By Michael DeFors
Vice President of Information Services
In the Oct. 30, 2009 Wall Street Journal, an article titled “Banks Get New Rules on Property” cited surprising statistics from a study by Foresight Analytics. It noted that “about $770 billion of the $1.4 trillion commercial mortgages that will mature in the next five years are currently underwater.” While Foresight’s data was solicited from a base of commercial banks, credit unions stepping into the field of member business lending should take note. While the world of business lending is potentially profitable, it brings with it a higher level of risk, and with that comes greater regulatory scrutiny and concern.
For a long time, credit union business lending practices went virtually unregulated as a specialty service by either Congress or the NCUA. Following a series of credit union failures involving unsound business lending practices in the mid 1980s, the NCUA took steps to curb excessive risk taking. While very few credit unions were engaged in business lending at that time, the risks of these types of loans became readily apparent.
When Congress enacted the Credit Union Membership Access Act in 1998, it codified the NCUA’s business lending definition and established the current member business lending cap – the lesser of 1.75 times net worth or 12.25 percent of total assets.
As credit unions grew, interest in adding member business services increased despite the additional risks. The availability of business credit from the banking industry continued to drop and demand for business loans from credit union members slowly expanded. State and federal regulators have expressed a renewed concern in light of this expansion. Losses to the NCUSIF over failed credit unions stemming from back in the mid 1980s, to more recently here in Michigan and elsewhere, offer a timely opportunity to highlight several key issues of regulatory concern.
Both OFIR and the NCUA stand firm on the requirement that before implementing an MBL program, the board, management staff and underwriters must have detailed knowledge of the NCUA’s Regulation on Member Business Loans found in Part 723. It provides essential information and procedures, including the definition of what is considered a member business loan; exceptions and prohibitions; specific requirements for construction and development loans; the process for implementing a member business loan program including the use of a third party such as a CUSO; elements of a business loan policy; collateral and security requirements; borrowing and aggregate loan limits; and waivers and the process for obtaining them.
Regulators indicate that it is not uncommon to see various violations of the regulations, especially for credit unions just getting started. They remind us, however, that ignorance of the regulations is no excuse and can carry stiff consequences including divestiture of a loan or costly restructuring to bring unlawful loans into compliance. While waivers of several of the requirements are available, they are limited to the items identified in Part 723.10. Furthermore, the regulators advise credit unions to seek waiver approval prior to underwriting and not wait until after the fact. The process to request a waiver is initiated with the NCUA regional director for federal credit unions and with OFIR for Michigan chartered credit unions.
The regulations also call for a business loan policy providing minimum elements, which the credit union board is required to approve and review annually. The policy represents the foundation for the credit union’s program and should reflect a well-considered approach with full board buy-in.
One important element of the business loan policy addresses the qualifications and experience required of business lending personnel. A minimum of two years and skills in making and administering the types of business loans authorized by the policy is expected. Loans to restaurants are very different than loans for a retail strip mall. Experience can be accomplished with in-house staff, an independent contractor, CUSOs, other credit unions, or another third party. If third parties are used, regulators remind us the final decision to grant a loan must still reside with the credit union.
As with any sound lending program, the ability to repay business loans rests on thorough underwriting and due diligence standards; again, these are to be outlined in the policy. Business loans bring their own unique demands in terms of how the credit union properly protects itself initially and throughout the life of the loan. The credit union must have controls in place to monitor, test, and continuously assess the financial health of a business borrower with respect to its internal operation and how it plans to survive in a competitive marketplace.
The final point to highlight is how the credit union evaluates the risks of its various business loans for purposes of funding the ALLL. Regulators will be assessing how the credit union evaluates the risk of each loan based on criteria it adopts to help it manage this new area of risk.
The world of business lending can be very profitable, but the credit union must recognize it as a significantly different animal that brings with it a higher level of risk and manage it accordingly. Regulators understand this and will be looking for how well your credit union understands the regulations and requirements for managing, underwriting and monitoring the new initiative.