Seal of the Board of Governors of the Federal Reserve System

WASHINGTON, D. C.  20551


SR 94-13 (FIS)
February 24, 1994


SUBJECT: Loan Review Requirements for On-site Examinations

                        A thorough review of a bank's loan and lease portfolio and other related sources of credit risk is one of the most important elements of the Federal Reserve's examination of a bank. Such credit reviews are a primary means for the examiner to evaluate the effectiveness of internal loan review and credit grading systems, determine that credit is being extended in compliance with internal lending policies and credit standards, and assess the adequacy of the allowance for loan and lease losses. Credit reviews also enable an examiner to ascertain a bank's compliance with applicable laws and regulations, make an overall judgement as to the safety and soundness of a bank's lending and credit administration functions, and, most importantly, evaluate directly the quality of a bank's loan and lease portfolio.

                        Since examiners must make the most efficient use of limited resources, they are not required to review every loan within a bank's portfolio.  Instead, examiners select for review a sample of loans that is of sufficient size and scope to enable them to reach confidently-held conclusions about the aforementioned aspects of a bank's overall lending function.  In selecting a sample of loans for review, examiners should be guided by the following requirements.  

Commercial and Industrial and Commercial Real Estate Loans

                        Commercial and industrial and commercial real estate loans1 subject to examiner review during an examination should include all known problem loans and all insider loans of significant size.  Problem loans are comprised of past due loans, nonaccrual loans, loans otherwise impaired as defined in Statement of Financial Accounting Standards No. 114, renegotiated or restructured debt, loans internally criticized or classified by the bank, and loans that were classified at the previous examination. Insider loans are defined by Regulation O and include loans to a related interest of the insider.  Special mention loans of significant size should also be reviewed.  

                        In addition to the loans just specified, "large" loans must also be reviewed.  Large loans are defined as loans, or aggregations of loans to the same or related borrowers, which exceed a dollar cut-off level established by the examiner-in-charge.  This cut-off level will typically be equal to about one percent of a bank's equity capital, but a higher or lower percentage may be warranted depending on the circumstances of the bank being examined.  

                        This "core" group of loans (problem loans, special mention loans, insider loans, and large loans) should represent a substantial portion of the dollar volume of a bank's total commercial and industrial and commercial real estate loans. Nevertheless, in the great majority of cases additional loans should be selected from the remaining portfolio so that the examiner can be reasonably assured of making an accurate and comprehensive assessment of the condition of the bank's overall loan portfolio and lending activities.2

                        In determining the size and nature of additional loans to be reviewed, the coverage ratio of the core group of loans3 should be an important consideration.  If the core group of loans reviewed constitutes a substantial portion of the total dollar volume of loans (at least 40 to 50 percent) then sufficient additional loans should be reviewed to raise the coverage ratio another 10 percent. If, on the other hand, the coverage ratio of the core group of loans reviewed is lower--primarily because the bank has fewer large loans--then a greater number and higher dollar volume of loans outside the core group should be reviewed.  For example, if the coverage of the core group of loans amounts to only 20 to 30 percent, then the loans reviewed in the remaining portfolio should raise the coverage ratio to a minimum of 40 to 50 percent.  Loan coverage at the lower end of this range, i.e 40 percent, would be appropriate only as long as the bank is: 1) in satisfactory condition, 2) has strong asset quality, 3) is well-managed, 4) has effective internal risk controls and underwriting standards, and 5) no other matter of significant concern is present or has been identified during the examination.  

                        In other words, coverage of the core group of loans could be 40 percent only for a bank that received a composite CAMEL rating of 1 or 2 and an asset quality rating of 1 on its last examination provided the findings of the current review of the core group of loans appears consistent with these ratings.  For banks that have high overall ratings (CAMEL 1 and 2) but a coverage ratio of core group of loans that is significantly below 40 percent, additional loans should be selected for review to bring the coverage ratio for all loans reviewed to a minimum of 40 percent.

                        Banking organizations with less than satisfactory composite supervisory ratings or other significant areas of supervisory concern should have loan coverage ratios of at least 55 to 60 percent or more, if necessary, to fully determine the financial condition of the organization.  Any divergence from these guidelines should be fully documented in the confidential section of the examination report.

                        Conclusions drawn from the review of the core group of loans should also be used in determining the extent to which additional loans should be selected for review since they will provide the most up-to-date indications of the general condition of the bank's loan portfolio and the adequacy of the bank's credit administration practices.  For example, if the review of the core group of loans reveals that an undue proportion of a bank's problem assets are concentrated in a particular type of loan or if a portion of the portfolio is growing rapidly, the additional loans to be reviewed should normally be weighted toward that loan type.

                        In determining the extent of additional loans to be reviewed significant consideration should be given to the effectiveness of the bank's internal credit review and grading system.  If, for example, the review of the core group of loans indicates that this system provides results essentially the same as those obtained by the examiner, then the number and dollar size of the remaining sample reviewed can be kept relatively low, unless the review of the remaining sample raises questions about the integrity of the system with respect to the remaining portfolio.

                        In addition to the coverage ratio of the core group of loans, an examiner should take into account other factors pertaining to the bank under examination when selecting loans to be reviewed from the remainder of the portfolio.  These factors include the overall condition of the bank at its last examination and, most importantly, findings in that examination with regard to the quality of the asset portfolio and the adequacy of loan administration activities (i.e. the accuracy of internal loan rating systems, the appropriateness of underwriting standards, the adequacy of documentation in files, the adequacy of management information and internal control systems, and the adequacy of loan loss reserves).  Other important factors to be taken into account are the ability and experience of lending officers and personnel managing the lending function, any changes in asset quality or lending policies since the last examination, and significant concentrations identified in the preliminary review of the loan portfolio.

                        Regardless of the total coverage afforded by the review of the core group and of the additional sample of loans, it is essential that the loans selected for review during the examination are of sufficient number, volume, and variety to enable the examiner to form an accurate judgement of the condition of the bank's entire loan and lease portfolio and the effectiveness of its credit administration policies and practices.

Trading and Derivatives Activities

                        The examination process should also include an assessment of credit exposures arising from foreign exchange and securities trading and derivatives activities for banks active in such markets.4 In particular, examiners should ensure that a sufficient number of these exposures are selected for review to allow an assessment of a bank's overall exposure to, as well as its ability to safely and soundly manage, trading and derivatives activities. Some commercial and industrial and commercial real estate loan relationships selected for review during an examination may include trading or derivatives exposures.  However, examiners should also review a material portion of credit relationships established solely for the purpose of facilitating trading or derivatives activities.

Retail Consumer Loans

                        Retail consumer lending involves a large number of relatively homogenous, small-balance loans such as instalment loans, credit card receivables, home equity lines of credit, and residential mortgages.  The 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 will generally be limited to past due and nonperforming assets.  However, the classification of retail loans using these uniform classification methods may also be supplemented by the direct review of larger loans within these segments as considered necessary.  

Documentation of Loan Review Coverage

                        Consistent with longstanding Federal Reserve practice, the scope of loan coverage and the loan sampling procedures used in the examination process should be fully documented within examination workpapers and the examination report.  In particular, examiners should ensure that the reasoning used in determining the composition and volume of the loans reviewed is thoroughly justified and documented.

                        If you have any questions regarding the procedures detailed above, please contact either Mr. William Spaniel or Mr. Kevin Bertsch, at (202) 452-3469 or (202) 452-5265.

Richard Spillenkothen


1.  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.  Return to text

2.  One approach to selecting the additional sample of loans to be reviewed is to lower the cut-off level of larger loans subject to review.  Alternatively, other methods (including random sampling, selecting recent loans or specific loan types) may be used to select the sample when these methods appear more suited to the circumstances of a bank.  Return to text

3.  A loan review coverage ratio 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 credits.  For the purposes of this calculation, loans are defined as they are in footnote 1.  Credit exposures arising from trading and derivatives activities are not generally included in this coverage ratio.  However, such credit exposures should be reviewed and evaluated in a manner consistent with guidance included on pages 4 and 5 of this letter.  Return to text

4.  Commercial banking organizations have significantly increased their trading and derivatives activities in recent years.  As a result, the credit exposure related to these activities has correspondingly increased.  Examiners should consult the Trading Activities Examination Manual to appropriately evaluate these exposures.  Return to text

SR letters | 1994