Key Examination Areas for Collateral-Dependent Loans

Key Examination Areas for Collateral-Dependent Loans

Collateral-dependent loans are a common focus during regulatory examinations, particularly when assessing credit risk and loan loss allowances. These loans rely primarily on the sale or operation of collateral for repayment, especially when the borrower is experiencing financial difficulty. Examiners from the OCC, Federal Reserve, and FDIC expect banks to have clear, well-documented processes for identifying, valuing, and managing these loans in accordance with U.S. GAAP and regulatory guidance. This post outlines the core areas examiners typically review and offers practical insights into meeting supervisory expectations.

Understanding Collateral-Dependent Loans

Under Accounting Standards Codification (ASC) 326-20-35-5, a loan is considered collateral-dependent when repayment is expected to come substantially from the collateral’s operation or sale, and the borrower is experiencing financial difficulty as of the reporting date. This classification has direct implications for how banks estimate credit losses and recognize charge-offs. Regulatory agencies expect institutions to apply consistent, supportable methodologies when identifying and managing these loans.

Examiner Focus Areas

During safety and soundness or targeted credit reviews, examiners typically assess the following aspects of a bank’s collateral-dependent loan management:

  1. Identification of Collateral-Dependent Loans: Examiners evaluate whether the bank has a clear process for identifying loans that meet the collateral-dependent criteria. This includes assessing whether the borrower is in financial difficulty and whether repayment is expected primarily through the collateral. The process should align with ASC 326 and be consistently applied across the loan portfolio.
  2. Collateral Valuation Practices: The adequacy of collateral valuation is a key area of scrutiny. Examiners look at:
    • The valuation methods used (e.g., appraisals, broker price opinions, internal evaluations)
    • The frequency of valuations and whether they are updated in a timely manner
    • The independence and qualifications of the valuation sources
  3. Adjustments to Fair Value: Management should have a process to adjust collateral values to fair value as of the reporting date. This includes:
    • Considering market changes that occurred after the appraisal date but before the balance sheet date
    • Documenting the rationale for any adjustments
  4. Estimation of Selling Costs: If repayment is expected through the sale of the collateral, the bank must reasonably estimate and deduct selling costs from the collateral’s fair value. Examiners expect these estimates to be supportable and based on historical or market data.
  5. Timely Charge-Offs for Shortfalls: When the fair value of the collateral (less selling costs, if applicable) is less than the recorded investment in the loan, the shortfall must be charged off. Examiners typically expect this to occur within the same call report period in which the shortfall is identified. Delays in recognizing charge-offs may be viewed as a weakness in credit administration or allowance practices.

Regulatory Expectations and Best Practices

Regulators expect banks to maintain documentation that supports their classification, valuation, and charge-off decisions. This includes internal memos, valuation reports, and management reviews. Institutions should also ensure that their Allowance for Credit Losses (ACL) methodology incorporates collateral-dependent loan considerations in a manner consistent with CECL requirements.

In practice, examiners will often request a sample of collateral-dependent loans and review the supporting documentation to confirm that the bank’s processes are sound and consistently applied. Weaknesses in any of the above areas may result in examiner findings or required corrective actions.

Conclusion

Collateral-dependent loans require careful oversight and documentation. By maintaining robust identification, valuation, and charge-off processes, banks can meet regulatory expectations and reduce the risk of examination findings. Institutions should regularly review their practices to ensure alignment with current accounting standards and supervisory guidance.

To learn more about how GLOBAL ABAS can support your compliance program, visit our website or subscribe for future updates.

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