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Board of Governors of the Federal Reserve System

Supervision and Regulation Letters

SR 14-7

Loan Coverage Requirements for Safety and Soundness Examinations of Community Banks

July 22, 2014
Revised July 29, 2014

Seal of the Board of Governors of the Federal Reserve System
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C.  20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 14-7
July 22, 2014
Revised July 29, 2014

Clarification as of July 29, 2014:  When calculating a concentration of credit in a loan portfolio or portfolio segment as described on page 3 under "Retail Consumer Lending," a concentration would be more than 25 percent of tier 1 capital plus the allowance for loan and lease losses.
TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
SUBJECT:   Loan Coverage Requirements for Safety and Soundness Examinations of Community Banks
Applicability:  This letter applies to community state member banks with $10 billion or less in total consolidated assets that are supervised by the Federal Reserve.

This guidance updates loan sampling expectations for Federal Reserve led examinations of community state member banks and clarifies when statistical sampling is expected to be used.1  In addition, the guidance establishes minimum coverage2 expectations for judgmental samples for full-scope and asset quality target examinations.  Examiners are expected to select for review a sample of loans3 that is of sufficient size and scope to enable them to reach sound and well-supported conclusions about the quality of, and risk management over, a community state member bank’s lending portfolio.  In selecting a sample of loans for review, examiners should be guided by the following requirements.

Commercial and Industrial and Commercial Real Estate Loans

For community state member banks with CAMELS composite and Asset Quality ratings of “1” or “2” that have not materially changed the composition of their loan portfolios or their credit administration practices since the prior examination, and whose most recent overall SR-SABR rating is not “1D,” “1F,” “2D,” or “2F,”4 examiners are expected to use the statistical loan sampling procedures outlined in SR letter 02-19, “Use of Statistical Sampling in the Review of Commercial and Industrial Loans and Commercial Real Estate Loans during On-Site Safety and Soundness Examinations of Community Banks.”5  Examiners are not expected to supplement statistical samples with additional loans to reach the specified minimum coverage ratios discussed below for judgmental samples.6

For all other community state member banks, examiners should draw a judgmental sample that includes a selection of large, insider, problem,7 watch, renewed, and new credits.8  The sample should mainly be drawn from the bank’s primary lending business lines, new business lines, and out-of-area loans or highly specialized lending or leasing portfolios.  Coverage targets should factor in the bank’s current asset quality rating and credit risk management assessment.  More specifically, for community state member banks with “weak” credit risk management practices, with asset quality component ratings of “3 or worse,” or where SR-SABR ratings of “D” or “F” raise questions about loan quality, coverage should be 40 percent or more.  Community state member banks with strong or acceptable credit risk management practices and asset quality component ratings of “1” or “2” should have 20 to 30 percent coverage.  This is illustrated further in the table below.

  Credit Risk Management
Asset Quality
Component Rating
Strong Acceptable Weak
1 20 to 30 percent coverage9  
2
3 40 percent or more coverage
4
5

It may be necessary to expand the sample when using either statistical or judgmental sampling in situations where there are several differences in credit ratings between those assigned by examiners and bank management.  To expand the sample when using the statistical sampling methodology, examiners should follow the guidance discussed in SR letter 02-19.  When using judgmental sampling, examiners should generally consider a community state member bank’s internal risk rating system to be unreliable when examiner downgrades10 are ten percent or more of the total number of credit facilities reviewed, and five percent or more of the total dollar amount of loans reviewed.  When a bank’s risk rating system is determined to be unreliable, examiners may need to expand sampling to better evaluate the effect of rating differences on the bank’s allowance for loan and lease losses (ALLL) and capital.  In such situations, examiners should direct the bank to promptly take corrective action to validate its internal ratings and to evaluate whether the ALLL or capital should be increased.  The Reserve Bank should follow-up with the bank to assess progress on corrective action and verify satisfactory completion.  The timeframe for follow-up will depend on the nature and severity of problems identified and typically should be no more than six months after the Reserve Bank notifies the bank of the deficiencies.

Retail Consumer Lending

Retail consumer lending involves a large number of relatively homogenous, small-balance loans such as installment loans, credit card receivables, home equity lines of credit (HELOCs), and residential mortgages.  The supervisory review and classification of retail consumer loans should be carried out in accordance with the procedures set forth in the Commercial Bank Examination Manual and SR letter 00-8, “Revised Uniform Retail Credit Classification and Account Management Policy,” and will generally be limited to past due and nonperforming assets.11

When a bank has a concentration (defined as more than 25 percent of the bank’s tier 1 capital plus ALLL) in retail consumer loans, examiners should include in their examination scope a review of the retail lending program, its underwriting standards and policies, and related risks and controls.  Examiners should also consider sampling a portion of credits in those segments (for instance, residential mortgages or HELOCs) of the bank’s retail loan portfolio with a high concentration in order to assess risks and the adequacy of underwriting, internal controls, and credit risk management practices.  A judgmental sample size should be used that is commensurate with concentration and credit risks and sufficient for the examiner to assess the quality and risks of the portfolio.

Loan Coverage of Commercial and Industrial and Commercial Real Estate Loans in a Target Examination

The Federal Reserve may deem it necessary to conduct a target examination prior to the next statutorily required full-scope examination.12  Such target examinations should be risk-focused in accordance with existing guidance, including SR letter 97-25, “Risk-Focused Framework for the Supervision of Community Banks.”  Any loan coverage goals should be determined using the judgment and discretion of the supervision staff involved in establishing the scope of the examination.  For banks with a “3” composite rating, loan coverage of 30 percent or more should be achieved at a target examination that includes a review of asset quality.  For banks with a “4” or “5” composite rating, loan coverage of 40 percent or more should be achieved at the target examination.

Loan coverage may consist of updates to credits previously reviewed and classified or downgraded at the previous examination and any credit originated or extended since the previous examination.  The examination results should be used to update the asset quality and credit risk management assessment and inform the level of coverage needed at the next full-scope examination.  Deteriorating asset quality or uncorrected credit risk management deficiencies noted at the target examination would generally necessitate expanded coverage for the next full-scope examination.

Documentation of Loan Review Coverage

The scope of loan coverage and the loan sampling procedures used in the examination process should be documented within examination workpapers and the examination report.13  In particular, examiners should ensure that the composition and volume of the reviewed loans are documented within the examination report.  This documentation should include the core loan categories that were included in the sample, the loan portfolio segments that were the focus of the review, and cutoff values that were used in deciding which loans are included in the sample.  Documentation supporting the establishment of the sample should be included in the workpapers.

Reserve Banks are asked to distribute this letter to appropriate safety-and-soundness examiners and other supervisory staff.  Questions regarding this letter should be directed to staff in the Community Banking Organizations Section:  Anthony B. Cain, Manager, at (202) 912-4377; and Jonathan K. Rono, Senior Supervisory Financial Analyst, at (202) 721-4568.  In addition, questions may be sent via the Board’s public website.14

signed by
Michael S. Gibson
Director
Division of Banking
Supervision and Regulation


Supersedes:
  • SR letter 94-13, “Loan Review Requirements for On-site Examinations”
Cross References:
  • SR letter 06-2, "Enhancements to the System’s Off-Site Bank Surveillance Program"
  • SR letter 02-19, "Use of Statistical Sampling in the Review of Commercial and Industrial Loans and Commercial Real Estate Loans during On-Site Safety and Soundness Examinations of Community Banks"
  • SR letter 00-8, "Revised Uniform Retail Credit Classification and Account Management Policy"
  • SR letter 97-25, "Risk-Focused Framework for the Supervision of Community Banks"
  • SR letter 85-28, "Examination Frequency and Communicating with Directors"
 
Notes:
  1. With the issuance of this guidance, SR letter 94-13, “Loan Review Requirements for On-site Examinations,” is superseded. Return to text
  2. A loan review coverage ratio, or “coverage,” should be calculated by dividing the dollar volume of commercial and industrial and commercial real estate loans reviewed during the examination by a bank’s total dollar volume of such loans in the bank’s loan portfolio.  Credit exposures arising from trading and derivatives activities should not be included in the coverage ratio. Return to text
  3. For the purposes of this letter, the term “loans” includes all sources of credit exposure arising from loans and leases.  Such exposure includes guarantees, letters of credit, and other loan commitments.  Both funded and unfunded commitments should be considered when assessing loan exposure. Return to text
  4. For additional information on SR-SABR, see SR letter 06-2, “Enhancements to the System’s Off-Site Bank Surveillance Program.” Return to text
  5. For the purposes of this SR letter, “Commercial and Industrial and Commercial Real Estate Loans” include all non-consumer related loan categories. Return to text
  6. SR 02-19 indicates that the sampling approach should be directed towards state member banks rated CAMELS composite and Asset Quality component of “1” or “2” and having total consolidated assets less than $1 billion.  With the issuance of this letter, statistical loan sampling may be used on state member banks having total consolidated assets of $10 billion or less, provided other qualifying criteria are met.  For instance, the statistical sampling approach is not recommended for use at de novo banks or other banks with unusually high or low capital ratios. Return to text
  7. Problem loans are comprised of past due loans, nonaccrual loans, impaired loans, renegotiated or restructured loans, loans internally criticized or classified by the bank, and loans that were classified at the previous examination. Return to text
  8. Together, these credits constitute the “core” loan categories. Return to text
  9. Where SR-SABR ratings of “D” or “F” raise questions about loan quality, coverage should be 40 percent or more. Return to text
  10. A credit risk grading difference is considered a downgrade when:  a) a risk rating is changed by the examiner from an internal Pass rating to Special Mention or classified category, b) a risk rating is changed by the examiner from Special Mention to a classified category, or c) a risk rating is lowered by the examiner within the classified categories, including a split classification. Return to text
  11. See the following section in the Commercial Bank Examination ManualSection 2130.3, “Consumer Credit.” Return to text
  12. SR letter 85-28, “Examination Frequency and Communicating with Directors,” indicates targeted examinations will be conducted when deemed necessary by the Reserve Bank between statutorily required examinations.  The Federal Reserve’s examination frequency requirements for state member banks are in Regulation H (12 CFR 208.64). Return to text
  13. See the following section in the Commercial Bank Examination ManualSection 1030.1, “Workpapers.” Return to text
  14. See http://www.federalreserve.gov/apps/contactus/feedback.aspxReturn to text
Last update: September 5, 2014