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Director's Corner

San Francisco Region Director's College Computer- Based Training
Asset Quality

Overview of Asset Quality
In evaluating asset quality, examiners will look at the existing and potential loss exposure, primarily in your loan portfolio, but also in the investment portfolio and other assets as well. As with every CAMELS component, we put a lot of weight on management's ability to recognize and control portfolio risk. Even if your bank has very few adversely classified assets, asset quality could still be rated less than satisfactory because management is not adequately controlling the potential credit risks. Keep in mind, our conclusions about asset quality will directly impact the other component areas, such as capital, earnings, and especially management.

 Evaluation Factors
The assessment of asset quality involves much more than simply calculating past due and adverse classification ratios. In addition to assessing trends in classified assets, delinquent loans, and credit concentrations, the asset quality component rating takes into account management's ability to underwrite and administer credits in a prudent and sound manner.

What Should a Director Do?
As directors, you have four primary responsibilities in the asset quality area:

  1. Adopt effective policies before loans are made
  2. Enforce those policies as the loans are made
  3. Monitor the portfolio after the loans are made
  4. Maintain an adequate Allowance for Loan and Lease Losses (ALLL)
 1. Adopt Effective Loan Policies
In today's environment, the need for effective policies is more critical than ever before. New products, new regulations, merger activity, etc. require that the board effectively convey their risk tolerance to the loan officers. Make sure it is your credit culture that the loan officers are adhering to, not their previous employer. Listed below are other items to keep in mind as you annually revise your loan policy.

  • Send a clear message - Don't confuse your loan officers with a loan policy that sounds conservative when management stresses growth. Whatever your plan is, use your policies as a guide to achieve that plan.


  • Customize your policies to suit your institution - There is no "one size fits all" loan policy just like there is no "one size fits all" for an audit program or business resumption plan. While examiners don't expect boards to reinvent the wheel, you will still need to take a generic policy and tailor it to your own size, products, risk tolerance, etc.
 2. Enforce Adherence to the Loan Policies
The two largest aspects of enforcing policy adherence are (1) requiring loan officers to provide comprehensive credit memos/write-ups to the loan committee during the approval process that identify exceptions to the loan policy, and (2) ensuring that an effective loan review function is in place to review the loans after they are approved (discussed below). Loan officers should be required to address exceptions to the loan policy in their credit approval memos/write-ups. The loan officers should explain why the exceptions are necessary and how the exposure is mitigated. This gives you and/or other approving officials the ability to track exceptions in monthly reports and ensures that the loan officers are familiar with the policy. Keep in mind that loan officers have been known to deliberately structure loans to avoid bringing them to loan committee. This exposure can be mitigated by requiring your bank's loan review process to review smaller loans, under the loan committee threshold, for exceptions to the loan policy.

 3. Monitor the Loan Portfolio
After loans are made, directors should be monitoring the portfolio to determine if the credits are being administered properly and what the overall condition of the portfolio is. At a minimum, directors should provide for an effective credit review program and review a variety of management reports on the loan portfolio during the board meetings.

  • Management Reports - The monthly board packages should include a variety of loan reports, including a watch list detailing all problem or potentially problem credits. The package should also contain a delinquency report, a listing of new and renewed credits, the results of the internal or external loan reviews, and asset concentration reports. The board should require management to explain changes or trends and should require accuracy and objectivity in the reports. For example, an examiner should rarely be the one to convey bad news regarding a credit. If your loan officers and management teams are truly monitoring their portfolios, then they should be the first to downgrade credits. Having a lot of downgrades at an examination indicates an internal control weakness that will impact not just the asset quality rating but also the management component rating.


  • Loan Review Systems - Every bank should have a loan review system that, among other things, accurately assigns risk ratings and promptly identifies loans or industries that are developing credit weaknesses. This allows senior management and the board to take appropriate action to mitigate risks and provides them with the information needed to assess the adequacy of the ALLL. The complexity of the loan review process will vary based upon a bank's size and type of operations and could be performed internally or externally.

Directors should ensure that the scope of the loan review covers all significant credits or pools of credits. Besides large loans and known problem credits, you might want your credit review to target loans from a specific branch, department, or officer - especially if they have generated an unusually large amount of business. The review could also focus on concentrations to a particular industry or collateral type, or areas that the board has deemed to be a higher risk. Expect management to address all of the concerns identified in the loan review reports and expect status reports and timelines for correction in an audit tracking report.

4. Maintain an Adequate ALLL
The board and management are responsible for maintaining an allowance for loan and lease losses that is adequate relative to the estimated credit losses in the loan portfolio. The adequacy of the ALLL should be evaluated at least quarterly based on a comprehensive analysis of the portfolio, including the loan review process that we discussed above. The ALLL analysis should include all significant, classified, and past due credits, with the remaining portfolio segmented into separate components based on similar characteristics, such as grade, loan type, etc. While historical loss experience provides a reasonable starting point for the analysis, this is not a sufficient basis for determining an appropriate ALLL. The ALLL analysis should also consider factors such as:

  • Changes in lending procedures and/or staff
  • Changes in the nature and volume of loans
  • Trends in past due and adversely classified credits
  • The existence of credit concentrations
  • Changes in local and national economic conditions

If you would like more guidance on the allowance, please review the Interagency Policy Statement on the ALLL.

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Last Updated 06/29/2005 Supervision@fdic.gov

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