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Examination Coverage of Underwriting Practices for Consumer Loans Not Secured by Real EstateFebruary 2009
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This report presents the results of our audit of FDIC examination coverage of underwriting practices for consumer loans not secured by real estate. Such loans are used by consumers to finance a variety of purchases, including: automobiles, appliances, furniture, home repairs, education costs, medical expenses, and vacations.1 As of March 31, 2008, FDIC-supervised institutions held approximately $94.7 billion in such loans. Accordingly, it is important for FDIC examiners to adequately assess the risks associated with such loans when they represent a material percentage of an institution’s assets. The audit objective was to assess FDIC risk management examination coverage of institution underwriting practices for consumer loans not secured by real estate. We conducted this performance audit in accordance with generally accepted government auditing standards. Appendix 1 of this report discusses our objective, scope, and methodology in detail. BACKGROUNDLoan underwriting is the process a lender uses to determine whether the risk of lending to a particular borrower under a particular set of circumstances is acceptable. To help assess the quality of, and the risks associated with, a particular loan, institutions commonly develop underwriting guidelines and use automated or manual credit scoring systems that evaluate creditworthiness on the basis of key attributes of the applicant and other aspects of the transaction. |
March 31, 2008 Call Report data showed that out of 5,183 FDIC-supervised institutions, 404 institutions had more than 10 percent of their assets concentrated in consumer loans not secured by real estate (see the table below). For the purpose of this report, concentrations refer to Other Consumer Loan portfolios that total 10 percent or more of the total assets of an institution. We sampled 14 of the 53 institutions for which the FDIC had conducted risk management examinations during 2007 and 2008. Details on our sample are discussed in Appendix 1. Concentrations of Consumer Lending at FDIC-Supervised Institutions
The FDIC’s Division of Supervision and Consumer Protection (DSC) (1) performs risk management examinations of FDIC-supervised institutions to assess their overall financial condition, management practices and policies, and compliance with applicable laws and regulations and (2) issues related guidance to institutions and examiners. DSC has issued underwriting standards to institutions and focuses attention on loan underwriting, including credit scoring, as part of its statutorily required risk management examinations of FDIC-supervised institutions. Primary examiner guidance on the review of an institution’s consumer credit underwriting practices is contained in DSC’s Risk Management Manual of Examination Policies (Examination Manual), which helps examiners to provide an overall assessment of, and identify the risks associated with, FDIC-supervised institutions’ consumer credit underwriting activities. Additionally, to aid in monitoring the overall level of risk in institutional lending practices with the emphasis on early risk detection, FDIC policy requires examiners to complete the Underwriting Survey at the conclusion of each on-site risk management examination of an FDIC-supervised institution. Examiners use the online Underwriting Survey Response System to complete the surveys. The FDIC uses the surveys to track whether institutions are making loans without adequate collateral protection and the extent to which the institutions make loans to borrowers who lack a demonstrable ability to repay. The FDIC also uses the surveys to develop reports on trends in risks in current underwriting practices. 2
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RESULTS OF AUDITDSC has established sound risk management examination guidance for the reviews of consumer loans not secured by real estate in FDIC-supervised institutions. Specifically, DSC has issued examiner guidance in the form of examination manuals, Regional Directors (RD) Memoranda, Examination Documentation (ED) modules, Financial Institution Letters (FIL),2 and FDIC policy statements. Based on our review of 14 examinations, we concluded that the examiners had followed established guidance and conducted procedures as part of risk management examinations to assess consumer loan underwriting risks. Specifically, we found evidence that examiners reviewed indirect lending agreements, underwriting practices, credit scoring systems, the adequacy of allowances for loan and lease losses (ALLL), asset classifications, and risk and account management systems (see Appendix 2). Additionally, examiners conducted transaction testing on a sample of consumer loans when necessary to assess compliance with underwriting standards. For the examinations we sampled, we concluded that the examiners had adequately considered the risks associated with consumer lending activities not secured by real estate (Examiner Assessment of Underwriting Practices for Consumer Loans Not Secured by Real Estate). Although our overall conclusion was positive with respect to examination coverage of institution underwriting practices for consumer loans not secured by real estate, examiners did not always properly complete the required Underwriting Survey. Specifically, FDIC policy requires that a knowledgeable examiner complete the Underwriting Survey at the conclusion of each examination; however, for 8 (57 percent) of the 14 sampled examinations, the examiners either did not complete the survey (2 cases) or provided responses that were inconsistent with information in the Report of Examination (ROE) on consumer loan underwriting (6 cases). Controls over the Underwriting Survey process were not sufficient to prevent and detect these errors. As a result, this process may not reliably identify trends in the risk associated with underwriting practices for various consumer loans. (Examiner Compliance With Underwriting Survey Requirements). EXAMINER ASSESSMENT OF UNDERWRITING PRACTICES FOR CONSUMER LOANS NOT SECURED BY REAL ESTATEDSC’s examination guidance has provided examiners the on-site examination tools to identify and assess consumer lending risk related to: indirect lending agreements, underwriting practices, credit scoring systems, adequacy of ALLL, asset classifications, risk and account management systems, and credit grading systems. 3
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The Examination Manual includes factors for addressing asset quality, such as the adequacy of underwriting standards, soundness of credit administration practices, and the appropriateness of risk identification practices and credit scoring systems. Further, in general, various other DSC risk management examination guidelines address reviews of transaction testing and analyses of loan portfolios (as described in Appendix 2). Our review of examination documentation for 14 examinations performed by 5 DSC field offices showed that examiners had followed examination guidance and conducted detailed procedures, such as testing of individual transactions, as part of risk management examinations to assess consumer loan underwriting risks as discussed in the following sections. Examination Coverage We sampled 14 of the 53 institutions identified by DSC as having concentrations of consumer loans not secured by real estate to determine the extent of examiner coverage of underwriting standards during on-site risk management examinations. The institutions were engaged in various combinations of consumer lending to include educational and student, home improvement, mobile home, recreational, marine, taxi medallion, subprime automobile, automobile, and indirect lending. Further, examinations for 9 of the 14 institutions indicated concentrations of consumer lending of 20 percent or greater during the period the examination took place. To determine the level of examination coverage related to consumer credit underwriting for the 14 institutions in our sample, we reviewed ROEs, examination planning documents, examiner working papers and summaries, and DSC’s Virtual Supervisory Information on the Net (ViSION)3 system documentation. The examination for 1 of the institutions focused on a review of the institution’s commercial real estate portfolio, and its consumer lending activities were not addressed in the ROE.4 Therefore, our assessment of DSC’s risk management coverage was ultimately limited to the 13 remaining examinations in our sample. Our conclusions on those examinations follow.
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Details of our assessment of the on-site risk management examination coverage of consumer underwriting practices in FDIC-supervised institutions are provided in Appendix 3. Transaction TestingWe also assessed the level of transaction testing examiners conducted during the on-site risk management examinations. For 11 of the 13 sampled examinations that addressed consumer lending, examiners conducted transaction testing to measure compliance with consumer lending underwriting standards. Although transaction testing was not conducted for two of the examinations in our sample, we concluded the following:
As a result of these generally positive results, we are not making any recommendations related to this finding. EXAMINER COMPLIANCE WITH UNDERWRITING SURVEY REQUIREMENTSBased on our sample of 14 institutions that had risk management examinations conducted during 2007, we found that examiners did not always properly complete the required Underwriting Survey. Specifically, FDIC policy requires that a knowledgeable examiner complete the Underwriting Survey at the conclusion of each examination; however, for 8 (57 percent) of the 14 sampled examinations, the examiners either did not complete the survey (2 cases) or provided responses that were inconsistent with information in the ROEs on consumer loan underwriting (6 cases). Controls over the Underwriting Survey were not sufficient to prevent and detect these errors. As a result, the Underwriting Survey process may not reliably identify trends in the risk associated with underwriting practices for various consumer loans. Also, the reports developed from the surveys may not accurately represent the underwriting trends at FDIC-supervised institutions. 5
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The requirement for examiners to complete an Underwriting Survey is contained in RD Memorandum 98-076, Underwriting Survey Questionnaire Changes. The RD Memorandum states that DSC uses examiner responses to the survey to monitor the overall level of risk in banks’ lending practices, with an emphasis on early risk detection of potential lending problems. Additionally, the FDIC’s Division of Insurance and Research (DIR) develops reports from the survey information, showing trends in risk in current practices for various loan types, including consumer loans. The survey questionnaire requests information about the institution’s underwriting trends since the last examination and the current underwriting practices of the institution examined. The questionnaire focuses on three topics: material changes in underwriting practices for new loans, the degree of risks in underwriting practices, and underwriting practices for specific categories of loans (one of which is consumer loans). The examiners are expected to answer questions related to: (1) the extent to which the institution makes “secured” consumer loans without adequate collateral protection, (2) the extent to which the institution makes consumer loans to borrowers who lack demonstrable ability to repay, and (3) the examiners’ concerns about the institutions’ consumer loan underwriting practices. Examiners are asked to classify the occurrence of specific risky practices as “frequent enough to warrant notice” or, if the risky practice is more prevalent, as “common or standard procedure.” We reviewed ROEs, Underwriting Surveys, examination planning documents, and asset review summaries for each of the 14 institutions in our sample and found the following:
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FDIC management stated it was aware of problems associated with the Underwriting Surveys. According to a DSC management official, there is no required secondary review of the responses to the Underwriting Survey at the field office or regional office level. Use of Information in the SurveysIn November 2003, DSC conducted a study to investigate (1) the relationships between examiners’ assessments of the riskiness of bankers’ lending practices and subsequent changes in bank condition and (2) the question of whether these relationships can enhance supervisors’ early-warning systems.6 According to the study, loan underwriting practices are the primary determinant of bank credit risk and bank credit availability. Specifically, the study found that:
The FDIC, the Board of Governors of the Federal Reserve System (FRB), and the Office of the Comptroller of the Currency (OCC) conduct surveys on underwriting practices at the banks they supervise and publish the results of the surveys on their Web sites.7 In addition, the FDIC’s DIR prepares semiannual reports entitled, Recent Underwriting Surveys by Federal Banking Regulatory Agencies and Recent Underwriting Practices at FDIC-Supervised Banks, based on information provided in the Underwriting Surveys. 7
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These reports show trends in risk in current practices for various loan types, including consumer loans. According to the DIR June 16, 2008 semiannual report on underwriting, the potential risk associated with institutions’ current underwriting practices and the credit risk of institutions’ overall loan portfolios increased compared to the last reporting period. However, the risks in overall underwriting standards were mixed: the frequency of risky practices increased for business, commercial real estate, construction, and consumer lending, but decreased for agricultural and home equity lending. If examiners do not complete the Underwriting Surveys or respond incorrectly to the questionnaire, the Underwriting Survey process may not accurately identify trends in the risk associated with underwriting practices for various consumer loans and may hamper the efficacy of the survey as an off-site monitoring tool. When we informed DSC management about our findings in this area, they told us that they were revising the survey process to ensure that the information is more useful. In particular, management plans to obtain more detailed data on institution loan portfolios and implement controls to ensure the completeness and accuracy of survey responses. Such actions can increase the efficacy of the survey as an off-site monitoring tool. Specific information on revisions being made to the survey process, including milestones for implementation, was not available at the completion of our audit. Once implemented, the new survey process could address the deficiencies related to completion of the surveys. Recommendation on the Underwriting Survey ProcessThe Director, DSC, should strengthen controls over completion of the Underwriting Surveys to ensure the completeness and reliability of survey information. CORPORATION COMMENTS AND OIG EVALUATIONOn January 29, 2009, the Director, DSC, provided a written response to a draft of this report. In its response, DSC stated that it plans to meet the intent of our recommendation as part of its ongoing revisions to the Underwriting Survey, which will be renamed the Credit and Consumer Products Survey, intended to enhance the quality and quantity of information collected. DSC’s response is presented in its entirety as Appendix 4 of this report. DSC’s actions are potentially responsive to our recommendation. A summary of management’s response to the recommendation is in Appendix 5 of this report. The recommendation is considered resolved but will remain open until we have determined that agreed-to corrective actions have been completed and are responsive. 8
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APPENDIX 1OBJECTIVE, SCOPE, AND METHODOLOGY
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APPENDIX 1
Audit Sample Our audit conclusions are based on a non-statistical judgmental sample.8 We focused on three categories of institutions with concentrations of Other Consumer Loans. We identified 404 FDIC-supervised institutions that reported over 10 percent of their assets as Other Consumer Loans on their March 2008 Call Reports. We then determined which of these institutions had an FDIC on-site risk management examination in 2007 or 2008. Based on the criteria illustrated below, we identified a universe of 53 institutions.
Out of these 53 institutions, we sampled 14 institutions identified as having various levels of consumer lending activities. The 14 institutions had from 11 percent to 93 percent of their total assets in Other Consumer Loans and were engaged in the following types of consumer lending.
Our sample was ultimately limited to 13 institutions because the examination for 1 of the 14 institutions focused on a review of the institution’s commercial real estate portfolio, and its consumer lending activities were not addressed in the ROE. 10
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APPENDIX 1
Internal Control To assess the relevant control activities, we identified the processes related to conducting on-site FDIC risk management examinations of institutions’ underwriting practices for consumer loans not secured by real estate. These controls included policies and procedures included in examiner and institution guidance as presented in the DSC Examination Manual, RD Memoranda, ED Modules, FILs, and FDIC Policy Statements. We identified the following relevant internal controls applicable to examination assessments of consumer credit underwriting and related supervisory and enforcement actions:
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APPENDIX 1
Reliance on Computer-processed Information Our audit objective did not require that we separately assess the reliability of computer-processed information, and we did not rely on computer-processed data to support our significant findings and conclusions. During the audit, we determined that the FDIC tracks the volume of FDIC-supervised institutions with consumer loan concentrations through the Call Report process. Schedule RC-C, Item 6.c. of the Call Report requires FDIC-insured institutions to report the volume of Other Consumer Loans, which include installment loans, demand loans, and single-payment time loans. However, our assessment centered on reviews of ROEs, examination planning documents, examination workpapers and summaries, DIR Underwriting Survey analyses, and ViSION system documentation. Performance Measurement We reviewed FDIC annual performance plans and strategic plans to identify goals, objectives, and results and determine whether the Corporation has (1) established quantifiable performance measures and (2) developed and analyzed data to assess program, project, or function performance related to its efforts to identify risk in institutions involved in the underwriting of consumer loans not secured by real estate. In fulfilling its primary supervisory responsibilities, the FDIC pursues two strategic goals: (1) FDIC-supervised institutions are safe and sound, and (2) consumers’ rights are protected and FDIC-supervised institutions invest in their communities. These strategic goals and objectives do not directly relate to on-site risk management examination coverage of underwriting and credit scoring practices for consumer loans not secured by real estate. In addition, we reviewed the FDIC’s 2005-2010 Strategic Plan, 2008 Annual Performance Plan, 2008 Strategic Priorities, 2008 Corporate Performance Objectives, and 2007 Annual Report, finding no specific information related to our objectives. Compliance With Laws and Regulations We reviewed applicable laws and regulations related to the FDIC’s risk management examinations of underwriting practices. We found no instances where the FDIC was not in compliance with applicable laws and regulations, but we did note areas for improvement related to controls over the Underwriting Survey process, as described in the report. Section 39, Standards for Safety and Soundness, of the Federal Deposit Insurance Act (FDI Act) states that each appropriate federal banking agency shall, for all insured depository institutions, prescribe standards relating to credit underwriting. The Interagency Guidelines Establishing Standards for Safety and Soundness, prescribed pursuant to section 39 of the FDI Act, as set forth in Appendix A to Part 364 of the FDIC Rules and Regulations, applies to all insured state nonmember banks and to state-licensed insured branches of foreign banks that are subject to the provisions of section 39 of the FDI Act. 12
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APPENDIX 1
According to these guidelines, an institution should establish and maintain prudent credit underwriting practices. We assessed the risk of fraud and abuse related to the audit objective in the course of evaluating audit evidence. 13
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APPENDIX 2EXAMINATION GUIDANCE FOR CONSUMER LOAN PORTFOLIOS
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Pre-Examination Planning and Scoping
- DSC Risk Management Manual of Examination Policies, Part II, Section 3.2, Loans - ED Module: Consumer and Check Credit
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Consumer Loan Review - DSC Risk Management Manual of Examination Policies, Part II, Section 3.2, Loans - ED Module: Consumer and Check Credit
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Indirect Lending
- DSC Risk Management Manual of Examination Policies, Part II, Section 3.2, Loans - ED Module: Consumer and Check Credit
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APPENDIX 2
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APPENDIX 2
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APPENDIX 3SUMMARY OF ON-SITE RISK MANAGEMENT EXAMINATION COVERAGE OF |
Area of Examination Coverage |
Number of Examinations Providing Coverage (Based on 13 Institutions) |
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The Pre-Examination Planning Memorandum addressed the institution’s consumer lending activities. | 11 |
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13 |
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13 |
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12 |
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12 |
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10 |
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The examiner identified subprime characteristics of the consumer loan portfolio and determined whether the subprime guidelines were followed for capital allocation and portfolio management. | 8 (Five of the institutions did engage in subprime lending.) |
APPENDIX 3
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APPENDIX 4CORPORATION COMMENTS
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January 29, 2009
The Federal Deposit Insurance Corporation’s Division of Supervision and Consumer Protection (DSC) appreciates the time and effort the Office of Inspector General (OIG) dedicated to this audit. DSC is pleased the OIG found that “DSC has established sound risk management examination guidance for the reviews of consumer loans not secured by real estate in FDIC-supervised institutions.” The OIG recommended that DSC “strengthen controls over the Underwriting Surveys to ensure the completeness and accuracy of survey data.” In this regard, I have directed my staff to ensure that revisions being made to the Underwriting Survey meet the intent of this recommendation. To enhance the quality and quantity of information collected through the Underwriting Survey, DSC is revising the document which will be renamed the Credit and Consumer Products Survey (Survey). Revisions to the Survey include the addition of credit-related questions that will address credit underwriting, funding, and consumer protection issues, among other areas of interest. The data collected from the Survey will be analyzed and compared with other financial and examination data collected from internal and external sources. This comparative analysis will serve as a reasonability test for the information collected through the Survey and provide critical information on emerging issues and trends in the banking industry. The results of our analysis will be provided periodically to DSC management at Headquarters and in the Regional Offices. DSC expects to implement the Credit and Consumer Products Survey by June 30, 2009. |
APPENDIX 5MANAGEMENT RESPONSE TO RECOMMENDATIONS
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Corrective Action: Taken or Planned on the Recommendation | Expected Completion Date | Monetary Benefits | Resolved:a Yes or No | Open or Closedb |
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DSC is revising the Underwriting Survey, which will be renamed the Credit and Consumer Products Survey, to enhance the quality and quantity of information collected. | 6/30/2009 | $0 | Yes | Open |
a Resolved – | (1) Management concurs with the recommendation, and the planned corrective action is consistent with the recommendation. |
(2) Management does not concur with the recommendation, but planned alternative action is acceptable to the OIG. | |
(3) Management agrees to the OIG monetary benefits, or a different amount, or no ($0) amount. Monetary benefits are considered resolved as long as management provides an amount. |
APPENDIX 6ACRONYMS USED IN THE REPORT
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ALLL | Allowance for Loan and Lease Losses |
DIR | Division of Insurance and Research |
DSC | Division of Supervision and Consumer Protection |
ED | Examination Documentation |
FDI | Federal Deposit Insurance |
FICO | Fair Isaac & Co. |
FIL | Financial Institution Letter |
FRB | Board of Governors of the Federal Reserve System |
GAO | Government Accountability Office |
OCC | Office of the Comptroller of the Currency |
OIG | Office of Inspector General |
RD | Regional Director |
ROE | Report of Examination |
ViSION | Virtual Supervisory Information on the Net |
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