Underwriting Due Diligence Can Be MBL's Bridge Over Troubled Waters
ALEXANDRIA, Va. -- As credit unions navigate through choppy lending waters, the due diligence critical for member business loan underwriting and approval remains stable.
The risks vary in the member business lending area, but at least four stand out as the ones to pay particularly close attention to, according to NCUA's Office of Examination and Insurance. Those four are concentration risk, interest rate risk, transaction risk and reputation risk.
"There are also a variety of credit risks to consider, including whether loans are priced appropriately to reflect their inherent default risk, whether collateral values are periodically reevaluated and whether the systems and staffing are in place to properly manage loan defaults," NCUA told Credit Union Times in a recent response to a query on the key member business lending risks.
Boards of directors need to also limit the strategic risk by setting appropriate operating parameters, including establishing prudent risk thresholds and acceptable rates of MBL program growth, NCUA said.
Based on feedback from NCUA, here are some of the more prominent risks:
Concentration Risk. Part 723 of the rules and regulations establishes lending limits to one borrower, groups of associated borrowers, and aggregate lending limits (exemptions to the aggregate limit exist).
Part 723.6 requires that board policies establish lending limitations in relation to assets and net worth, based on loan type, category and borrower or group of associated borrowers.
Disruptions in a particular industry or trade area could have an exaggerated effect on a credit union when a concentration exists.
Concentrations in loans whose repayment is dependent upon the cash flows from the underlying asset could be severely affected from an economic downturn.
Interest Rate Risk. Mismatches can occur between the interest rate earned and the term of the loans granted compared with the cost and term of the source of funds, causing net interest margins on such loans to shrink or even become negative.
MBLs have a maturity limit of 15 years but are often rewritten during their life or at maturity, further extending their true term.
Transaction Risk. Arises from potential fraud or errors in each loan transaction.
Part 723 stipulates experience requirements for member business lending to ensure credit union staff or third parties have the requisite knowledge and experience to grant such loans.
Risk reduction requires sufficiently robust internal control and monitoring systems. (Part 723.6 requires certain documents be obtained and analyzed during the credit granting and ongoing monitoring process.)
Proper due diligence over third-party lending relationships is critical (as discussed in Letter to Credit Unions 07-CU-13, Evaluating Third Party Relationships); management needs to ensure third parties are acting in the credit union's best interests and that loans originated are in line with written agreements with those third parties.
Proper identification of loans as member business loans and accurate internal and external reporting of such loans is also important for risk identification and monitoring.
Reputation Risk. Lack of due diligence over the third parties participating in the lending process could negatively impact the credit union if the third party is not performing to expected or agreed-upon standards.
Funding sources for such programs need to be well matched with the loan granted and the potential risks fully considered (which could create interest rate and liquidity risk)--the inability to fund loans once a program is established could negatively impact the credit union.
NCUA noted that all these risks apply to loans originated as well as loans purchased.