a borrower.

Some of these common elements are captured in the Credit Checklist , a tool you can use to organize your loan review and assist you in spotting sources of credit risk in requests that deserve further attention. By answering the four questions included on the checklist you should be able to identify basic credit risk issues that exist in a loan proposal.

Invariably, much of the information needed to complete the checklist will come from loan officer presentations to the board and loan presentation sheets. These sheets, prepared by the bank's lending function, summarize pertinent facts for each loan presented to the board for its approval.

• In general, a loan presentation sheet includes the name of the borrower and the amount to be borrowed.
• It conveys information on the purpose of the loan, frequency of the rate adjustment and the terms under which the loan is being made. These terms include interest rate, term/time to maturity/renewal, borrowing restrictions and other requirements placed on the borrower.
• The presentation sheet will also show current balances for other loans the borrower may already have at the bank.
• It may have information on the primary source of loan repayment, a plan for administering the credit including an exit strategy in case of problems, secondary sources of repayment and notation of any exceptions to the bank's loan policy.
• Other relevant information to assist the committee or board in reaching a credit decision may be attached such as credit reports and financial analysis documents.

Lesson Objectives

After you finish this lesson, you should be able to:

• Assess credit risk in an individual loan request.
• Analyze a bank's overall credit quality from bank-provided loan reports.
• State why the Watch List report is one of the bank's most important credit risk reports.