The Federal Reserve has published examination guidance that describes loan sampling expectations for the examination of state member banks with $10 to $50 billion in total consolidated assets. According to Supervision and Regulation Letter 14-4, issued on April 18, the Federal Reserve Banks will conduct at least two loan quality reviews during the annual supervisory cycle of each state member bank with $10 to $50 billion in total consolidated assets. Each review will focus on one or more material commercial loan segment exposures by Call Report loan type and, in total over the annual cycle, will cover the four highest concentrations for commercial credits in terms of total risk-based capital for any Call Report loan type from Schedule RC-C. The guidance says that examiners will also sample any loan category that contributes 25% or more to annual revenues, because loan segments that generate substantial revenues are generally likely to entail higher risk, and other loan segments that examiners or the bank’s internal loan review have identified as exhibiting high risk characteristics. Such risk characteristics include liberal underwriting standards, high levels of policy exceptions, high delinquency trends, rapid growth, new lending products, concentrations and concentrations to industry, significant levels of classified credits, or significant levels of special mention credits, according to the guidance.

Nutter Notes: According to the Supervision and Regulation Letter, examiners will generally consider a bank’s internal risk rating system to be less reliable when examiner downgrades or internal loan review downgrades equal 10% of the total number of loans reviewed, or 5% of the total dollar amount of loans and commitments reviewed. When a bank’s risk rating system is determined to be unreliable, the guidance suggests that examiners may need to expand the loan sample to better evaluate the effect of rating differences on the bank’s allowance for loan and lease losses and capital. In such situations, examiners will likely direct the bank to take corrective action to validate its internal ratings and to evaluate whether the allowance for loan and lease losses or capital should be increased, according to the guidance. The guidance also recommends that an institution’s internal loan review program should cover substantially more loans than examiners’ annual samples of material loan portfolios. Examiners will review the findings and recommendations of each institution’s internal loan review program to help identify areas of risk, according to the guidance. In selecting loans from each segment of the loan portfolio to review, the Federal Reserve said that examiners will review a selection of the largest loans, problem loans and newly originated loans.