Risk management is a big part of the lending space. Commercial lending risks have to be studied and analyzed, both for the sake of the borrower and the lender. In this episode, Mark Treichel and subject matter expert Vin Vieten tackle managing commercial lending risks in credit unions. Vin discusses the changes to the rules and gives us a look at NCUA resources on risk management. Tune in and learn more about credit unions and financing in America.
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Managing Commercial Lending Risks With Expert Vin Vieten
I'm excited to have Vin Vieten back. Vin has been on two times before. We are going to be talking about commercial loans, how to manage risk, and how that relates to some resources out there that NCUA provides relative to understanding how NCUA expects you to manage risk. How are you doing?
I'm doing great, Mark. Thanks for having me.
I'm glad you are back. For our readers who may not have read your two previous episodes, could you tell them a little bit about yourself and what you've done in the world of commercial lending?
I retired from the agency in February of 2021. I had worked for the agency for eleven years as a Senior Credit Specialist. Prior to that, I had practical in the field experience as a commercial lender and worked in the banking industry in New England. I primarily started as a commercial lender, and then I had the opportunity to start commercial loan departments in two community banks. I was a senior lender at two banks.
During that time, I also worked in banking in the '90s. I had the opportunity to work for some large banks as the banks I worked for got taken over. I’ve got exposed to some pretty good credit systems. Finally, I had the opportunity to work for one of my borrowers, who had a ready mixed concrete company with about 300 employees. That gave me another perspective from the borrower. I was on all three sides of the desk. I was a lender, a borrower, and also a regulator. I appreciated the ten years I had at NCUA because it allowed me to share what I had learned over the years with credit unions. It was a lot of fun.
It was great working with you at NCUA when we were both there. You played a major role in the last rewrite of the regulation. Some of the key languages and changes there are recommendations that you made and wrote up that made it into the final rule. We are going to talk a little bit about that and some other things here. Let's have a philosophical discussion on the expectations of credit unions in managing risk, which was highlighted in this new rule that I referred to. What are your thoughts relative to that?
It was interesting. When I had worked for NCUA for about 2 or 3 years prior to us being involved with amending and checks, it was a full rewrite of the rule. During that time, I got a sense of how credit unions looked at commercial lending. We found that there was too much focus on regulation and not enough on risk. One previous rule written in the late '90s is that credit unions and the agencies didn't have a lot of experience in making commercial loans.
Therefore, the rule was prescriptive. You will do this. We had LTV restrictions. You needed to get waivers, which was cumbersome. What we had realized when we rewrote this rule in about 2015 was both the agency and credit unions had progressed. It was time to change the rule from being prescriptive to principles-based.
The new rule focuses on principles of commercial lending. In fact, the name of the rule changed from member business loans, MBLs, and commercial lending. The reason why we added commercial lending was because although we call them in the credit union world MBLs, they are commercial loans. This means credit unions should be considering commercial loan risk. There are accepted and expected policies and processes for commercial loans that would then allow us to more focus on managing risk appropriately as opposed to following a reg.
One of the examples you gave was like a loan to value. It may have been 80% in the old regulations, if I'm not mistaken. In your reference to a waiver, if a credit union wanted to do something over 80%, they needed to come into NCUA and get a waiver for that. Now they can write their policies so that they can have different requirements relative to what the LTV is. That can be based on the many qualitative factors that you are referring to. Do I have that right?
Yes, that's correct. The fun part of commercial lending is every borrower is different. You need to take some time and understand that borrower. In some cases, 80% LTV is too risky based on the quality of the borrower. In other cases, you can go above that and feel comfortable, especially if there's a lot of equity built into the business. Those are the things that need to be considered. Although there were waivers available for that in some other provisions, the amount of effort that went into first, from the credit union and then the agency was not helping anybody.
By changing it to principles-based, it relieved that. One thing I want to point out, and I have said this before, I think in another podcast, the credit union world is in business for one reason, their member, to say it simply. You can't provide appropriate service to a commercial borrower unless you take that time to fully understand that borrower so that you can structure the loans correctly.
If you read through the preamble, which we will talk about in a little bit of the new rule, that's where the focus is. Don't analyze risk for the sake of the agency but analyze the risk, which means understanding the borrower’s financial abilities and needs so that you can structure a loan appropriately for that borrower. I always felt my job as a lender is that I’m one of the teams of professionals that commercial borrowers rely on, one being the accountant, the other being their attorney. I was the financing expert. I felt obligated to the borrower and also to not only protect the bank but provide the correct financing for the borrower.
I always thought the annual review of a borrower was a great service. Once a year, that borrower gets a review of their business by a financial expert for a free interest rate. It's important that credit unions take the time to fully understand the financials of the borrower and have an open, honest and respectful conversation about the quality of that business. I have always felt that it was an incredible value-added service for free to have a financial expert do a thorough review of that business.
Financial education for commercial lending is equally as important as it is for consumer financial education. As you said in another podcast that those businesses support a lot of people, and support a lot of families, so for them to succeed is good for the community.
You are obligated as a lender to fully understand that business. As I was competing for deals, you would hear that the bank down the street wasn't asking for the same information I was asking for. For years, I would say, "This is what we need." I finally realized what I needed to say to them was, "Why are you doing business with them?" Here I am. I'm not asking for this information to make it difficult. I'm asking for this information so that I can provide you with the best service." That did resonate with individuals who are good businessmen. They realized and appreciated the fact that this is a significant relationship with borrowing money. They appreciated the fact that I wanted to do it right for them.
I'm going to touch on one thing on waivers before we jump into the NCUA resources to manage commercial lending risk. Before I left NCUA years ago, we’ve got rid of all of those waivers because they took judgment out of the process for the credit union, and made them put in big packages, whether it was a fixed asset waiver or a commercial loan waiver. That ate up time in the regional offices.
You can't provide the correct or appropriate service to a commercial borrower unless you take that time to fully understand that borrower so that you can structure the loans correctly.
Going to more of a principle-based approach to regulations, we have pulled all those waiver actions out. NCUA has pulled out all of those waiver options and converted them into principle-based rules, which was a big step forward for NCUA over the last several years. NCUA resources to manage commercial lending risks. There are resources out there that NCUA has that not every credit union may be aware of, and we are going to walk through those. Which resource would you like to speak to first?
The first resource is the actual Preamble and Proposed Rule that was issued in July of 2015. It's important to understand the difference between the preamble and the rule. I remember hearing often, "Where does it say that?" Hopefully, we are not saying, "Where does that say that?" anymore but we are supporting the reasons why.
First, identifying the risk and then supporting the reasons why it's an acceptable risk. That first preamble and proposed rule was issued in 2015 and went out for comment. The Final Rule that was issued in 2016 reacted to those comments. What's important is the rule text was written. The rule text is the law that credit unions are required to follow. The preamble explains what the expectations are under that rule.
What you will find if you read through the preamble of the 2015 proposed rule is the philosophy and expectations for credit unions under that new rule. It explains how you use a credit risk rating system. It explains in-depth the responsibilities of the board. One of the things we tried to do with the new rule was get away from the NCUA determining the level of risk in the credit unions.
It had focused on the credit union's responsibility to know that level of risk from the lender all the way up to the board. On the board, it wasn't the individual credits but the overall risk in the portfolio. With that new rule, we added the requirement of a credit risk rating system. We had found anecdotally that probably about 80% of credit unions had used risk grading systems. It wasn't a large request as most credit unions were already doing it, and they would fine-tune it.
Take some time to read that preamble. If your question now is, “What exactly is NCUA looking for under the rule?” you may find that answer in the preamble. The final rule, which was issued in February of 2016, again read that preamble. That's mostly explaining what the concerns were of the stakeholders through the comment period and our response to that. There's still some good support in that. I want to point this out as often you hear, "That's the proposed rule, so that preamble doesn't mean anything." In this case, the good news was overall, there was acceptance of the proposed rule. There was no real material change to the final rule, which means the proposed real preamble is important to understand.
As you were describing this, I came up with an analogy in my head. It may be a good or bad one but I'm going to go with it. Every play in every movie has three acts. I would consider the preamble to a proposed rule as the 1st act, the preamble to the final rule as the 2nd act, and the actual regulation itself as the 3rd act.
If you only watch the last 3rd of a movie or you only come in and watch the last 3rd of a play, you are not going to understand how we got there. Those two preambles both contribute to the play or the movie. That's my new analogy for preambles and final regulations. You can see the intent of the board and why something got built the way it did. It's important to read and understand that.
That's a good analogy. You never thought of it that way because the third act would not have a lot of meaning if you didn't understand the 1st and 2nd acts. It's important to do that. Technically, the preamble is not enforceable. If you are doing something different than the preamble explains and you can't, and it's okay to do that, as long as you have the support that you're acting in a safe and sound way.
That covers the preambles and the regulations. Let's talk about Letters to Credit Unions and particularly, in addition to that, the interagency letter commercial credit risk.
Can I make one more comment? We are talking about the MBL Commercial Loan Rule part 723. The same discussion goes for the Appraisal Rule, which was done in 2021. It was rewritten, and that's part 722. Read that preamble and better understand the requirements of the rule. The next level of support is the letters to credit unions. Generally, there had been some in the past. There's one on Taxi Lending and one on MBL waivers, which are still available.
Although waivers don't count anymore, there's good information in there on how to manage credit risk. Take a read through it. Don't be concerned about the waiver part. However, look at how you review credit risk and then the Taxis letter. Although Taxis are not that big an issue anymore in credit unions, there's good risk management guidance in that letter also.
The NCUA works with other agencies on Interagency Guidance. The Guidance Provided on Credit Risk Review is good guidance that I would recommend everyone to read. It's a rewrite and made it standalone, an attachment to an accounting bulletin from 2006 on credit review. They updated it and made it a standalone. It's good on the expectations of the board.
Each board at a credit union should be aware of this interagency letter because the board's responsible for knowing the level of risk in the portfolio. This letter gives guidance on how the board should be performing credit risk reviews. It also does a good job of explaining what a credit risk rating system should be. Keep an eye out for those letters to the credit union. Probably the best NCUA guidance for the MBL Rule, the Commercial Loan Rule is the actual examiner's guide.
Right after we did the rule and before it became official in January of 2017, there was a team of NCUA commercial loan experts. Some were with significant other agency regulatory experience, some with extensive NCUA experience and bank experience, and then me, with primarily commercial lone experience, wrote over 100 pages of guidance. It's the online examiner's guide. That reviews each section of the rule. It's additional support. The preamble discusses each section of the rule but this also provides some additional explanation and support on how commercial loan lending should be approached by credit unions.
I pulled the Examiner's Guide online, which we will talk about here. The commercial member business loan, the Examiner Guide, the section the Examiner Guide addresses, business-entity types, board, and management responsibilities that you have spoken to.
The commercial loan policy that you mentioned, credit risk rating systems, loan administration, collateral, personal guarantees, and how and when to use those.
The construction and development loans, prohibited activities, aggregate member of business loan limits, state rules, and then exam procedures. A lot of information there has been pointed out. Beyond NCUA resources, are there any other resources out there that credit unions should look at if they have a commercial lending program or are considering starting one?
The other agencies have good resources. We added the Commercial Loan Title to the rule because there are accepted and reasonable practices for managing commercial loan risks. The support the other agencies have is also helpful as you determine policy on how to approach the commercial loan risk. I want to point out, especially and most people are aware of them but the OCC has done a lot of work in managing risk.
When you're approaching managing the commercial risk in your portfolios, keep the members' needs at the forefront. It's really important that you fully understand the borrower so that you can provide the right financing for them.
This is through the issue handbooks, which are extensive resources for different areas of risk. There are five that are valuable for commercial loan risk. They are the OCC loan portfolio management, their rating of credit risk, commercial loans, agricultural lending, and CRE lending. That's five separate handbooks that are good support. The agency has always felt that the OCC's recommendations for credit risks are appropriate.
There’s wisdom at the other agencies. The body of work, the more you read on the topic, the more you understand it, and that’s again a good resource. We have been at my company, Credit Union Exam Solutions. You and I have helped credit unions as a third party. Any thoughts relative to how we have assisted credit unions on the commercial lending side that you would like to share here?
We have been helpful to credit unions to help point them and to better understanding what NCUA is looking for and also help them understand where they should be accepting of NCUA and maybe how to approach NCUA when the credit union risk management makes sense and needs to be better understood by the NCUA. It's good, as our group, with the connections we have in the agency and out in the credit union industry. There's mutual respect. Generally, we can have a reasonable conversation to settle any issues.
There are instances where we have assisted credit unions that have had examinations going on where NCUA was wanting some things to be required. We alerted the credit union why NCUA required them and that they probably were going to have to do them. In other instances, we have been able to say, "The way NCUA is suggesting it is one way to do it but you might be able to try methods A, B, and C."
In some instances, you might be able to say, "We don't believe that's necessary based on our capital, program or some guidance out there," that you may be able to point them to. We have had some good success in assisting credit unions on the commercial lending side, and that's because of your expertise that we are able to connect with the credit union. I want to thank you for that, Vin.
Since we are so involved with what the expectations of NCUA are, I have found that by helping, not writing the policy but reviewing and editing policy, sometimes we don't have to change the credit union's policy but maybe give a different perspective, point of view or introduction to a section that's going to make it more acceptable for the NCUA.
Are there any last thoughts, Vin, before you wrap up this episode?
No, I have a quick soapbox comment. When this is all done, when you are approaching managing the commercial risk in your portfolios, keep the members' needs at the forefront. It's important that you fully understand that borrower so that you can provide the right financing for the borrower. Think of it that way. I used to tell credit unions when they were so focused on the rule, "Make sure you meet the borrowers' needs, you finance them within their capacity, you have protected your credit union, and then look at the rule. Probably if you do those things, you have met the conditions of the rule."
Vin, I want to thank you for sharing all this information on NCUA resources on managing risk. To the audience, I want to thank you for your time and for reading this episode. I hope you will join us next time for the next episode of With Flying Colors.
Vin Vieten – LinkedIn
OCC – Handbook