A regulatory examination of lending activity, whether fair lending related or safety and soundness, always focuses on data. Data integrity notwithstanding (which is another blog post entirely), such data is a function of (2) things: (1) policies and (2) actual practices. The interaction of these two forces creates the lending data that will be the subject of a regulatory examination. These data, in turn, will shape the ultimate outcome of the review.
It is understood, of course, that these two (policies and practices) should be highly correlated in that actual practices should sync up with loan policies. Again, this issue alone could be the subject of another post or more accurately a series of other posts. Therefore, we will save this for another day and focus on the policy aspect alone.
There are a number of subtleties that can emerge from the application of loan policies that can produce some serious issues. There are often things that are taken for granted and consequently may escape attention until it is too late. These may go unnoticed and lead to ambiguities that may unknowingly weaken credit quality or create fair lending risk.
As an example, let’s consider one of the most universal and seemingly straightforward underwriting components: the debt-to-income ratio. The DTI is designed to provide a measure of the debt payments relative to income by which to evaluate creditworthiness.
It involves simple math and is just debt payments divided by income. Looking a little closer, however, we can see that as a matter of policy, it may not be that simple.
A Few Questions to Ask
Let’s look at some of the basic questions that can arise. First, will the calculation be based on gross income or net income? And, if gross income is used, what about public assistance or other income that may not be taxed? Is it viewed the same as other forms of income, or will it be adjusted since it results in more disposable income?
Second, what about fees that may be financed into the loan amount? Are these included in the DTI calculation? Will this vary by type of loan? What about credit life or other products a lender may offer? Would these additions to the payment be considered in the DTI or not?
The DTI ratio is typically based on monthly payments as a ratio to income. How then will payments be handled that are irregular, such as quarterly or semi-annual? What about single-pay or interest only loans, deferred payments, or lines of credit?
The point here is that policies may be much more complex to implement than they may appear. Even with just one basic attribute as shown here, there can be a number of variations or situations in which the “policy” may not fit. Things also change over time in terms of the credit environment, products, loan operations, and a host of other things.
If loan policies have not been evaluated recently and tested against actual practices, it may be time for a tune-up. If it has been an exceedingly long time, then it may be time for an overhaul.
Things To Consider
One of the most important things to keep in mind is that policies should be implemented and then tested to make sure that they will work and not raise issues. A critical error institutions often make is that management creates a policy and requires it be implemented but then never tests it to make sure it will work.
Unless it is something very basic, we always suggest that changes should be implemented over time with the recognition that adjustments may need to be made before finalizing. Such changes should also involve input from lending staff since they often can see potential issues before they arise as they deal with the day-to-day.
Finally, and most importantly, do not forget the first rule of policy analysis: any change will produce some intended but also unintended consequences. This should be expected with ANY change, and it does not mean that the change is wrong. It is inevitable, and recognizing this upfront will head off a lot of problems in the future.
How Do I Know If My Institution Needs a Policy Tune-Up?
Here are some basic questions to ask yourself:
- Is there certainty that practices match policy?
- Have loan products been added or changed?
- Are there new lending staff and/or has the institution gone through a merger?
- Are loan policies well defined or is there subjectivity?
- Has there been a comprehensive review within the last year?
The answers to the above provide some indication of where an institution may be. As with a vehicle, the bank’s lending function requires regular maintenance and occasionally an overhaul for optimum performance.
How to cite this blog post (APA Style):
Premier Insights. (2019, January 24). Looking Under The Hood: Do Your Loan Policies Need a Tune-Up? [Blog post]. Retrieved from https://www.premierinsights.com/blog/looking-under-the-hood-do-your-loan-policies-need-a-tune-up.