OCTOBER 1997 THROUGH MARCH 1998

HIGHLIGHTS

• Responses from examiners during the six months ending March 31, 1998, indicated that a

greater proportion of banks examined had loosened underwriting practices since the previous examination than had tightened them (6 percent and 5 percent, respectively). About

88 percent of the banks showed no material change in underwriting practices since the previous examination.

• Twenty-five percent of responses characterized the banks’ loan growth since the previous

examination as “rapid.” The demand for loans has resulted from a strong economy plus

low interest rates and optimistic consumer expectations.

• Underwriting practices were seen as weaker compared to a year earlier in each of the major

loan categories covered in this report, particularly commercial (nonresidential) real estate

and construction lending.

• In three of the eight FDIC regions, examiners indicated that a larger proportion of banks

had loosened underwriting standards than had tightened them since the last examination.

Purpose and Design of the Report

In early 1995, the FDIC began using an examination questionnaire on risk in current underwriting practices at FDIC-supervised banks. The examiner in charge completes the questionnaire at

the conclusion of each bank examination that the

FDIC conducts. This systematic collection of responses from examinations provides an earlywarning mechanism for identifying potential

lending problems.

The questionnaire focuses on three topics: material changes in underwriting standards for new

loans, the degree of risk in current lending practices, and underwriting standards for specific major loan categories. These categories are business, commercial (nonresidential) real estate,

consumer, agricultural, construction, home equity, and credit card loans. Excluded are banks

specializing in residential real estate loans that do

not pose more than normal risk to the bank and

banks not actively making any of the abovementioned types of loans.

Examiners evaluate underwriting practices in

terms of FDIC supervisory standards, rating the

risk associated with a bank’s underwriting practices as above average, average, or below average, and classifying the occurrence of specific

risky practices as “frequent enough to warrant

notice” or, if more prevalent, “common or standard procedure.”

Examiners can use the results from the questionnaire to monitor the underwriting practices of

banks over time or within the FDIC regions. But,

comparisons across periods or regions must be

interpreted cautiously. Because the questionnaire is completed at the conclusion of each bank

examination, the banks included during any

given period depend on examination scheduling

requirements, such as the financial condition of

the bank, coordination with state regulators, and

the availability of examination staff. As a result

the sample is not random, and the banks sampled

during a particular reporting period and within a

particular region are not necessarily selected for

Federal Deposit Insurance Corporation Andrew C. Hove, Jr., Chairman

Division of Research and Statistics

Virginia Olin (202)898-8711

Internet address: World Wide Web, www.fdic.gov.

Division of Supervision

Robert W. Walsh (202)898-6911
examination for the same reasons as banks during a

different period or in another region. Accordingly,

time series comparisons should not be interpreted

without corroborative data.

GENERAL UNDERWRITING TRENDS

Reports received from examiners during the reporting period October 1, 1997 through March 31,

1998 showed that in almost 12 percent of the 1,212

banks examined, underwriting practices had materially changed since the previous examination.

Slightly more than 6 percent of the banks had loosened their underwriting practices, while 5 percent

had tightened them. These results are noteworthy:

(1) The proportion of banks showing a material

change since the previous examination is larger than

during any previous reporting period since early

1995, when the questionnaire came into use. (2) For

the first time, the proportion of banks showing

looser standards is greater than the proportion

showing tighter standards.

Changes in the composition of banks examined in

each reporting period could contribute to fluctuations in results. However, a comparison of the characteristics of banks examined during two reporting

periods, this one and the one a year earlier (the six

months ending March 31, 1997), shows that both

groups are similar. Moreover, the continuation of

the strong economy and the current stable interestrate environment would not contribute to a weakening in underwriting standards. Thus, we believe that

the latest results reflect a true weakening in underwriting practices. Outside support for this conclusion appears in a study released in mid-December

1997 by the Office of the Comptroller of the Currency (OCC), showing a weakening of credit underwriting standards at big banks.1

As has usually been the case, the major reason

cited by examiners for loosened standards was to

achieve loan-growth goals (approximately 70 percent cited this reason). In addition, twenty-five

percent of responses characterized the banks’ loan

growth since the previous examination as “rapid,”

up from the period a year earlier. The demand for

loans has resulted from a strong economy plus low

interest rates and optimistic consumer expectations.

Despite an increase in the proportion of banks

loosening standards, examiners continued to report

no widespread problems in underwriting practices

for new lending overall. Examiners did indicate

“above-average” risk in underwriting practices for

new loans in 11 percent of the banks examined, but

this was up only slightly from the period a year earlier. Of that 11 percent, 21 percent (or 27 banks) also

“commonly” failed to adjust price for loan risk. In

addition, 11 percent of all banks examined were reported to have “above-average” risk in their current

loan portfolios—a proportion essentially unchanged from the period a year earlier.

Other findings are the following:

• “Above-average” risk in loan administration

surfaced in approximately 13 percent of the

banks examined (about the same as was reported during the period a year earlier).

• Approximately 7 percent of banks examined

“commonly” made loans that resulted in high

concentrations of loans to one borrower or to

one industry (up slightly from the period a year

earlier). Most of the banks examined are small,

community-based banks and tend to lend

mainly to people or industries dominant in the

area.

March 1998 2 Report on Underwriting Practices

1This study, the 1997 Survey of Credit Underwriting Practices, can be

obtained from the OCC (phone: 202/874-5770).

PERCENT OF RESPONSES RECEIVED: 10/97 - 3/98

Unchanged

88%

Tighter

5% Looser

6% Average

Risk

58%

BelowAverage

Risk

31%

Above-Average

Risk

11%

Have Underwriting Practices

Materially Changed?

How Risky Are Current

Practices?

Current Underwriting Practices
• Six percent of banks examined “commonly”

failed to require a material reduction in principal before renewing term loans (essentially unchanged from the period a year earlier).

• In 5 percent of the banks examined, the written

lending policies differed “substantially” from

actual practices (up slightly from the period a

year earlier).

INDIVIDUAL LOAN TYPES

The questionnaire asks examiners to indicate the

types of loans that are a significant portion of the

bank's new lending and that were reviewed during

the examination. Note that banks may be actively

lending in more than one loan type. Responses during this reporting period showed that 67 percent of

the 1,212 banks examined were active business

lenders; 51 percent were actively making commercial (nonresidential) real estate loans; and 6 percent

were not active in any of the major loan categories

covered. The proportions for other loan types are

shown in the accompanying chart.

Examiners showed greater concerns than in prior

reports for underwriting practices in each loan

category.

Business Loans.

In business lending, the borrower's financial

strength and source of repayment are important criteria for soundness in underwriting standards. With

asset-based loans, monitoring the collateral pledged

is also critical. Of the 806 banks examined during

the reporting period that were active in business

lending, approximately two-thirds (or 520) made

asset-based loans. Among the 806 banks actively

making business loans,

• Almost 21 percent made business loans to borrowers who lacked documented financial

strength to support such lending “frequently

enough to warrant notice.” An additional 3 percent did so “commonly.”

• Slightly less than 17 percent made business

loans without a clear and reasonably predictable repayment source “frequently enough to

warrant notice.” Two percent did so “commonly.”

• Of the 520 banks making asset-based loans, approximately 19 percent failed to monitor the

collateral pledged “frequently enough to warrant notice”; another 3 percent “commonly”

failed to monitor.

Almost all of these proportions were up substantially from the period a year earlier.

Commercial (Nonresidential)

Real Estate Loans.

In commercial real estate lending, the income

generated from the property is the primary source of

repayment. However, because future income is uncertain, sound underwriting practices generally require alternative sources of repayment. Of the 612

banks examined during the reporting period that

were active in commercial real estate,

• Fifteen percent made short-term commercial

real estate loans with minimal amortization and

large balloon payments “frequently enough to

warrant notice.” Another 5 percent were characterized as making these loans “commonly or

as standard procedure.”

• Approximately 13 percent failed to consider repayment sources other than the project being

funded “frequently enough to warrant notice.”

Only eight banks (1 percent) actively making

commercial real estate loans “commonly”

Report on Underwriting Practices 3 March 1998

**Loans not specified that pose more-than-normal risk to the institution.

**Mainly residential loans that do not pose more-than-normal risk to the institution.

Banks Actively Making Loans by Loan Type

PERCENT OF RESPONSES RECEIVED: 10/97 - 3/98

Business

Non-Residential

Consumer

Agricultural

Construction

Home Equity

Other*

Credit Card

Not Applicable**

0 20 40 60

67%

51%

50%

38%

32%

14%

13%

6%

6%
failed to consider alternative sources of repayment.

These proportions were up slightly from the period a year earlier.

Consumer Loans (Excluding Credit

Card Lending).

In some of the 604 banks examined during this reporting period that were active in consumer lending,

underwriting standards weakened slightly from the

period a year earlier:

• Approximately 19 percent were considered to

have made loans to borrowers who lack a demonstrable ability to repay “frequently enough

to warrant notice”; an additional 3 percent were

cited for lending in this manner “commonly or

as standard procedure.”

• Fifteen percent made consumer loans without

adequate collateral protection “frequently

enough to warrant notice”; an additional 3 percent made loans lacking collateral protection

“commonly or as standard procedure.”

Agricultural Loans.

Examiners continued to monitor the extent to

which banks' agricultural loan portfolios were tied

to major crops affected by the Federal Agriculture

Improvement and Reform Act of 1996. The 464 responses during the reporting period from examiners

in banks that were active agricultural lenders indicated that 27 percent—about the same as during the

period a year earlier—were reported to have portfolios tied to crops affected by the phaseouts “enough

to warrant notice.” And, 15 percent—compared

with 7 percent in the period a year earlier—were affected by the phaseouts “substantially.”

Construction Loans.

Typically, developers receive funds to repay

construction loans only upon completion of projects. Thus, an important concern for examiners is

that the majority of a lender’s development loans

be covered by commitments for either the sale or

lease of the property or for the refinancing of the

property by another lender. Moreover, sound policy requires that the lender consider sources of repayment other than the project being funded (unless the bank has set loan terms, such as collateral,

pricing, and loan-to-value ratios, that fully mitigate the need to consider an outside source of repayment.)

Of the 387 banks that actively made construction

loans,

• Thirty-one percent funded speculative construction projects (i.e., those unaccompanied

by commitments) “frequently enough to warrant notice”; a little less than 8 percent did so

“commonly or as standard procedure.”

• Further, 19 percent were reported to have made

construction loans without consideration of

sources of repayment other than the project

being funded “frequently enough to warrant

notice.” Approximately 5 percent did so “commonly or as standard procedure.”

• In addition, 16 percent had required alternative

sources of repayment but failed to verify the

quality of these sources “frequently enough to

warrant notice”; an additional 5 percent “commonly” failed to verify the quality of these

sources.

• Fourteen percent of the banks funded, or deferred, interest payments during the loan term

March 1998 4 Report on Underwriting Practices

0 10 20 30 40 50

Key Construction Loan Practices

Interest payments funded by lender or

deferred during loan term

Failure to verify alternative repayment

sources other than project funded

Projects funded are speculative in nature

Failure to consider alternative repayment

sources other than project funded

Frequent Enough

to Warrant Notice

Common

Percent

5% 19%

5% 16%

8% 31%

7% 14%

PERCENT OF RESPONSES RECEIVED: 10/97 - 3/98
“frequently enough to warrant notice”; an additional 7 percent did so “commonly or as standard procedure.”

Each of these proportions was up substantially

from the period a year earlier.

Home Equity Loans.

Of the banks examined during the reporting period, 14 percent were actively making home equity

loans. As with lending in the other major loan types,

examiners noted a troubling trend.

• Fifteen percent of the 168 banks actively making home equity loans calculated the equity on

the basis of recent escalation in home prices

“frequently enough to warrant notice.” Another 1 percent did so “commonly or as standard procedure.” These proportions—higher

than during the period a year earlier—probably

reflect the recent escalation in home prices.

Credit Card Loans.

Slightly more than 6 percent (or 77 banks) were

active in credit card lending. Of these, 5 are credit

card specialty banks (according to examiners, all

of these banks showed “average” risk in current underwriting practices for new credit card loans).

The 72 remaining banks are not major players in

credit card lending, holding slightly more than 1

percent of their total assets, on average, in such

credits.

• Of the 77 banks that were active in credit card

loans, 84 percent showed unchanged underwriting practices for new credit card lending,

13 percent (10 banks) showed tighter practices,

and 3 percent (2 banks) showed looser practices. Interestingly, the proportion showing

tighter practices was substantially above what

it was in the period a year earlier, while the proportion with loosening standards was unchanged.

• Of the banks examined, 96 percent showed “average” or “below-average” risk in underwriting

practices for new credit card loans—unchanged from the period a year earlier.

REGIONAL DIFFERENCES:

GENERAL UNDERWRITING TRENDS

In three of the eight FDIC regions, responses indicated that the proportion of banks with looser underwriting standards since the previous examination was larger than the proportion with tighter standards. Of the 134 banks examined in the Atlanta region, the figures were 9 percent (looser) and 4 percent (tighter). Of the 202 banks examined in the

Chicago region, the figures were a little more than 9

percent (looser) and about 2 percent (tighter). Finally, in the Dallas region, 130 banks were examined and 8 percent had loosened their standards

while 5 percent had tightened them.

Report on Underwriting Practices 5 March 1998

Current Credit Card Underwriting Practices

PERCENT OF RESPONSES RECEIVED: 10/97 - 3/98

Have Underwriting Practices

Materially Changed?

How Risky Are Current

Practices for Credit Cards?

Looser

Unchanged 3%

84%

Tighter

13% Average

Risk

73%

BelowAverage

Risk

23%

Above-Average

Risk

4%

FDIC Regions with Looser Underwriting Practices

Since the Last Examination

PERCENT OF RESPONSES RECEIVED: 10/97 - 3/98

Atlanta

0

2

4

6

8

10

12

4

9

Chicago

2

9

Dallas

5

8

Percent

Tighter Looser
March 1998 6 Report on Underwriting Practices

Characteristics of the Banks Examined in the Examination Supplement

on Current Underwriting Standards

• Coverage: 1,212 FDIC-supervised depository banks.

• Period: Reports filed between October 1, 1997, and March 31, 1998.

• Charter types: state-chartered commercial banks, 93 percent; state-chartered savings banks,

7 percent; branches of foreign banks on U.S. soil, less than 1 percent (4 banks).

• Size distribution of banks: assets of $1 billion or greater, 3 percent; assets between $300 million and $1 billion, 7 percent; assets between $25 million and $300 million, 72 percent; assets

less than $25 million, 17 percent.

• Proportion of all FDIC-supervised banks (as of December 31, 1997): 22 percent of assets and

20 percent of the number of banks.

Objectives of the Report on Underwriting Practices

• To identify (1) material changes in underwriting standards since the previous examination,

(2) overall risk in new lending practices, and (3) specific risks in underwriting practices for

major loan categories.

• To track emerging issues in the underwriting of new loans.

• To provide an early-warning mechanism for identifying potential problems.