LOAN COMMITTEES (PART 2 OF 2)

If your loan committee approves more than 75% of the presented loans, your approval process might need a revision. In other words, if loan committee is just a rubber stamp to the CCO, why waste the committee's time? Yesterday, we discussed how a bank's loan committee should be reviewing the riskiest loans that are not necessarily the largest loans. By looking at the overall expected loss of a credit exposure (such as output derived from our Loan Pricing Model), loan committee resources can be focused on the tough decisions, hopefully increasing effectiveness. The tacit assumption for loan committee is that its collective intelligence is superior to the CCO (otherwise they would be better off in letting the CCO make the tough credit decisions). If true, then it stands to reason that the CCO inaccuracies run both ways. This points to the fact that loan committees should also be reviewing loans that have been turned down at the CCO level. Reviewing the turned down loans is almost equally important to better understand what credits the bank is passing on, as it represents a loss of a potential revenue stream (opportunity cost). If risk tolerances are set correctly and the loan process is efficient, then statistically speaking, turndowns and approvals will happen with equal frequency. Therefore, approval rates should be between 30% and 70% depending on where the loan risk tolerance levels are set. In summary, the less risky loans should receive faster approvals that should hopefully translate into better pricing because of superior customer service. The more risky loans should face more accurate decisions, as more resources are spent analyzing these credits for both approval and disapproval. Of course, as stated earlier, all of this is predicated on the fact that your loan committee can make better decisions than the CCO or other less formal credit authority. This we realize is a celestial leap of faith, which brings us to our last point in analyzing loan committee efficiency. In a majority of banks, officers and/or the loan committee can approve loans up to some threshold, with the board approving anything above this number. The board, which is mainly a group of non-bankers, has the approval to make a bank's riskiest loans, while the professionals of the loan committee are relegated to lower approval status. This is mis-use of resources, as the board's role should be in the setting and monitoring of policies and risk/return limits in order to ensure the safety, soundness and profitability of an institution. This is a check mechanism against management, not an operational function. The board should have the right to change management, limits or policies, but not approve loans. A board extending beyond this introduces the very risk that they are seeking to eliminate – namely poor loan judgment and the potential for a conflict of interest. Board members that approve loans have a stake in the loan process and may not be able to render judgment in a fair and impartial manner. More importantly, if part-timers override the decisions of full-time professionals, then either new professionals or a new board is needed.