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Managing Lending RiskPresentedby:CarrieKennedy,CPA,PartnerAnthonyPorter,CPA,Manager

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Thematerialappearinginthispresentationisforinformationalpurposesonlyandshouldnotbeconstruedasadviceofanykind,including,withoutlimitation,legal,accounting,orinvestmentadvice.Thisinformationisnotintendedtocreate,andreceiptdoesnotconstitute,alegalrelationship,including,butnotlimitedto,anaccountant‐clientrelationship.Althoughthisinformationmayhavebeenpreparedbyprofessionals,itshouldnotbeusedasasubstituteforprofessionalservices.Iflegal,accounting,investment,orotherprofessionaladviceisrequired,theservicesofaprofessionalshouldbesought.

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ABOUT MOSS ADAMS LLP

• Full‐servicepublicaccountingfirmwithassurance,tax,andconsultingservicesformiddle‐marketpublicandprivatecompanies

• Oneofthe15largestaccountingfirmsintheU.S.andlargestfirmheadquarteredontheWestCoast

• 22officesinArizona,California,Kansas,NewMexico,Oregon,andWashington

• Foundedin1913andheadquarteredinSeattle,Washington

• Wearethe4thlargestfirmservicingcreditunionsinthenation(basedonassets)

• FoundingmemberofPraxity,aglobalallianceofaccountingfirms

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PRESENTERSCarrieKennedy,CPA,PartnerCarriehaspracticedpublicaccountingsince1997.Sheperformsinternalauditoutsourcing,supervisoryaudits,annualopinionaudits,loanreviews,andSECreportingengagements.CarrieisamemberoftheFinancialServicesGroupandprovidesauditandbusinessassuranceservicestoher20creditunionandfinancialinstitutionclients.Herexperienceincludesfinancialandoperationalaudits,withrelatedmanagementrecommendationsforcostsavingsandefficiencyimprovements; loanfilereviewandevaluation;numerousrecurringauditsoffinancialstatements;assistance,preparation,andreviewofSECregistrationstatements,includingFormsS‐1,S‐4,andForms10,10‐K,10‐Q,and8‐Q;andemployeebenefitplanauditsandqualificationstatusreviews.

AnthonyPorter,CPA,ManagerAnthonyhasbeeninpublicaccountingandwithMossAdamsforsixyearsworkingwithfinancialinstitutions.Hemanagesfinancialandoperationalaudits,withrelatedmanagementrecommendationsforcostsavingsandefficiencyimprovements.HehasexperiencewithSECfilingsandregistrationstatements,mutual‐stockconversions,andmergerandacquisitionengagements.Heisproficientinallphasesofaudits,includingHUDreporting,Sarbanes‐OxleyandFDICIAcontroltesting,fieldwork,andreportpreparation.Anthonyisalsoinvolvedinthefirm’sFinancialServicesGroup.HereceivedaBAinBusinessAdministrationwithanemphasisinAccountingandaMastersofProfessionalAccountancyfromtheUniversityofWashington.

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OBJECTIVES

• Distinguishbetweenpreventativeanddetectivecontrols

• Gainanunderstandingthetypesofcontrolsthatshouldbeinplaceforastrongcontrolenvironment

• Understandtherisksassociatedwitheachtypeoflending:mortgage,consumer,indirect,andmemberbusiness

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CONTROL ENVIRONMENT

• Whatisthetone?o Ethicaltenorstartsattopmanagementandtricklesdown

o Codeofconduct?

• CreditUnioncancontrol“opportunities”forfraud

• Active,strongcontrolsreducetheopportunitiesavailabletothosewhofindthemselvesinthecircumstancesreferredtoabove.

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CONTROL ENVIRONMENT

• Internalcontrolobjectivesaredesiredgoalsorconditionsforaspecificeventcyclewhich,ifachieved,minimizethepotentialthatwaste,loss,unauthorizeduseormisappropriatewilloccur.Theyareconditionswhichwewantthesystemofinternalcontroltosatisfy.

• Foracontrolobjectivetobeeffective,compliancewithitmustbemeasurableandobservable.

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INTERNAL CONTROLS

• Internalcontrolscanbedetective,corrective,orpreventativeinnature.

o Preventativecontrolsaredesignedtokeeperrorsorirregularitiesfromoccurringinthefirstplace.

o Correctiveerrorsaredesignedtocorrecterrorsorirregularitiesthathavebeendetected.

o Detectivecontrolsaredesignedtodetecterrorsorirregularitiesthatmayhaveoccurred.

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INTERNAL CONTROLS

• Preventativevs.Correctivevs.Detective

o Preventative Strongesttypeofcontrol Largercompanieswithlotsofemployees

o Corrective Notassaspreventative Difficulttoimplement MorecommoninITareas

o Detective Notasstrongaspreventativeorcorrective Smallercompanieswithlimitednumberofemployees BetterthanNO controls

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LOANS – INTERNAL CONTROLS

• Lendingfunctioncanbebroadlydividedintothefollowingcategories:o Originationanddisbursemento Loanreview(QCandCreditQuality)o Creditsupervision/monitoring

• Segregationofdutieso Separatetheunderwriting,disbursement,andboardingprocesses

o Systemcontrols• Preventivemeasures

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LOANS – ORIGINATING AND DISBURSEMENT

• Originating

o ApprovedloanpolicycoveringLTV’s,loantypes,DSC,andother

factors

• Hasitbeenupdatedbasedoncurrenttimes?

‐ Properapprovalauthority

o Approvedappraisers

Orderedbysomeoneotherthanloanofficerorunderwriter

o AppraisalreviewsonALL appraisals

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LOANS – ORIGINATING AND DISBURSEMENT

• Appraisalreviews‐Howareyoucomfortablethe

appraisalcanbereliedupon? Appraisalreviewconductedbyindependentqualified3rd party,

eitherinternalorexternalparty

Usuallya“deskreview”andincludes:

– Descriptionofthepropertyandconclusiononappraisersvalue

– Discussionofkeyassumptionsusedbytheappraiser

– Summaryoftheappraisersfindings

– Ultimateconclusiononvaluecomparedtoappraisersfindings

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LOANS – ORIGINATING AND DISBURSEMENT

• Originatingo Collateralliens UCCsearchesandfilings Filingdeedoftrust Titlepolicies Freezingshares

o Qualitycontrolreviewtoensureallcollaterallienshavebeenperfected

o Ticklersystemforoutstandingdocumentsnotyetreceived

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LOANS – ORIGINATING AND DISBURSEMENT

• Disbursemento Performedbyindividualseparatefromtheorigination/underwritingprocess

o Ensureproceedsareusedfortheborrower’sstatedloanpurpose

o Unabletosegregatedisbursementfunction???

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LOANS – LOAN REVIEW

o Boardingreview

Detectscommonerrorssuchasinterestrateandmaturity

dateerrors

o Qualitycontrolreview

Determinewhetherloansadheretotheloanpolicy

Conductedbypersonnelindependentofcreditfunctions

Don’trelyonyourexternalauditors!

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LOANS – LOAN REVIEW

• CreditQualityReviewo IncreasinginfrequencyatCreditUnionswiththeincreasein

MemberBusinessLending

o Usuallyperformedbyexternal3rd party

o CanbetiedinwithQCloanreviews,butultimatepurposeisto

validatethecreditevaluation/monitoringbytheCreditUnion

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LOANS – CREDIT SUPERVISION/MONITORING

• CommonKeyCreditRiskIndicators

o Delinquency(60+dayspastdue)

o Earlystagedelinquency(1– 59dayspastdue)

o Charge‐offhistory

o FICO/LTV/loangrademigration

o Concentrations

o Multiplemodifications/extensionsandrenewals

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LOANS – CREDIT SUPERVISION/MONITORING

• Questionstoaskregardingmonitoring:

o Istheloanreviewfunctionindependentofthecreditadministrationandloanapprovalprocesses?

o Areanyloanfindingsreporteddirectlytotheboardofdirectorsorboardlevelcommittee?

o Doestheboardreceivenecessaryandreliableinformationonaregularbasistoassessandpotentialriskswithinthelendingportfolio?

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LOANS – CREDIT SUPERVISION/MONITORING

• Questionstoaskregardingmonitoring:

o Areproceduresinplacetoensurethepromptidentificationofloanswithwell‐definedweaknessesandrelevantlendingpatternsthatmaypotentiallybeindicativeoffictitiousorfraudulentactivity?

o Doloanreviewpersonnelhavetheknowledgeandconfidencetochallengetransactionsthatlooksuspicious?

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LOANS – FRAUD CONTROLS

• Commondetectivecontrolstoidentifyerrorsand/orfraudo Reviewlowrateloanreportso Commonaddressreviewo Filemaintenancereportsshouldbereviewedfor:

Advancingpaymentduedates Changesininterestrates Changesofthepaymentamount Severaladdresschangestothesameaddress Changingthepaymentfrequency

o Overdraftreportsreviewedfor: Overdraftscreatedforpurposeof“paying”loan

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LOANS – FRAUD CONTROLS

• Otherfraudanderrordetection

o Largeamountofinterestisdue,buttheloaniscurrent

o Originalloanamountandcurrentloanamountarethesame,buttheloanisnotdelinquent

o Reviewofemployeeandofficialloans

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LOANS – INTERNAL CONTROLS

• Othercontrolstoconsider

o Reconcilingsubsidiariestothegeneralledger

o Globalratechangereview

o Loanexceptionreport

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LOANS – INTERNAL CONTROLS

• Memberstatementsarethefinaldetectioncontrols

o Propercontrolsoverno‐mailandprintsuppressed

o Reconcilingtotalstatementsprocessedtomembers

o Timelyresponsetomemberinquiries

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INDIRECT LENDING

• Whatisit?o Existsindifferentformso Mostcommonformisanarrangementwhereacreditunioncontractswithamerchant(commonlyacardealer)tooriginateloansatthepointofsale.

• Whataretherisks?o Rapidgrowthinanindirectproductlinecanleadtoamaterialshiftinacreditunion’sbalancesheetcomposition.

o Improperlymanagedindirectprogramscanleadtounintendedriskexposureincludingcreditrisk,liquidityrisk,transactionrisk,andcompliancerisk.

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INDIRECT LENDING

• MitigatingRisko Processinplacetoperformduediligenceonthethirdpartyvendorswhichshouldinclude: Aplanningprocesswhichassessestheriskofthevendorrelationshipbothinitially andongoing

Writtenpoliciesaddressingallfacetsofindirectlendingprogramincludingunderwritingandmonitoring

Aprocesstoperiodicallyassessthelegalagreements Areviewprocesstoassessthevendor’sfinancialandoperationalrisks

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INDIRECT LENDING

• MonitoringActivitieso Approval/declineratiosbydealer

o Firstpaymentdefaultsbydealer

o EvaluateALLLlossratios

Separatefromdirectautos

o Earlypayoffsbydealerandincentivespaid

o Loansapprovedbyloanofficer

o Loan‐to‐valuebydealer

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INDIRECT LENDING

• MonitoringActivities‐ Delinquencyrates

• Bydealer• Byloanofficer• Byoriginationdate• Bycreditscore• Bydays– typicaldelinquencyreport

‐ Trackchargeoffsbythesecategoriesaswell

‐ Ratesofreturn/profitabilityanalysisbyvendor

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INDIRECT LENDING

• QualityControlProcess

o Reviewoftheapplication

Isincomeconsistentwiththestatedjob

CreditReport– Comparisonwithapplication

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MEMBER BUSINESS LOANS

• Increasinginfrequencyacrosscreditunions

• Thesearecommercialloansandaremorecomplexthanthetypicalconsumerloano Alsoincludesallparticipatedloans

• TheyareregulatedbyNCUAPart723

• Requiresincreasedunderwritingcontrolsandmonitoring

• Increasedrisk

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MEMBER BUSINESS LOANS

• Therearerestrictionsonloantypesandvolumeofloanso CreditUnionscurrentlylimitedtolesserof1.75xcreditunionnetworth,or12.25%oftotalassets

o Legislationintroducedtoincreasethelimitto27.5%oftotalassets

• Needtomonitorandreportratiostoensurecompliancetobothpolicyandregulatorylimits

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MEMBER BUSINESS LOANS

• UnderwritingIssueso Rightpeoplewithadequateexperience

o Appropriatesegregationandlimitsonapprovalauthority

o Understandinganddocumentationofcashflows(spreads),collateral,guarantees,strengths,andweaknesses

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MEMBER BUSINESS LOANS

• Monitoringo Goodsecondaryreviewprocess Stronglyrecommend3rd partyreview

o Concentrations Typicallycreditunionsaregeographicallyandmemberoccupationconcentrated.Isthereproductconcentrationtoo?

o MonitoringLTV’sandfuturematuritiesofcollateraldependentloans

o Morepronetoextensions,renewals,anddelinquencies PotentialTDR’s

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MEMBER BUSINESS LOANS

• Participationspurchased‐ Purchaseroftenreliesontheworkperformedbyotherinstitution

• Purchasesofmorethan50%shouldberare!‐ Monitoringismuchmoredifficult

• Knowtheparticipatinginstitution‐ Substantiallosseshaveoccurredhereandforeclosuresgetmessy

• Participationlosseshavegrown

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MEMBER BUSINESS LOANS

• Allowanceforloanlosses

o Loangrading

3rd partycreditreview

o Impairmentanalysis

Policyonfrequencyofanalysisandcollateralvaluation

updatesandtypesofacceptablecollateralvaluations?

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OTHER LOAN ISSUES

o TroubledDebtRestructurings(TDR)

Whocanapprove?

ProcesstoidentifyTDR’s

ReportTDR’stomanagementandtheBoard

Disclosureandproperaccountingtreatment

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OTHER LOAN ISSUES

o CreditCards– StillRisky?

Creditcardchargeoffscontinuetodecline

Stabilityoftheaveragecreditcardholderstillunpredictable

Competitiverisksincreasing

Reviewunderwritingapproachesandportfoliomanagement

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OTHER INTERNAL CONTROL ISSUES TO CONSIDER…

o Nomatterhowwellinternalcontrolsaredesignedand

implemented,theycanonlyprovideareasonableassurancethat

objectiveswillbeachieved.Somelimitationsareinherentinall

internalcontrolsystems.Theselimitationinclude:

Judgment– theeffectivenessofcontrolswillbelimitedbydecisionsmade

withhumanjudgment

Breakdowns– evenwelldesignedinternalcontrolscanbreakdown.

Employeessometimesmisunderstandinstructionsorsimplymake

mistakes.Errorsmayalsoresultfromnewtechnologyandthecomplexity

ofcomputerizedinformationsystems.

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OTHER INTERNAL CONTROL ISSUES TO CONSIDER…

o Controllimitationsalsoinclude:

ManagementOverride– highlevelpersonnelmaybeableto

overrideprescribedpoliciesorproceduresforpersonalgainsor

advantages.Thisshouldnotbeconfusedwithmanagement

intervention,whichrepresentsmanagementactionstodepartfrom

prescribedpoliciesandproceduresforlegitimatepurposes.

Collusion – controlsystemcanbecircumventedbyemployee

collusion.Individualsactingcollectivelycanalterfinancialdataor

othermanagementinformationinamannerthatcannotbe

identifiedbycontrolsystems.

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OTHER INTERNAL CONTROL ISSUES TO CONSIDER…

o Whataresomecommonissuesfacedbylending

controlsofCreditUnions?

Notenoughstaff– eachdifferentlendingcyclerequires

separatecontrolsandcreatessegregationofdutiesissues

Tooexpensive – considerthecostsofabreakdown

Trustofemployees– trustworthyemployeesarenotagood

reasontolimittheamountofcontrols

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QUESTIONS

CarrieKennedy,CPAPartnerMossAdamsLLP509‐777‐0760Carrie.kennedy@mossadams.com

AnthonyPorter,CPAManagerMossAdamsLLP425‐258‐5899Anthony.porter@mossadams.com

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QUESTIONS

CarrieKennedy,CPA,PartnerMossAdamsLLP(509)777‐0160Carrie.Kennedy@mossadams.com

AnthonyPorter,CPA,ManagerMossAdamsLLP(425)258‐5899Anthony.Porter@mossadams.com