Policy Exceptions Matter as a Rule: Policies Are the Guardrails That Keep Banks on the Road. Exceptions Must Be Infrequent and Properly Mitigated
Strischek, Dev, The RMA Journal
Rock musician Frank Zappa once observed, "Without deviation from the norm, progress is not possible." But before we unequivocally equate exceptional behavior with progress, let's remember Ambrose Bierce's definition of "exception" in The Devil's Dictionary: "A thing which takes the liberty to differ from other things of its class, [such] as an honest man ... the exception tests the rule, puts it to the proof, not confirms it." In that spirit, we bankers try to set rules for lending based on prior experience that helps us steer clear of past errors and make profitable, prudent loans.
It's important to understand not only why a bank tracks exceptions to credit policy, but also how to monitor and manage them. After all, banks expend considerable time and effort on credit policies, and deviations from those policies generally lead to increased risk that can turn into problem loans and losses. Further, implicit in a sound credit culture is the expectation that credit policy reflects the risk tolerances of the institution. A bank with a conservative credit culture and a moderate risk tolerance is likely to accommodate exceptions to policy for very creditworthy customers, as long as prudent underwriting properly mitigates risk and yields a satisfactory return through support from other cash flow, collateral, guarantees, and additional protection.
Accordingly, banks need to identify policy exceptions in order to document the thought process, assess underwriting practices, and provide accountability for the credit decision. Additionally, the frequency of policy exceptions is monitored as part of portfolio management to track frequency trends, identify potential training topics, monitor underwriting issues in the market, and assess the potential impact on asset quality.
Roles and Responsibilities: Exceptional People
Typically, banks expect their relationship managers in the line of business to be responsible for risk-rating their loans and identifying their policy exceptions at inception and over the life of the loans. Usually, credit approvers concur with the relationship managers' recommendations or have the power to change the recommended citations--that is, to add or delete. Of course, the loan review function usually can override the line-credit decision, and outside examiners trump everyone. Therefore, the two key players in policy exception governance are:
Final credit approver: Responsible for the final decision on the citation of a policy exception in a given transaction.
Line of business (LOB) team: Team members from the line responsible for managing the client relationship--for example, the relationship manager (RM) and the portfolio manager (PM). Because they are closest to the relationship, the LOB team is responsible for identifying and recording any policy exceptions in every credit request as part of the approval, review, and renewal process. Credit approval constitutes approval of cited policy exceptions.
If additional policy exceptions are noted by the final credit approver, by the bank's internal risk review function, or by external examiners, the LOB team usually is also responsible for recording the additional policy exceptions. Conversely, if the final credit approver, risk review, or examiners decide that a policy exception should not be cited, the LOB team is responsible for removing the exception.
Descriptions of Policy Exceptions: Exceptional Definitions
To ensure consistent application of trackable policy exceptions (TPEs) across a bank's portfolio, all lines of business typically are subject to a stand-alone policy that describes and explains each TPE. Many banks have their credit policies online, so each TPE can be linked to the underlying policy for ready reference. The electronic linkage avoids redundancy in the TPE policy and induces readers to reacquaint themselves with the appropriate policies. …