Loan exception tracking is a key component of effective lending compliance management system. It can assist in ensuring controls as well as help to reduce fair lending risk in a bank or credit union.
Overview of Loan Exceptions
Loan exceptions occur any time a loan file does not meet the established standards for a financial institution. Lenders typically have guidelines they must follow, and when those guidelines are not exactly adhered to, an exception occurs. There are typically two types of loan exceptions: 1) Policy exceptions and 2) underwriting exceptions.
Policy exceptions occur when a required procedure does not take place. For example, a financial institution may have a policy where credits over $500,000 may require the approval of a President/CEO. If the loan file does not have this required signature, a policy exception has occurred. Alternatively, a bank policy may require that the loan file has two years of tax returns in file to evidence the income of the applicant. If the file does not contain the prior two years of tax returns, a policy exception has occurred. Policy exceptions are important from a control perspective - as well as a safety and soundness perspective - and are typically evaluated during an internal audit or loan review.
On the other hand, an underwriting exception is a deviation from the established credit requirements for a borrower. When a borrowers credit score, debt-to-income ratio, or loan-to-value ratio do not meet the organization’s defined standards, an underwriting exception occurs. Underwriting exceptions are important from a fair lending perspective and are typically evaluated during a compliance review.
Tracking Loan Exceptions
Tracking loan exceptions is a management best practice for any creditor. The primary reason for this is to ensure that your established guidelines are being followed and that unintended consequences do not result from a deviation of policy.
In order to track exceptions, creditors often utilize one of three methods. First, exceptions can be tracked through the use of a loan operating system (LOS). Exceptions are tracked on the LOS when a predefined field (often designated by the LOS vendor) is selected when the loan is booked on the system. To ensure that exceptions are appropriately recorded in an LOS, a creditor should have sufficient controls in place to ensure that all exceptions and appropriately recorded and logged. This can occur by having a second person review each loan uploaded on the system, or by utilizing a checklist to ensure the task is completed.
The second way creditors often track exceptions is through the use of a spreadsheet. To collect and record exception information, some creditors have developed a process where all exceptions are documented in the loan file with the signature of a superior officer. When the officer signs off on the exception, they log each exception into the spreadsheet. Other times, creditors have a policy where all exceptions must be approved by the Board of Directors or a loan committee. In this case, each exception is usually included in an agenda or the meeting minutes, and this information can be easily transferred to a tracking spreadsheet.
The final method that creditors often utilize to track loan exceptions is to purchase stand alone software from a third party. There are many different software solutions available, but each creditor must determine exactly what their needs are to ensure that the software is an effective purchase.
Regardless of the method utilized, loan exception tracking is an important part loan management.
Using Loan Exceptions to Reduce Fair Lending Risk
Once a financial institution has implemented a method to track loan exceptions, they must next review the data for risks. In fact, financial institutions that do not review their loan exceptions are at a significant risk of examiner criticism as their examiners are certain to analyze the tracked exceptions. Basically, a creditor should know what is contained within the information they are handing over to examiners.
As explained previously, one of the best ways to reduce fair lending risk is through effective management of loan exceptions. Underwriting exceptions are typically the primary concern from a fair lending perspective as deviations of credit standards can lead to inconsistencies in credit decisions. When inconsistencies occur, there is an increased risk for disparate treatment of protected class applicants (those who are protected by fair lending laws).
In order to mitigate fair lending risk, and organization should regularly review loan exceptions and compare them to denied protected class applicants. Basically, a creditor should ensure that there is no overlap between the most qualified denied protected class applicants and the least qualified approved control group applicants (i.e. individual white male applicants). When exceptions are effectively compared to denied protected class applicants, an organizations fair lending risk can be greatly reduced.