LoanPortfolioManagement

FARM CREDIT ADMINISTRATION

Acknowledgements

Three individuals were instrumental in producing this publication:

T. Harold Derrick, Special Examination and Supervision Division, Office of ExaminationLeonard Peterson, Sacramento Field Office, Office of ExaminationCarl Premschak, Denver Field Office, Office of Examination

The Farm Credit Administration expresses its thanks and appreciation for their contributions and leadership. Also,a special word of thanks is given to Professor John B. Penson, Jr., Texas A&M University, for his contributions.Questions regarding the content of this publication or requests for free copies should be directed to the following:

Office of Congressional and Public AffairsFarm Credit Administration1501 Farm Credit DriveMcLean, VA 22102-5090Telephone: 703-883-4056Facsimile: 703-790-3260E-mail: info-line@fca.gov

Additional information about the Farm Credit Administration and the Farm Credit System is available on FCA’sHome Page on the World Wide Web. The Web site is located at http://www.fca.gov.

Roland E. SmithChief Examiner and Director of the Office of Examination

Foreword

In 1998, the Farm Credit System (FCS or System) reported the best financial health and credit quality of its 65-yearhistory. Managerial talent, coupled with strong capitalization and stable earnings, has bolstered the System’s viability.Its capacity to serve as a sound source of credit for America’s farmers, ranchers, and cooperatives remainsunquestioned. We attribute much of the System’s safety and soundness to the extensive contributions of its manyboards, who ensure that its financial condition is sound despite constant volatility in world economies and theagricultural markets. We also view these boards as the leaders of their respective institutions, and they have theunique honor and responsibility of shaping the institution’s future through the proper stewardship of its assets —the loans to the farmer-owners of their institution.

The System’s excellent financial condition and low-risk profile provide opportunities to augment portfolio managementprocesses and to prepare for potential systemic risk. Thus, this publication provides recommendations on loanportfolio management for all System institutions to consider. This publication achieves a twofold objective. First,it outlines methods of controlling risk in individual loans and loan portfolios. Second, it explains interrelationshipsbetween planning, directing, controlling, and monitoring of lending operations, which are crucial to the performanceof director responsibilities.

We at the Farm Credit Administration endorse the philosophy that managing risk, not avoiding it, is crucial toSystem viability. This pivotal capability has maintained the financial strength and competitive position of all Systeminstitutions. Impending competitive forces in agricultural lending will continue to mandate that System institutionsprovide exceptional customer service, produce more with less, and remain well capitalized. Doing so will necessitateusing technology to enhance loan portfolio management processes that will immunize capital against undue risk.

This publication does not cover all aspects of the puzzle of what we characterize as effective loan portfoliomanagement, but we do describe its major components. As we visualize the puzzle’s layout, the publication beginswith a strategic vision that encompasses the entire agricultural market. The pieces of the loan portfolio managementpuzzle are then set in a risk environment that presents the challenges to System institutions, and we conclude withputting the 10 pieces of the loan portfolio management puzzle together into an effective system. We hope thispublication will help each System institution fulfill its mission to provide a dependable source of credit for ruralAmerica.

Marsha Pyle MartinChairman and Chief Executive Officer

Michael M. ReynaMember of the Board

Ann JorgensenMember of the Board

Table of Contents

Visualizing the Puzzle — The Changing Marketplace 1Demographics of the American Farmer 1Competition Among Agricultural Lenders 2Changes in Public Policy and the Regulatory Environment 3Credit Evaluation Practices 3

Laying Out the Puzzle — The Risk Environment 5Lessons from the Past 5Balancing Risk and Return 6

Mastering the Puzzle — Building an Effective Loan Portfolio Management System 8Board of Directors 8Planning 9Directing 9Controlling 10Loan Portfolio Objectives 14Loan Underwriting Standards 14Loans 16Management Information System 16Monitoring 17Evaluation 18

Conclusion 20Framing the Puzzle — Diagram for Effective Loan Portfolio Management 21

The lifeblood of each lendinginstitution is its loan portfolio, andthe success of the institution dependson how well that portfolio is man-aged. Therefore, any study of a FarmCredit institution’s loan portfolio mustbe based on characteristics of thefarmers and on their agriculturalindustries, economic and competitiveconditions, and commonly usedlending practices within the territoryserved by the institution. This sec-tion presents an overview of each ofthese factors from the regulatoryperspective of the Farm CreditAdministration (FCA or Agency) andprovides Farm Credit System (FCS orSystem) boards with guidance inestablishing the strategic vision fortheir institutions.

Demographics of theAmerican Farmer

To remain competitive in the agricul-tural lending market, successfulagricultural lenders must continuallyconsider the changing demographicsand needs of their farm customers.The foundation for their success isbuilt on sound loan portfolio man-agement systems that clearly recog-nize and understand the changingnature of the American farmer andcustomer. The number of full-timefarm operators has declined dramati-cally since 1935, and this trend isexpected to continue. Despite thetrend toward fewer and larger opera-tors, American farmers remain themost efficient and abundant produc-ers of food and fiber in the world.A clear understanding of this oper-ating environment and the nature ofAmerican farmers helps agriculturallenders maintain safe and soundoperations.

Visualizing the Puzzle — The Changing Marketplace

While each American farmer isunique, categorizing farmers intolarger groups with common charac-teristics can help lenders make pru-dent loan portfolio decisions and canguide the strategic planning process.American farmers can be divided intothree broad groups: generational,commercial, and lifestyle farmers.1

Each category has its own borrow-ing requirements and position in thecredit marketplace.

Generational Farmers

The generational group is the larg-est category and comprises farmersover the age of 50 who intend tofarm until retirement. They generallyaverage $250,000 or less in annualgross agricultural income. Genera-tional farmers have typically farmedall their lives, have come from pre-vious generations of farm families,and are firmly entrenched in theAmerican family farming tradition.This group of American farmersexperienced the greatest loss of num-bers during the 20th century, and thedeclining trend is expected to con-tinue into the next century.

Commercial Farmers

Commercial farmers have annualsales in excess of $250,000, and theyproduce more than 49 percent of allagricultural outputs. They make uponly about 6 percent of Americanfarmers. The commercial farmer canbe a sole proprietorship, partnership,corporation, or any other legal entity,while generational and lifestyle farm-ers are almost always sole propri-etors. Commercial farmers need torun highly efficient operations. Theyusually competitively shop for creditand tend to run the more complex

1 These definitions and farmer categories are used solely as a means to provide a background for this publication and should not be associatedwith any other U.S. Department of Agriculture (USDA) or FCA farmer classifications.

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and higher-leveraged operations.The credit needs of commercial farm-ers are quite different from the othercategories.

Lifestyle Farmers

This third major category representsa growth sector of American farmers.Lifestyle farmers desire to reside inrural areas, typically have a part-timefarm operation, and rely on nonfarmincome for their primary support.Many rural homeowners are alsoincluded in this group. The creditneeds of this group can vary greatly,depending on location and the eco-nomic conditions in the nonfarmsector. Loans to this group are gen-erally smaller with repayment termstied to nonfarm income. Historically,loan losses from lifestyle farmershave been less than the other twocategories.

Lending to these diverse groups offarmers poses challenges and oppor-tunities that each lender must fullyconsider in developing market strat-egies. The changing market demo-graphics must be an integral part ofa lender’s strategic business planningprocess and can become the basis forits loan por tfolio managementsystem.

Competition AmongAgricultural Lenders

The financial services marketplacehas undergone dynamic and substan-tial changes as commercial lenders,vendors, and service organizationscompete to meet customer needs.The decline in agricultural lendingfrom 1984 through 1989 saw manylenders, including commercial banksand insurance companies, leave themarketplace. Total agricultural loanvolume declined, and loan lossessoared in both commercial banks and

Farm Credit institutions. However,this trend reversed in the 1990’s asagriculture regained its financial foot-ing and as lenders returned to themarketplace.

According to USDA statistics, agricul-tural loan volume peaked in 1984,when total farm sector debt was$193.9 billion. By the end of thefarm crisis in 1989, total agriculturaldebt declined to a low of $137.9billion. Agricultural debt resumed itsgrowth in the 1990’s with USDAestimating that total agricultural debtclimbed to more than $162.2 billionby year-end 1997.

Although the System concluded itsthird year of positive loan growth in1997, it has not yet recaptured itsposition as the dominant lender toAmerican agriculture. Before 1987,the System was the largest singlesource of funding for agriculture.However, commercial banks becamethe leader in agricultural lending in1987 and retain that position today.

While the historical, cyclical nature ofagriculture remains a concern, manyeconomists have made positive long-term projections for the agriculturaleconomy. Lenders’ net interestincome remained high in 1997,allowing many System institutionsand agricultural commercial banks toenjoy record earnings. By 1998,agricultural credit quality was at anall-time high and nonearning assetswere at the lowest level of thedecade. Land values — while not ris-ing as fast as in 1996 — are still strongrelative to just a few years ago. Asa result, competition is strong foragricultural borrowers, and somelenders are making loans that wouldhave been denied just a few yearsago. The 1998 Survey of CreditUnderwriting Practices, prepared bythe Office of the Comptroller of the

Currency, confirms these findings ofa relaxation of loan underwritingstandards. Many fear that this com-placency and appetite for risk is per-vasive among many lenders, includ-ing the System, and that this attitudemay again threaten the safety andsoundness of agricultural lendinginstitutions.

New entrants into the market foragricultural loans have increasedcompetitive pressures for FCS insti-tutions. During the 1990’s, a varietyof nonbank lenders, such as JohnDeere Credit, J.I. Case Co., andothers, have become more active inthe marketplace. These vendor-related lenders generally rely onpoint-of-sale financing and havebecome aggressive competitors forboth System institutions and commer-cial banks. These lenders typicallyrely on scorecard loan applicationsand are known for rapid approval ofloan requests. Agricultural lendingmarkets will continue to attracttraditional agricultural lenders likecommercial banks and insurancecompanies. However, the new, non-traditional participants — such as therecent entrance of General MotorsAcceptance Corporation — will likelychange the landscape for agriculturalfinancing in the future.

Competitive pressures on Systeminstitutions for the higher-qualityagricultural loans will remain intense.To remain competitive, System insti-tutions will feel increasing pressureto further control or cut operatingexpenses, reduce paperwork, andprovide faster loan approvals withless information. These competitiveand market-driven pressures placeadditional demands and requirementson System institutions to develop andmaintain high-quality and efficientloan portfolio management andinformation systems.

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Changes in Public Policyand the RegulatoryEnvironment

In addition to the changing marketbase, dynamic competition, and theinherent economic risks in financingagriculture, lenders face increaseduncertainty from State and Federallaws, policy, and regulations. Forexample, the Federal AgriculturalImprovement and Reform Act of 1996(FAIR Act) has affected the agricul-tural lending environment in at leasttwo major ways. Most dramatic is thedeparture from annual deficiencypayments that reimburse producersfor the difference between target andcurrent market prices. The FAIR Actplaces producers and lenders in anenvironment of declining predeter-mined contract payments, which arescheduled to drop to zero after 2002.The FAIR Act’s second major changeis the elimination of ad hoc disasterpayments that have protectedunderinsured borrowers and theirlenders in the past. The eliminationof price support and disaster reliefpayments substantially increases alender’s exposure to credit and col-lateral risk.

Global policy risk is another elementthat lenders will face in the future.For example, the optimistic picturethat was painted for the demand ofagricultural exports into the nextcentury was abruptly undermined bythe 1998 Asian crisis. Without a sus-tainable strong export demand,American farm incomes will decline.Declines in farm income willdiminish a farmer’s debt repaymentcapacity.

In addition to declining Governmentsupport programs and the volatilityof world markets, agricultural produc-ers and lenders face heightenedregulatory and public awareness ofenvironmental and health concernsrelated to farming enterprises acrossthe Nation. The ban on any newswine confinement operations inNorth Carolina and the pfiesteriainfestation in the Chesapeake Baydemonstrate this new reality. Poten-tial Federal, State, or local regulationswill likely address issues such asagricultural pesticides and the han-dling of waste products fromextremely large livestock operations.Agencies like the Environmental Pro-tection Agency are increasingly activeand are more involved in determin-ing the way farmers can conducttheir operations.

With greater price volatility in thefuture, reductions in Governmentsubsidy and disaster payments, risinginput costs, and changing environ-mental regulations, the agriculturallending environment will be exposedto greater risks. Many of these fac-tors are largely unpredictable. Creditofficers and loan portfolio managerswill be increasingly challenged todevelop effective portfolio manage-ment skills and tools to provide moreaccurate and reliable credit and loanportfolio analyses. Successful lend-ers must effectively use those toolsto evaluate the past while lookingforward to reasonably predict howspecific adverse conditions will affecttheir customers.

Credit Evaluation Practices

An irony of agricultural lending isthat the credit evaluation process hasundergone little change despite allthe dramatic changes that haveoccurred in the marketplace. Allcommercial lenders, including Systeminstitutions, establish and maintain abasic process for making creditdecisions. The evaluation of agricul-tural loans has traditionally beenbased on analysis of the five primarycredit factors. These credit factors,often called the “five C’s of credit” forcapacity, capital, collateral, character,and condition, remain valid for mak-ing sound credit decisions today. Foranalytical purposes, institutions typi-cally assign a relative weight to eachof these credit factors based on thespecific circumstances for each indi-vidual borrower.

While the “five C’s” are a useful tool,credit analysis should increasinglyemphasize the evaluation of theapplicant’s future debt repaymentcapacity. This analysis should bebased on various sources of informa-tion about the borrower that becomemore reliable and sophisticated asthe complexity and size of the farm-ing operation increases. Theyinclude historical financial indicators,credit bureau reports, an assessmentof the borrower’s managerial abilities,and a demonstrated willingness torepay the loan. Historical financialindicators can be calculated fromprevious financial statements andshould be used to assess past trendsin liquidity, solvency, profitability,efficiency, and debt repaymentcapacity. This information is impor-

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tant to lenders as they evaluate theborrower’s current financial positionand how well the borrower has per-formed in recent years. These indi-cators should then be compared tothe lender’s underwriting standards toassess the individual borrower’s cred-itworthiness.

Credit scoring models have gainedacceptance among agricultural lend-ers. The popularity of these modelsstems largely from the cost savingsand the shorter time required forloan decisions. In general, credit-scoring models are based more onpast lending history and collateralconsiderations than on the factorsthat predict the reliability of futureincome. Current models have notundergone periods of declining netincome like those experienced dur-ing the 1980’s farm crisis; therefore,

some degree of uncertainty exists onthe reliability of these models.

Lenders are expected to establishreasonable exposure limits onscorecard approved loans and toensure that loan loss reserves aresufficient to prevent the dissipationof capital. Lenders should determinethe factors that will be used toestablish the scorecard and the extentto which variables used in theinstitution’s loan underwriting stan-dards will be included. Finally, lend-ers should decide whether the creditscores are used only as input for theloan approval process or whether thescorecard becomes the only basis forloan approval. The use of lendingtools, such as stress testing andscorecard lending, will continue tochange the way lenders analyze andprocess agricultural loans.

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Agricultural loans are the mainstay ofthe System’s business and revenues.To enhance this business, the insti-tution should use the lessons learnedin the past to develop strategies tosafeguard its future. Avoiding oreffectively managing the types ofrisks previously experienced betterprepares the institution to identifyand control the variety of existingand potential risks on the agriculturallending horizon. The key underlyingstrategy is to manage risk exposureby effectively underwriting the creditrisk at a return that adequately com-pensates the institution for the riskincurred.

Lessons from the Past

Lessons from the past must beremembered as System boards andmanagement teams establish strategicplans, goals, and objectives to leadtheir institutions into the 21st century.Successful lenders must guard againstcomplacency from their recentachievements and must take the timeto reconsider where they have been.It is essential that these lessons fromthe past be incorporated in theinstitution’s philosophy for loan port-folio management.

No serious student of farm credithistory can forget the conditions thatoccurred in the agricultural commu-nity during the 1980’s. The decadeof the 1970’s brought unprecedentedgrowth and prosperity to the agricul-tural sector, which carried over intothe early 1980’s. During this period,agricultural lenders, including someSystem institutions, rapidly increasedloan volume and followed lendingpractices that were contrary to safeand sound lending principles. Anover-reliance on inflated expectationsfor future incomes combined with

rapidly increasing values for agricul-tural assets, especially farm realestate, gave lenders a false sense ofsecurity in the unsubstantiated valueof their loan portfolios. Loan deci-sions were largely driven by loan-to-value ratios that were supported bymarket-driven analysis of comparablesales of agricultural properties ratherthan by a realistic analysis of the cashflow that was generated from theproperties. In many cases, cashflows were insufficient to support thedebt levels placed on the property.Income from sources other than thepledged farm collateral was oftenneeded to repay loans made duringthis period. Beginning in 1979, majorshifts in Federal Reserve policy ledto soaring interest rates that causedmaterial declines in agriculturalincome. By 1983 this problem hadbecome widespread, and it was fol-lowed by a collapse of the agricul-tural real estate market in most areasof the United States.

These conditions contributed to sub-stantial loan losses for all majoragricultural lenders, including theSystem, commercial banks, insurancecompanies, and the Farmers HomeAdministration (predecessor to theUSDA’s Farm Services Agency) from1984 through 1989. But as cata-strophic as conditions were in thatera, more farmers survived the crisisthan succumbed to its perils.

Lessons from this period must beremembered and considered as theboom years of the 1990’s usher in anew century. Future loan portfoliomanagement must rely on depend-able and realistic incomes from allagricultural sectors and commoditygroups to establish goals and objec-tives for the institution.

Laying Out the Puzzle — The Risk Environment

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Balancing Risk and Return

Each institution’s board is responsiblefor ensuring profitable, safe, andsound operations, regardless of eco-nomic conditions in local, domestic,or international markets. The plan-ning process that is directed by eachboard functions as a key mechanismfor managing risks through periodsof market volatility and ensures thatreturns remain stable and commen-surate with the risks taken. Boardsare responsible to ensure that opera-tions will be conducted in a prudentand balanced manner in order toprovide sufficient returns to capital.

The board cannot control all thingsthat affect a borrower’s profitability inthe operating environment, such asweather, economic conditions, orcommodity prices. Yet the board ischarged with the fiduciary duty tomake certain the institution operateswithin prescribed policies, in compli-ance with laws and regulations, andin a safe and sound manner throughwhatever perils its borrowers mayencounter. Therefore, the boardmust focus its direction on thosecomponents it can control to ensurethat the institution remains financiallysound and profitable for the benefitof its stockholders and for futuregenerations of farmer-borrowers. Afew of those controllable compo-nents include the following:

• Planning strategically for variousrisk scenarios;

• Hiring capable and talented man-agement;

• Establishing loan underwritingstandards that are comparable withthe institution’s risk-bearing capac-ity and that result in sound loans;

• Pricing loans commensurate withrisk;

• Managing loan concentrations byindustry, size, commodity group,customer type, or affiliated group;

• Managing the institution’s capital;and

• Maintaining an effective and reli-able internal review process withprompt reporting to the board andmanagement.

Maintaining the balance between riskand return is a core principle thatmust guide the institution’s planningprocesses. It is especially importantin today’s business environment,which is growth driven, is highlycompetitive, and demands that morebe accomplished with less. Internalcontrols and review systems are oftende-emphasized during good timesand may result in declining capitalratios and low returns on assets.However, these effects on operationscan be mitigated through effectivemanagement processes that identify,monitor, and, in a timely way, reportrisk within an institution to its board.Once the board is aware of thesefactors, contingencies can be initiatedto control operational stability andmaintain safety and soundness.

The risk-return balance mandated bythe board must be effectively com-municated through the board’s oper-ating culture, plans, and direction.This guidance should establish initia-tives that are essential to safety andsoundness including:

• Growth Balanced by Controls —Maintaining the equilibriumbetween growth and controls iscritical during periods of economicexpansion and intense competition.As a board’s credit culture andgrowth initiatives are communi-cated through its goals and plans,its lending controls (risk param-eters, lending standards, and loan

structure limitations) should func-tion to offset the underwriting ofundue risk and provide a basis fordenying unacceptable risks. With-out these preventive lending con-trols, growth initiatives will domi-nate lending decisions. Inevitably,as the risks within commodity sec-tors and industry concentrationsremain unidentified and create anaggregated exposure, bad debtswill increase, which could becomeunmanageable.

• Loan Pricing Commensurate toRisk — Equally important as man-aging the institution’s growth withproper controls, each board mustestablish loan pricing policies thatresult in appropriate capitalaccretion and return to share-holders. For every loan that isoriginated, a loan price mustaccurately compensate the institu-tion for the risks that are assumed.These pricing risks can be segre-gated into three categories: inher-ent credit risk, risk of inadequatereturn to capital, and value-addedrisk.

Inherent risk is the probability of lossin the loan and is determined bymeasuring the likelihood thatplanned repayment will or will notoccur as projected. Conclusions onthe extent of inherent risk in anyloan are drawn from a comparisonof past and projected performancewith peers and the board’s creditstandards. Risk ratings and creditclassifications evolve from this analy-sis, and loan pricing generallyincreases in proportion to the inher-ent credit risk determined by thesemeasures. Concerns about safety andsoundness may arise during periodsof excessive growth and intense com-petition when reduced loan pricingis used to “make the credit work” or

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“keep the account.” These actionsoften understate risk to capital, aslow loan prices may inflate cash flowmargins and camouflage the inherentloan risk against detection by theinstitution’s established internal con-trols. If this condition becomes port-folio-wide or systemic, then institu-tional risks increase as performingaccounts ultimately must be repricedat a higher level to compensate forthe inaccurate risk-return situation onlower-quality loans.

The risk of an inadequate return tocapital is a safety and soundnessissue, evident during periods of rapidgrowth or intense competitive pres-sures. This risk is prevalent wheninstitutions attempt to meet compet-ing prices on individual loans with-out regard for the institutional risk-return level needed. For an institu-tion to maintain safe and soundperformance, its loan portfolio mustbe priced to yield an aggregate returnto capital that is commensurate withthe institution’s risk-bearing capacity

and its own portfolio characteristics.This goal is accomplished by quan-tifying and analyzing the materialrisks facing the institution to deter-mine what levels of profits (price)and capital (value) are needed foreach risk sector to insulate sharehold-ers from undue exposure. Each risksector should be considered bothindividually and collectively for theentire portfolio. These sectors mayinclude credit risk, concentration risk,collateral risk, interest rate risk, li-quidity risk, and others. Each riskrepresents a varying degree of poten-tial cost, and the institution’s loanpricing policy must adequately com-pensate shareholder equity for theexposure assumed. The performanceof each institution depends on theboard’s prudent oversight of opera-tions to balance the return to the riskon each individual asset. To estab-lish this balance, the institution mustconsider the aggregate balance of allparts of the portfolio, not just thepricing decision on an individualloan.

Value-added risk is the risk thatintangible benefits will not be appro-priately considered as loans arepriced. Intangible benefits mayinclude the borrower’s relationshipsto other borrowers or to potentialcustomers who do not borrow fromthe institution. This factor representsa significant business risk, especiallyin a highly competitive market. Therisk often occurs in an institution thatmarkets and services its borrowers inan impersonal manner. Loan-pricingpolicies that are developed in anenvironment characterized bygrowth, competition, and impersonalpractices will often fail to considerthe promotion, distribution, andproduct development costs that areessential to maintain a competitiveadvantage or to position the institu-tion in its niche. Therefore, theinstitution should consider value-added risk and price its loans accord-ingly. Following this practice, theinstitution will possess the means toconvert potential customers intogood business.

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Mastering the Puzzle — Building an Effective Loan PortfolioManagement System

Board ofDirectors

As the leaders of each System insti-tution, members of the board facethe unique challenge of overseeingand directing the affairs of that insti-tution. Although the board ischarged with many responsibilities,loan portfolio management (LPM) isone responsibility critical to the suc-cess of the institution. However,portfolio management does not havebe a perplexing puzzle to the lend-ing institution or its directors. Rather,the board is urged to view it as thesimple, but dynamic, process of man-aging the institution’s primary earn-ing assets (i.e., loans) to achieve theobjectives established in the board’sstrategic business and capital plans.LPM encompasses all systems andprocesses used by the board andmanagement to adequately plan, di-rect, control, and monitor theinstitution’s lending operations. Theprincipal components of an effectiveLPM system include strategic portfo-lio planning, lending policies andprocedures, loan underwriting stan-dards, a reliable risk identificationprogram, clearly defined limits forportfolio concentrations, and an in-ternal credit and collateral review.While not all inclusive, these compo-nents should be incorporated in theinstitution’s portfolio managementsystem and lending operations.

Portfolio management is a continu-ous process that must include analy-sis of how business results wereachieved, whether such results willcontinue, and how the institution canmaximize its opportunities and pro-vide the greatest benefits to its mem-bers. Because of the inherent risksin lending and the System’s statutorylimitations on lending authorities,each institution must effectively man-age the loan portfolio. While aneffective LPM system must incorpo-rate and maintain many diverse ele-ments and components, the scopeand coverage of the system may varybased on the size, organizationalstructure, and complexity of theinstitution and its loan portfolio. Inevery institution, the LPM systemmust ensure that all material aspectsof lending operations are adequatelycontrolled relative to the institution’srisk-bearing capacity.

An institution’s board should recog-nize that loan underwriting standardsare a critical component of effectiveportfolio management. Loan under-writing standards form the criticallink between the institution’s strate-gic portfolio objectives and the indi-vidual loans in its portfolio. Whilethe safety and soundness of theinstitution is ultimately determined byits portfolio management system,loan underwriting standards becomethe foundation that supports thequality, composition, size, and prof-itability of the portfolio.

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Planning

Directing

A board’s strategic business and capi-tal plans outline the vision, culture,profit potential and risk-bearingcapacity of an institution. Together,they define the institution’s operatingculture that provides the momentumfor growth, performance, and finan-cial stature. An institution’s strategicplan must communicate both theboard’s mission today and its long-term vision. In doing so, the planlays out a course of action based onan assessment of opportunities.Through an evaluation of capabilitiesand competitive forces, the planidentifies areas where an institutionshould confront competition andwhere it should avoid competition.As it relates to lending, this evalua-tion is where decisions are made toeither expand into new markets orproducts or to contract lendingoperations in anticipation of somepredicted adversity.

While the business and capital plansshould clearly project near-term per-formance, goals, and objectives, inpractice, the plans should generallyencompass a 3- to 5-year planninghorizon. The intent is that the suc-cession of several business and capi-tal plans will advance the institutiontoward achieving the vision con-tained in the strategic plan. From alending perspective, an institution’sbusiness and capital plans should

quantify the expansion and contrac-tion of its interest earning assets.These loan assets, including operat-ing loans, installment financing, “low-doc” programs, loan participations,etc., are assigned target penetrationlevels with the intent of generatingthe best possible return to equity.Within targeted asset categories, theplans should show the compositionby commodity sector, loan type, geo-graphic region, credit classification,and other loan portfolio measures.This approach quantifies the board’sestimate of what volume can beachieved within each asset classthrough the institution’s marketingefforts.

Lending policies and procedures arekey elements of LPM and shouldprovide specific direction and controlover lending operations and for eachauthorized lending program. Aninstitution’s credit policy is an agreed-upon philosophy of the board andmanagement and encompasses allphases of lending activities. Creditpolicies direct the framework ofethics, standards, and pricing pro-cesses that ultimately become theinstitution’s lending practices. Inaddition, lending policies should beconsistent with the goals and

objectives developed through strate-gic planning and should be reviewedand revised annually during the plan-ning process.

Depending on board philosophy andthe financial objectives of the insti-tution, lending policies may varyfrom offering general guidance tooffering very specific direction tomanagement. However, at a mini-mum, direction provided by lendingpolicies should be commensuratewith the program’s impact on lend-ing operations and should adhere tothe principles of sound lending andregulatory requirements. Board poli-cies and management proceduresshould specifically define theinstitution’s process and the require-ments for analyzing and document-ing loans (12 CFR 614.4150), loanservicing (12 CFR 614.4510), andcollateral evaluation (12 CFR614.4245) as prescribed in the citedFCA regulations. Board-approvedloan underwriting standards shouldbe fully defined in the lending poli-cies to clearly establish the board’sminimum standards for creditworthi-ness and acceptable risk margins.While lending policies should allowsufficient flexibility for changing con-ditions, the institution’s procedures,controls, and information systemsshould ensure that lending policiesare adequately and consistentlyimplemented.

In today’s lending environment, acredit culture is critical for eachinstitution. A credit culture shouldbe based on the way loans are made,and it should be implementedthrough the board’s credit risk man-agement and its loan underwritingstandards. The culture may originatein institutional organization and plan-ning, but it is perfected by board andmanagement through their directing,monitoring, and controlling of

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Controlling

lending operations. The optimalcredit culture strives to avoid unac-ceptable loans while making the rightones.

More specifically, a good credit cul-ture seeks to reduce risk whileincreasing growth and profits throughhigh-quality loan volume. Reducingrisk may be accomplished by evalu-ating credit applications againstunderwriting standards. Maintaininga consistent credit culture is mostoften achieved through effectivecommunication of board directionthrough plans, policies, procedures,and underwriting standards.

blocks for a safe and sound institu-tion, including appropriate checksand balances over the lending opera-tions.

FCA regulation 12 CFR 618.8430requires the board of each institutionto adopt an internal control policythat provides adequate direction forestablishing effective controls overand accountability for its operations,programs, and resources. This policyshould be comprehensive and pro-vide guidance for all operating areas,including LPM. Because of theinherent risk in lending operations,the regulation specifically calls for aninternal control program to routinelyreview and assess the institution’sassets. If properly designed andimplemented, the board’s policy andits system of internal controls providean effective framework to accomplishmanagement objectives, safeguardassets, maintain accurate financialreporting, and ensure compliancewith laws and regulations.

Effective internal controls prevent orguard against undesired actions andprovide continuing reasonable assur-ance that the institution is operatingin a safe and sound manner. If aninternal control policy or system isweak or lacking, risk exposureincreases substantially, and thechances for effective performanceand desired results are significantlyreduced. Therefore, a primaryobjective of FCA’s examination pro-cess is to ensure that effective inter-nal control systems are in place ineach institution.

An institution’s lending operationsshould be controlled by a number ofinternal control components, whichwill generally include a combinationof both “preventive” and “detective”controls. In portfolio management,preventive controls ensure that

transactions and activities are per-formed in compliance with boarddirection and objectives. As shownin the following list, preventive con-trols can be implemented in a vari-ety of ways:

• Business and capital planning;• Board policies and procedures;• Risk parameters;• Loan underwriting standards;• Risk identification and classification

systems;• Delegations of authority;• Performance standards and ap-

praisals;• Management information systems;

and• Board reporting.

Detective controls, however, prima-rily test completed transactions. Thepurpose is to identify actions oractivities that fall outside policy, pro-cedure, or risk parameters and, there-fore, are not in compliance with theboard’s objectives or direction forportfolio management. Conditionsidentified through detective controlsgenerally warrant board and manage-ment attention through remedial cor-rective actions or through plans thatcorrect weaknesses. For loan port-folio management, detective controlsgenerally include several processes asshown in the following list:

• Supervisory or managementreviews of operations;

• Internal loan review and classifica-tion systems;

• Independent internal audit,appraisal, and credit reviews;

• External audits or examinations;and

• Management’s corrective actionplans.

Internal Control System

Loan portfolio management, likeother management programs andoperations, requires an effective sys-tem of checks and balances to ensurethat the institution is meeting pro-gram objectives and is adequatelyprotected from unnecessary riskexposure. These safeguards are gen-erally provided through a system ofinternal controls that includes a com-bination of both “preventive” and“detective” controls. The foundationfor an effective control system is theboard’s internal control policy. Therelated controls developed throughthat policy will provide the building

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The depth and scope of the internalcontrol system will vary with the sizeand structure of the institution. How-ever, both preventive and detectivecontrols are necessary to ensure thatLPM objectives are achieved and toprovide reasonable assurance that theinstitution’s capital is not placed atrisk. Several components of internalcontrols are discussed in other por-tions of this publication, includingbusiness and capital planning, poli-cies and procedures, risk parameters,and loan underwriting standards.

Delegations of Authority

The board of directors has ultimateresponsibility for the conduct of theinstitution’s affairs. A major elementof that responsibility is determiningwhat authorities and powers theboard must retain and then establish-ing appropriate levels of delegationto management for the remainingareas of operation. In the area ofcredit operations, the board mustensure that lending authorities areestablished and maintained at levelsthat effectively control risk exposure,yet are not so restrictive as to impedethe lending function or operatingefficiency. Boards need to carefullybalance risk exposure with the costof internal controls, staff develop-ment, efficiency of operation, andservice to borrowers.

Meeting the credit needs of the cus-tomer while maintaining operatingefficiency is a key business objectivethat must be balanced with soundlending decisions that protect theinstitution’s capital. The aggregatedepth, experience, and capability ofthe institution’s management and staffshould form the basis for the creditauthorities that are extended tosenior management and to the loancommittee through board policy.Management, in turn, must consider

the knowledge, skills, tenure, andexperience level of each staff mem-ber when developing the appropri-ate individual level of authority. Themore complex, higher risk, and largercredits should be reviewed andapproved by those with the highestlevels of delegated authorities in theinstitution.

The appropriate delegation of creditauthority is an effective internal con-trol mechanism that can limit aninstitution’s exposure to risk fromunsound loan decisions. Boardsshould establish delegated lendingauthorities in a well-conceived, con-structive, and sound business man-ner to avoid undue risk exposure.Additionally, the board must have anunderstanding of and confidence inmanagement’s capacity to identifyand control risk through loan deci-sions, agreements, and servicing.Delegation is deemed appropriatewhen it successfully matches theinstitution’s risk-bearing ability andthe staff’s experience, tenure, andcompetence with the loan size andcomplexity that the staff members arebest suited to handle. From theboard’s perspective, delegation oflending authority must be consideredon both an institutional and indi-vidual basis. The following are someof the areas of an institution’s opera-tions where boards should considerhow delegation of authority wouldbe implemented:

• Loan Committees — A loan com-mittee, which uses group decisionmaking, can be an additional andeffective control over the lendingoperations. Depending on institu-tion staffing, the loan committeeshould be structured to enhancethe credit decision-making processby bringing in additional expertiseand management perspective. Thecommittee’s participation in the

lending function is based on theauthority delegated by the board.This participation can vary fromacting on every credit decision toacting on only credit decisions withgreater complexity, risk exposure,and visibility. As an internal con-trol element, a loan committee canbe very effective in establishing theboard’s credit philosophy andensuring compliance with theboard’s plans and policies.

• Asset-Liability Committees — Anasset-liability committee (ALCO)could be established to monitorand direct asset-liability manage-ment and interest rate risk issuesthat are important to theinstitution’s overall financial safetyand soundness. The size and com-plexity of the institution will dic-tate the structure of this group andwill determine the level of exper-tise required. The board shouldcontrol the authorities delegated tothe ALCO and establish the levelof reporting requirements from theALCO back to the board.

• Performance Standards and Evalu-ations — Staff performance plansand periodic performance reviewsfunction as internal controls toensure that board direction, objec-tives, and delegations are effec-tively implemented and results areachieved. Therefore, the perfor-mance standards that are estab-lished should be consistent withthe authorities granted and thelending policies and plans of theinstitution. Appropriate perfor-mance standards hold managementand lending staff accountable andthus greatly increase the chancesthat plans and policies will beeffective and that desired resultswill be attained. Below the boardlevel, accountability rests withsenior management, such as the

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chief executive officer and thechief credit officer, who superviseand control the lending staff.

• Compensation and Incentives —Staff salary, compensation, andincentive plans must also beclosely tied to the individual del-egations of authority and perfor-mance standards. However, theseprograms must be carefully craftedto appropriately emphasize andrecognize both the quality and thegrowth of the loan portfolio.Boards must ensure that lendingofficials and staff are not improp-erly rewarded for achieving growthobjectives through the addition ofmarginal or poor quality creditsthat place the institution’s capital atrisk. In addition to portfolio qual-ity and growth, timely risk identi-fication and reporting should beincluded as a key performancestandard. The institution’s boardand management should use thelending staff’s performance stan-dards and appraisal process toemphasize and recognize that earlyrisk identification and reporting isan important key for timely correc-tive actions and preservation ofportfolio quality.

Risk Identification Systems

Timely identification of risk in theloan portfolio is critical to the over-all effectiveness of LPM and directlyaffects the institution’s safety andsoundness. Maintaining and report-ing accurate risk ratings and classifi-cations on loan assets is a criticalcontrol to ensure effective LPM andprotection of the institution’s capital.The institution must establish adynamic and reliable internal loanreview and classification process.Material changes in performance orconditions that affect the loan’s riskexposure and classification should be

adjusted when known and shouldappropriately reflect credit r iskthrough the institution’s informationsystems and reporting processes.Typically, the assigned loan officerhas the greatest knowledge andfamiliarity with the individual cred-its, plus ongoing interaction with theborrower through loan transactions.In these types of circumstances, theloan officer holds first-line responsi-bility and must be held accountablefor ensuring that the current loanclassification reflects the borrower’sexisting condition, performance, andrisk profile.

Assessing and managing loan risk hasalways been critical to the success ofa lending institution. Many tools,including the Uniform ClassificationSystem, described in the FCA Exami-nation Manual, Section EM 320, havebeen devised to assist in these tasks.Traditional risk assessment and loanclassification systems have centeredon five categories of loan qualitywhich are: (1) acceptable, (2) otherassets especially mentioned, (3) sub-standard, (4) doubtful, and (5) loss.Additionally, an institution shouldlink loan pricing with the loan qual-ity classifications. Pricing decisionsshould form a direct link betweenthe institution’s financial performanceand its ability to assess and manageloan risk.

As the institution becomes larger andmore complex, more sophisticatedcredit risk-rating analysis has becomeessential for the well-managed insti-tution. The proper risk rating ofloans allows the board and manage-ment to establish strategic and opera-tional goals for the institution andmake necessary adjustments as eco-nomic and loan performance condi-tions change. Therefore, rating sys-tems must continually be able toevaluate and track the credit risk

both in individual loans and in theentire portfolio.

A properly structured risk-rating sys-tem can accurately estimate the riskof loss within the institution’s loanportfolio. However, the skill, expe-rience, and use of sound judgmentby credit personnel remain primaryfactors for accurate risk assessment.Effective risk identification is accom-plished when the risk-rating systemis followed and credit personnel con-sider the major components of riskrating: the identification of bothborrower risk and transaction risk.Borrower risk is the risk of loss thatis driven by factors intrinsic to theindividual borrower, such as theborrower’s financial condition, busi-ness stability, history, and past repay-ment performance. Transaction riskis the risk that is associated with theterms, conditions, and structure ofthe credit transaction, such as thelength of terms, liquidating versusunderlying collateral, and loan cov-enants.

Many System institutions and largecommercial banks have establishedand implemented risk-rating systemsthat use multiple-tier rating categories(or grades). These risk-rating catego-ries or grades can characterize allborrowers according to the level ofrisk the credit poses to the institution.Each category or grade should havea written, standardized definition thatis accepted and used by all creditpersonnel. While there are no regu-latory mandates for the categories orgrades of an institution’s risk-ratingsystem, an 8- or 10-point gradingscale, similar to the ones describedin the Robert Morris Associates 1994publication, A Credit Risk-Rating Sys-tem, has seen increasing use andacceptance by System institutions.FCA expects each institution todevelop, implement, and maintain a

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system to monitor and control thecredit risk appropriate for its portfo-lio. The accurate assignment of riskratings or grades requires all creditpersonnel to exercise prudent judg-ment, common sense, and soundcredit principles, regardless of theinstitution’s formal risk-rating system.

Therefore, at a minimum, each Sys-tem institution should have a risk-rating system that:

• Uses a common framework forassessing loan risk according todefinitions in Section EM 320 ofthe FCA Examination Manual;

• Maintains uniform definitions forall loan risk categories, which areconsistently used by all creditpersonnel;

• Identifies loans the institution seeksto pursue, those to retain, andthose to be disposed or reduced;

• Establishes the basis for appropri-ate loan pricing; and

• Determines the level of servicingand monitoring required for indi-vidual loans and specific loan port-folio segments.

Internal Credit and AppraisalReviews

The internal credit and appraisalreview process is one of the mostimportant internal control functionsin portfolio management. To empha-size the importance of this process,FCA regulation 12 CFR 618.8430requires each institution to establisha policy that includes direction forthe operation of a program to reviewand assess its assets. The reviewfunction and the reliability of thereported data contribute to theinstitution’s overall safety and sound-ness.

An effective internal credit review(ICR) program is critical for the boardto monitor asset quality, compliancewith policies and procedures, andthe adequacy of lending policies andprocedures. These periodic reviewsshould be sufficiently frequent andhave adequate scope to establish thereliability of the institution’s reportedasset classifications, the adequacy ofthe allowance for loan losses andcollateral valuations, and the effec-tiveness of credit administration. Inaddition to evaluating compliancewith lending policies, procedures,laws, and regulations, the ICR shouldassess internal controls over thecredit function, the status of correc-tive actions on previously identifiedweaknesses, and the causes formaterial deficiencies or adversetrends.

The internal audit plan and ICR pro-gram should provide for periodicportfolio and collateral appraisalreviews by qualified personnel whoare independent of the credit andappraisal functions and who reportresults directly to the board.Resource constraints may preventsmaller institutions from supportingeither a comprehensive program orfull-t ime reviewers. In theseinstances, the board should considerother alternatives, such as usingemployees on a part-time or rota-tional basis or contracting with out-side reviewers.

Another key component of the ICRprogram is management’s response tonoted deficiencies and correctiveactions and plans that are developedto address the conditions or weak-nesses that have been identifiedthrough the review process. Theseresponses and plans should be pre-sented to the board for review andapproval. The board should ensure

that appropriate follow-up is com-pleted so that planned correctiveactions are effective in resolving theidentified weaknesses.

Risk Parameters

Board policies should clearly definerisk parameters that are specificallytailored to the institution’s lendingenvironment. Risk parameters arelimits on the levels and types of riskand lending practices that are accept-able and that fall within theinstitution’s risk-bearing ability. Theseparameters are often expressed interms of a specific risk or in termsof the loan volume in a particular riskcategory in relation to the institution’scapital, risk funds, or both. There-fore, establishing risk parameters isa component of the institution’s con-trol system, which flows from itsplanning process. Risk parametersshould be adjusted as appropriateafter a careful review of the internaland external factors affecting theinstitution.

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Loan PortfolioObjectives

LoanUnderwritingStandards

Strategic portfolio planning is a majorsegment of the institution’s overallbusiness and capital planning processand a primary component of effec-tive portfolio management. Throughthe mission statement and an analy-sis of internal and external factors,the strategic planning process shoulddefine portfolio goals and objectives.This planning establishes a frame-work for directing and controllinglending operations to achieve planobjectives. Strategic planning, at aminimum, should develop four basicportfolio objectives: (1) quantifiednumerical targets for portfolio qual-ity, (2) composition of the portfolio,(3) growth, and (4) profitability.

Quality

Portfolio quality objectives shouldclearly define expectations for newloan originations and loan renewalsand should determine which loansenter or remain in the portfolio. Theinstitution should use its loan under-writing standards to control the assetquality and monitor trends in indi-vidual loans, portfolio segments, orthe entire portfolio. Quality objec-tives can be modified to initiatedesired changes in portfolio quality.If quality objectives are tightened andif the institution becomes moreselective in the new loans it acceptsor the loans it renews, loan qualityimproves, and portfolio risk exposure

Profitability

Attaining portfolio profitability objec-tives depends on the institution’sloan-pricing policies that effectivelyrelate the costs of funding, originat-ing, and servicing individual loanswith the loan’s quality and inherentrisk. As a result, loan-pricing andportfolio profitability depends onconsistent assessment of loan qual-ity against the numerical standardsthat are considered necessary forcontinuing viability.

is reduced over time. Conversely, asthese objectives are eased or as theinstitution approves an increasingnumber of loans with exceptions tounderwriting standards, portfolioquality declines, and the potential forloan deterioration and risk exposureincreases.

Composition

In conjunction with the board’s riskparameters, portfolio compositionobjectives control the quality andlevel of portfolio risk concentrationswithin a specific industry or geo-graphic region. For example, loan-underwriting standards can be spe-cifically tailored to meet theinstitution’s composition objectivesfor managing portfolio concentrationsin new or special loan programs orwithin individual industries or com-modities. Composition objectives canbe tightened or eased in response tochanging conditions or risks to adjustthe flow and quality of loan volumethat is accepted or maintained withineach portfolio segment. Once com-modity or industry concentrationswithin the portfolio reach the board’srisk parameter for the institution,board and management may con-sider selling participating interests inloans to other institutions to maintainbusiness development and loanrelationships while distributing therisk.

Growth

Portfolio growth is a specific objec-tive that each institution shouldaddress. In that regard, growthobjectives must clearly consider mar-ket conditions and the level of com-petition faced by the institution. Thecharacteristics and quality of loansthat can be approved to achievedesired loan growth must bebalanced with the institution’s creditexpertise and its risk-bearing ability.

Loan underwriting standards areestablished by the board, and theinstitution’s lending staff shouldoperate in compliance with thesestandards. Any exceptions to thestandards generally must be sup-ported by compensating strengths inthe individual loan’s credit factors,approval controls above delegatedlevels, or both. Additionally, FCAregulation 12 CFR 614.4150 requiresthat each institution establish loanunderwriting standards for the vari-ous loan products and purposes forwhich funds are advanced.

The institution’s credit procedureslink and complement its credit policyand should be consistent with theapproved underwriting standards.Credit procedures detail how creditpolicies will be implemented and

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define actions to be followed ifexceptions to the underwriting stan-dards are to be authorized. Creditprocedures often detail the ancillarylending controls that may be neededin specific situations or lending cir-cumstances to reduce and price anyrisk in the portfolio commensuratewith the capital base of the institu-tion. Another key focus of theinstitution’s credit procedures is tooutline what actions will be taken tomaintain compliance with establishedunderwriting standards. The controlsover compliance with underwritingstandards that are used in portfoliomanagement will help determine ifthe institution has taken on anacceptable level of risk.

Boards should ensure that loanunderwriting standards adequatelyand individually address each of themajor commodities or industriesfinanced by their institution.Adopted standards should be com-modity or industry specific andshould be developed based onindustry studies or analyses thatdepict the financial condition and theoperating and performance levelsachieved by the most successful pro-ducers or operators in that industry.As a result, the specific standardsdeveloped for the individual indus-try or commodity will then reflect thecharacteristics that have determinedsuccess in that commodity group. Assuch, the standards will differentiateby industry, based on the uniquecharacteristics of that industry. Forexample, standards for capitalrequirements would vary consider-ably between commodity producersgrowing one or two crops per yearversus those producing and generat-ing revenues throughout the year.

Board-approved underwriting stan-dards are indispensable to the safeand sound capital planning and port-folio administration in all institutions.Underwriting standards delineate theminimum level of creditworthinessfor individual loans and the risk-return margin acceptable to theboard. Similarly, standards ensurethat loans that are originated or pur-chased through participations complywith applicable laws and FCA regu-lations. If the institution specifiescreditworthiness through standards,capital is better insulated from unsafeand unsound lending conditions.

Underwriting standards clearly de-fine, in measurable terms, the desiredcredit criteria for granting acceptableloans. Acceptable loans may be cat-egorized under three key areas:( 1 ) c reditworthiness, (2) docu-mentation and file completeness, and(3) legal and policy compliance.The appropriate evaluation of thesethree areas before loans are bookedwill reduce loan losses and will bemore effective than the best loanworkout skills that are used after aproblem loan has been advanced.Therefore, underwriting standardsshould include the following:

• Assessment of the loan’s purposeand associated repayment program(primary and secondary);

• Evaluation of the major loan creditfactors — character, capacity, capi-tal, condition, and collateral;

• Evaluation of loan legality;• Determination of the economic

benefits (risk-return) to the institu-tion;

• Assurance that speculation is pro-hibited; and

• Assurance that loans originated arewithin the institution’s area ofexpertise.

Once these components are assessed,the institution may weight the scor-ing of the components in accordancewith its perceptions of importance.Regardless of the process chosen, aninstitution must determine and reportloans that do not meet or complywith accepted loan standards asdefined by the board. The boardshould be provided periodic reportsdetailing loans that are not in com-pliance with standards. Additionalreports by commodity risk class,price, size, branch location, etc.,could also be provided to delineatea pattern of practice and implementcorrective actions.

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ManagementInformationSystem

The heart of an institution is its loans.Agricultural lending is the principalbusiness activity for every Systeminstitution, and loans are its majorsource of revenue. Conversely, loansalso represent the greatest source ofrisk to the institution’s safety andsoundness, and they have been themajor cause of losses and institu-tional failures. Because of their pre-dominate importance to the existenceand success of the institution, theassets within the loan portfolio con-tinually warrant the highest and bestmanagement skills and the mosteffective tools and processes to man-age and control the opportunitiesand inherent risks.

provides sufficient, accurate, andtimely information on the condition,quality, and performance of the loanportfolio to enable board and man-agement to make informed and pru-dent decisions on credit extensions,controls, and risk exposure. Withtechnological advancements continu-ing at a rapid pace, the number,variety, and complexity of availableloan products and the size and com-position of loan portfolios haveescalated. In some institutions, theMIS capabilities have not kept pacewith these dynamic changes nor withthe increased need for more effectiveloan portfolio management. There-fore, the board and managementmust periodically assess the informa-tion needed to effectively lend andmanage in this changing credit envi-ronment and must evaluate theadequacy of its MIS to provide thatneeded information in an accurateand timely manner.

Components of the MIS

Each institution must have an MIScapable of providing sufficient infor-mation, data, and reports to identifyand monitor all primary business andcredit risks. The minimum compo-nents for MIS are a comprehensiveloan accounting system and a gen-eral ledger system that accuratelytracks and reports the institution’sfinancial condition and operatingresults. Standard accounting andregulatory reports are necessary toassist the board and management infulfilling their responsibilities. Whilethe composition and format of port-folio management reports may vary,every MIS should routinely report onthe financial condition and perfor-mance of the institution and on therelated quality of its loan portfolio.

To achieve portfolio objectives, acomprehensive MIS is necessary tosupport the internal control system,to measure compliance with loanunderwriting standards, and to iden-tify and manage portfolio risk. As acritical component of portfolio man-agement, an MIS, at a minimum,should have sufficient componentsand capacity to provide for the fol-lowing:

• Systems Integration — The MISshould be capable of acceptingmultiple data entries to effectivelyintegrate borrower financial andcredit information with the loanaccounting system. The informa-tion system should also have thecapacity to generate standard andcustomized detailed managementreports based on queries of port-folio characteristics.

• Current and Accurate Data — Inter-nal controls should provide reason-able assurance that MIS data isaccurate, updated, and maintained.Credit procedures should providedetailed and specific guidance forcalculating loan underwriting stan-dard ratios to ensure consistent andcomparable data throughout theportfolio and over consecutive timeperiods.

• Integration With Capital Planningand Allowance for Loan Losses —An effective MIS should be linkedto and facilitate the institution’sprocess for periodically analyzingand determining the allowance forloan losses and capital adequacy.MIS information and summaryreports on the loan portfolio, in-cluding compliance with under-writing standards, should be regu-larly extracted to determine lossexposure (probable, potential, orremote possibility) based on creditquality, collateral position, andother measurable portfolio risks.

Loans

An institution’s loan portfolio man-agement system and its internal con-trol system depend on an adequatemanagement information system(MIS). An adequate MIS is one that

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Monitoring

• Compliance With UnderwritingStandards — The MIS should iden-tify and report each loan’s compli-ance with the approved underwrit-ing standards (where standards arequantifiable) and clearly and con-tinually report exceptions that falloutside the underwriting standards.The system should have the capac-ity to summarize and report port-folio noncompliance on a routinebasis and to query for customizedreports on portfolio segments.

• Loan Pricing — Sufficient loan pric-ing information should be includedin the MIS to permit periodic evalu-ations of pricing in relation tocredit risk factors. Additionally, theMIS should measure whether ornot loan pricing decisions result inthe building of capital as risk in theloan portfolio changes.

• Risk Monitoring — The MIS shouldbe an integral part of strategic andbusiness planning. To effectivelymonitor portfolio risk, institutionsshould have a loan accounting sys-tem that incorporates risk param-eters, loan underwriting standards,and interest rate assignments withthe collection and analysis of bor-rower financial data. The riskparameters established for portionsof the portfolio that require greaterscrutiny should be incorporated inthe MIS and routinely monitored.

A reliable and comprehensive report-ing process should be establishedthrough board policy. Reporting isessential for maintaining an effectiveportfolio management program. Theinstitution’s reporting mechanismshould provide the board with rea-sonable assurance that lendingoperations and activities are beingcarried out in accordance with theirdirection, delegations, and objectives.In addition, board reporting shouldprovide continuing evidence thatloan portfolio objectives in the busi-ness plan are being achieved andthat the institution’s capital is notplaced at unnecessary risk.

One of the key elements that boardsshould address in developing institu-tion policies is the establishment ofmanagement reporting requirements.The policy should generally describewhat is to be reported to the board,the frequency and content of thereports, and the individual(s) respon-sible for report preparation. In mostinstitutions, the chief executive officerhas overall responsibility for report-ing to the board, and the chief creditofficer generally has primary respon-sibility for the development andaccuracy of reports provided for port-folio management areas. In estab-lishing reporting expectations, theboard must adequately consider boththe need and sources of the desired

information. Useful loan portfoliodata can originate in either theexisting automated information sys-tems or can be compiled throughmanual processes. Periodically, theboard should review the quality, con-tent, and type of information pro-vided to ensure that it complies withboard reporting criteria and satisfiesthe board’s need for information andcontrol.

Therefore, the board must define andperiodically adjust its reportingrequirements to ensure that itreceives adequate information tomonitor portfolio performance inrelation to board objectives and goalsas well as to the changing conditionsand risks in the lending environment.The frequency and timeliness ofreports should also be clearly estab-lished to delineate board expecta-tions for monthly versus quarterlyreports and for individual transactionreporting versus summaries of perfor-mance and planned-to-actual com-parisons.

While reporting requirements mayvary with the size, structure, anddiversity of lending operations,adequate board reporting require-ments become increasingly importantin proportion to the level of delega-tions granted to management andstaff. As the board has ultimateresponsibility for the affairs of theinstitution, sufficient reporting sys-tems must be in place to keep theboard adequately informed of loanactions taken. On a routine basis,management should summarize andreport all loan actions completedunder delegated authority. Moreimportant, the board should ensurethat management reports all loanactions that are exceptions to policyor loan underwriting standards orthat are outside the board’s delegatedauthorities. These exceptions to

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board direction warrant a higherdegree of review as, individually orcollectively, they expose theinstitution’s capital to increased risk.

Portfolio Stress TestingThrough the MIS

An effective MIS should be flexibleand capable of providing advancedanalysis and reporting. As institu-tions are exposed to increasing ordifferent levels of risk, such as sig-nificant commodity concentrations orprice volatility, more sophisticatedMIS capabilities and customizedreporting are warranted. To ensureeffective and timely portfolio and riskmanagement for the more complexinstitutions, the MIS should have thecapability to conduct portfolio stresstesting and to predict portfolio risksunder a variety of changing condi-tions or within a combination ofalternative scenarios.

In those institutions, the MIS shouldfacilitate an analysis of the impact ofchanging economic or industry con-ditions on the quality and inherentrisk in the existing loan portfolio.For example, any stress-testing modelshould enable testing of changes inkey variables that can affect aborrower’s repayment capacity, cashflow, or financial condition. At aminimum, stress-testing modelsshould be able to predict the impacton a loan or group of loans. Thatimpact could be the result of changesin the following:

determine how much of that indus-try it is willing to finance based onits current risk-bearing ability.

MIS and stress-testing models shouldbe capable of categorizing risk inrelation to the portfolio’s compliancewith loan underwriting standards.The models should easily identifyloans that are clearly “low” or “high”in relation to standards. Loans thatfall in the middle require additionaljudgment or analysis by managementto fully assess risk. A reliable MISwith the capacity to effectivelyaddress the above areas providesreasonable support for the portfoliomanagement functions, maintainseffective internal controls, and helpsensure the institution’s safety andsoundness.

Risk Evaluation

A common approach to portfolio riskanalysis involves analyzing thepresent composition and perfor-mance of the existing loan portfolio.This analysis may be accomplishedby “slicing and dicing” portfolioinformation and does not require anystress testing beyond the currentperiod. Typical goals may be todetermine the number and volume ofloans outstanding by predeterminedcategories, such as loan qualityclasses, primary commodity, branchoffice, loan officer, size of loan, orvarious financial or performanceratios.

The loan portfolio “slicing and dic-ing” gives an overall characterizationof the institution’s principal assets,including the concentration of loansin specific ranges or commoditygroups. Further, this method allowsassessment of the current perfor-mance of key portfolio segments.For example, the current financialposition of all dairy farmers in the

Evaluation

• Interest rates;• Production costs and operating

expenses;• Commodity prices;• Production levels; and• Collateral values.

Periodic stress testing enables theinstitution to assess the borrower’scapacity to absorb financial stress andto identify what level of stress causesthe loan to move outside the under-writing standards for that particularloan or commodity. As a result, theinstitution could quickly and effec-tively forecast the impact on borrow-ers from either potential or projectedchanges within a given industry,commodity, or portfolio segment.The changes in the individualborrower’s income stream, financialcondition, or both can then beaggregated across the portfolio or aportfolio segment to project potentialchanges in reported loan classifica-tions and asset quality.

Stress testing enhances management’sability to identify and control risk andto plan, prepare, and respond to realand potential portfolio threats. Stresstesting is particularly critical where aninstitution cannot control the keyvariables that create risk in its lend-ing environment. For example, fourof the five variables cited above thatcan affect a borrower’s financial per-formance and condition are outsideof the institution’s control. As theinstitution controls only the borrowerinterest rate, loan repayment andinstitution capital remain especiallyvulnerable to uncontrollable vari-ables. However, the institution cancontrol the level of risk it is willingto assume in any lending environ-ment by adjusting its loan under-writing standards. If the variableschange and production costs increasein a certain commodity or industry,the institution should be able to

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portfolio can be specifically exam-ined. This examination wouldinvolve sorting out all loans listingdairy as the primary commodity andthen determining the number andamount of dairy loans in specificranges for such key ratios as debt-to-asset and term debt coverage orother ratios used as loan underwrit-ing standards.

While the analysis described abovedeals with individual loans or port-folio segments, another approach toportfolio analysis is based on theinstitution’s current performance andits capital position. This type ofanalysis requires data from theinstitution’s current or projected bal-ance sheet, income statement, andthe sources and uses of its fundsstatement. A primary goal is toassess the institution’s profitability

relative to its risk exposure. A num-ber of ratios and other indicatorsassist the board and management inassessing portfolio risk and returns.These risk indicators should focus onthe capitalization, asset quality, andliquidity of the institution and itsfinancial statements. Profitabilityindicators should focus on operatingefficiency and rates of return. Eachinstitution should tailor its perfor-mance measures to the conditionsand environment particular to theinstitution. However, measures ofperformance for the FCA’s FinancialInstitution Rating System are identi-fied in the March 2, 1998, Informa-tional Memorandum from the ChiefExaminer, and provide guidelines inthe areas of capital, earnings, assetquality, and liquidity.

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Conclusion

An institution’s success depends on the proper assessment and measure-ment of its primary earning assets — loans. Neither the assessment norany measurement can be deemed a reliable or reasonable predictor of futureperformance unless the institution accurately identifies and manages the creditrisk in its portfolio. Therefore, an LPM system that encompasses all theprocesses used by the board and management to adequately plan, direct,control, monitor, and evaluate the institution’s lending operations is anessential component of a well-managed institution. Just as the pieces ofthe LPM puzzle are laid out in this publication, loan portfolio managementis solved through the careful and prudent implementation of each respec-tive component or, figuratively speaking, each puzzle piece. Further, prop-erly established and implemented loan underwriting standards form the link-age between individual loan assets and portfolio objectives.

When properly established, approved, and implemented, all components ofan effective loan portfolio management system, working together, providethe controls for the institution to maintain its operations in a safe and soundmanner. The LPM puzzle is framed as a diagram on the following page todemonstrate how each component may be linked to fit into an effectivemanagement system that any institution can use.

Thus, as each System institution analyzes its lending environments andestablishes its loan portfolio management systems, the recognition of lessonsfrom the past and use of historical credit analyses must be coupled withrealistic projections of future scenarios. The Agency anticipates the increasinguse of stress-testing models for individual loans, loan portfolio segments,and for the institution itself. Establishing comprehensive risk evaluation andmonitoring systems by using pro-forma analyses for the institution’s overallperformance should help the Farm Credit System profitably compete in the21st century.

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Framing the Puzzle — Diagram for EffectiveLoan Portfolio Management

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Copies Are Available From:Office of Congressional and Public AffairsFarm Credit Administration1501 Farm Credit DriveMcLean, Virginia 22102-5090703-883-4056

2500/1198