FCA Examination Manual

Module Management
Section Internal Credit Review (ICR) Process
Number EM-527
Date Published 09/1999

Introduction

The ICR process is one of the most important components of an institution's control system.
FCA Regulation 12 CFR 618.8430 requires each System institution to establish a policy that
includes direction for the operation of a program to review and assess assets. An effective ICR
process is critical to the board's ability to monitor the quality of the institution's assets,
management's compliance with law and regulation, and the adequacy of and compliance with
lending policies and procedures. The failure of an institution to maintain a reliable and effective
ICR process is an unsafe and unsound practice that an institutions board of directors is expected
to correct immediately.

Examination Objectives

Determine whether the ICR process provides reasonable assurance that risk in the portfolio is
properly identified, serviced, and reported to management and the board.

Determine whether the ICR process provides an accurate ongoing assessment of risk in the loan
portfolio in accordance with a risk rating system adopted by the institutions board of directors.

Determine whether the ICR process evaluates credit administration and provides for the prompt
correction of deficiencies.

Evaluation Criteria

Examiners will use the following criteria when evaluating an institution's ICR:
An institution's ICR process should be an ongoing, dynamic process that identifies,
categorizes, and reports risk in the entire portfolio.
The process should provide for a periodic review of the portfolio by qualified people who
are independent from the credit decision processes and who, for ICR purposes, report to
executive management and/or the board. Since smaller institutions may not have the
resources necessary to support a comprehensive program and/or a full-time reviewer, a
process that utilizes employees on a part-time or rotational basis, or outside reviewers on
a contract basis, is considered acceptable.
The process should provide for the analysis of all risk characteristics of the portfolio. For
example, it should identify the characteristics of risk in portfolio segments and
concentrations, and discuss credit factor strengths and weaknesses in comparison to the
entire portfolio.
The review process should be sufficient in frequency and scope to determine the
reliability of asset classifications and performance categorizations, and the adequacy of
credit administration and the allowance for loan losses. Furthermore, the ICR should
encompass review and testing of the risk grading or classification of a sufficient number
of assets to validate the accuracy of reports on the risk in the portfolio and the condition
of the institution.
The ICR should include sufficient testing of lending and loan servicing practices and
controls to detect noncompliance with established policies and procedures, violation of
law and regulations (including consumer compliance regulations), and deviation from
sound business practices.
The ICR should include an assessment of the system of internal controls over the credit
function, the status of corrective action on previously identified weaknesses, and the
cause of any deficiencies or adverse trends.
Management should promptly update classification of assets as changes occur. There
should not be a lengthy lag-time between receipt/analysis of new loan information and
the date on which the risk assessment is recorded in the institutions information system.
A formal ICR report to the board should be issued on a periodic basis. The typical ICR
report should summarize evaluations of the institution's risk rating assessments, credit
administration, and results of prior corrective actions. It should identify the underlying
causes of weaknesses identified, and recommend corrective actions when weaknesses are
identified. This formal report should be completed at least quarterly in large or more
complex institutions, although it may be completed less frequently in smaller, or less
complex institutions. However, in no instance should this formal report be completed less
than annually. As conditions in the institution change or its lending environment
deteriorates, more frequent, formal ICR reporting to the board should be required.

Risk Identification Accuracy Standard

The Office of Examination will employ an accuracy standard as a guide for examiners to use in
determining the reliability of an institutions ICR. Generally, an ICR will be considered
"unreliable" when classification errors are found in excess of 10 percent of the volume examined,
provided this is applied with judicious caution. The following guidance should be used in
applying these accuracy standards:
Examiner judgment is critical in applying the 10 percent threshold for reliability. For
example, a single large loan may distort this threshold. Therefore, a pattern or practice
that causes the institution's assessment of risk to be flawed must be identified.
ICR classification reliability is generally measured by differences between adverse and
non-adverse classifications, or differences between non-accrual and accrual accounting
classification. Loans classified OAEM by the examiners generally will not significantly
influence the determination of reliability unless a pattern or practice has been identified
where the institution is clearly not identifying or addressing emerging risk.
A conclusion that the ICR is unreliable must be supported by a scope of examination
sufficient to substantiate the conclusion. If loans are discovered that are classified
incorrectly, the EIC should determine if a "pattern or practice" exists. Examiners must be
mindful that a few isolated exceptions do not establish a pattern or practice. Where
classification errors are confined to loans evidencing certain characteristics or
commonalties, the conclusions regarding the reliability of the ICR might be targeted to
that particular aspect of the process.
Examiners should clearly identify the pattern or practice and the extent the problem has had, or
may have, on other aspects of the institution's operations and financial condition. This will also
help develop the examination finding and conclusions as to condition, criteria, cause, and effect.
Where an ICR is unreliable, conclusions on other aspects of an institution should carefully weigh
this finding.

Examination Follow-up Actions

Where weaknesses exist with an institutions ICR process, examiners should consider a course of
action using the guidelines outlined below:
If examiners are able to quantify a significant difference with the institution's risk
classification assessment, the institution's asset quality statistics should be adjusted
accordingly in the Report of Examination and ratings analysis. In addition, examiners
should assess the impact those changes might have on the adequacy of the allowance and
adequacy of risk management practices. Where the institution's incorrect risk assessment
cannot be quantified by FCA examiners, the ICR process should be deemed unreliable
and examiners should consider the need to require the board to obtain an independent
review of risk until reliability of the ICR process can be established. The independent
review will be important for the board to effectively direct the institution through this
period of uncertainty. Furthermore, examiners should recommend the institution be
placed under special supervision, at a minimum, and consider recommending other, more
severe administrative actions as appropriate.
When it is discovered that classification errors range from 5 to 10 percent of the volume
examined, examiners should include in the letter to the board chairman a requirement or
recommendation to strengthen controls in order to correct the weakness that caused the
inaccuracies in the ICR process. The pattern or practice that led to the incorrect risk
assessments should be disclosed so the board and management can focus on correcting
the problem. This usually can be accomplished in the normal course of business within a
reasonable timeframe (90 to 180 days). Examiners should consider recommending an
institution that meets these criteria be placed under special supervision until this problem
is resolved.
For institutions with classification errors of less than 5 percent, examiners may address
the weaknesses in the Report of Examination but conclude the ICR is generally reliable.
Examiner judgment as well as the commitment of the institution to correct the identified
weaknesses will be considered to determine the appropriate manner for addressing this in
the Report of Examination.
Where an institutions management is unwilling to correct the performance classification
of a loan from accrual to non-accrual or record a charge-off when directed by an
examiner, the letter to the board of directors shall direct the appropriate accounting
transaction(s). The Report of Examination should comment on the basis for the
conclusion and cite managements unwillingness to adjust the institutions accounting
records and reports to the FCA. Additionally, depending on the severity of the
institutions condition and other pertinent factors, examiners should consider
recommending that the institution be placed under special supervision or an alternative
enforcement action taken.

Examination Procedures

As a starting point in assessing an institutions ICR process, examiners should review the
policies and procedures guiding the ICR process, ICR reports provided to the board and
management, and audit reports on the ICR process. To test the accuracy and effectiveness of the
ICR process, a sample of the loan portfolio must be examined. Additional guidance on selecting
and examining individual loans for this purpose is provided in the Asset Classifications,
Accounting for Problem Assets, and Credit Administration sections of the Assets module. The
following list of procedures is provided to assist examiners in the evaluating the internal credit
review process. Consistent with risk-based examination principles, examiners should modify
procedures as needed to fit the particular circumstances of the institution.

1. Determine if the board established policies to direct the operation of a program to review and
assess its assets [FCA Regulation 12 CFR 618.8430(c)].

2. Review the policy established to direct the operation of a program to review and assess assets
to determine if it includes standards that address the following areas:
a. Loans, loan-related assets, and collateral reviews;

b. Scope of review selection;

c. Workpapers and supporting documentation;

d. Asset quality and loan performance classifications;

e. Assessing credit administration;

f. Assessing compliance with policy and procedures; and

g. Training required to initiate and to maintain the program.
3. Through discussion with appropriate personnel and the use of flowcharts, observations, and/or
investigation, analyze the operation of the overall ICR process by considering:
a. Method of loan selection;

b. Frequency and scope of reviews;

c. Manner in which loans are analyzed;

d. Criteria for upgrading criticized assets;

e. Reports generated and provided to the board;

f. Use of results by appropriate personnel, (i.e., follow-up and corrective actions);

g. Assessments of the institution's adherence to regulations, credit policies, procedures,
and underwriting standards;
h. Identification of credit administration weaknesses;

i. Accurate and timely asset and performance category classifications;

j. Identification of causes of any deficiencies and adverse trends;

k. Assessment and status of corrective action plans; and

l. Input for credit reports and the quarterly allowance for loan losses study.

4. Through discussion with appropriate personnel and other alternative methods of investigation,
determine if the ICR function operates independent of the lending function and reports to the
board are unimpeded by considering:
a. Any possible restrictions placed on the review function personnel;

b. Whether the review function reports directly to the board; and

c. Independence and objectivity of the review function.
5. Through discussions with the board and management and a review of pertinent personnel files,
evaluate the competency of the ICR personnel by considering:
a. Level of education;

b. Significant experience;

c. Availability and participation in continuing education programs;

d. Membership in professional organizations;
e. Training methods; and

f. Level and quality of supervision.

6. Examine a sample of loans reviewed by the ICR process and compare examination findings to
those identified by the review function.

7. Determine if any audits of the function have been performed and review the audit results.

8. Conclude on the adequacy of the ICR process using the criteria discussed under the
"Evaluation Criteria" heading of this section.

9. Discuss tentative conclusions and examination findings with examiners assigned areas that
may be affected by the findings.

10. Discuss items of concern, scope of work performed, and conclusions with the EIC and with
the appropriate institution manager. Obtain a response regarding cause(s) of deficiencies or
weaknesses and anticipated corrective actions.

11. Prepare a leadsheet or other summary document to provide workpaper support for the work
performed and the conclusions reached.