TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
On March 1, 1991, the Federal bank and thrift
regulatory agencies jointly issued a statement clarifying certain
supervisory and accounting policies. The statement was issued in
response to concerns that some supervisory policies, or
depository institutions' misunderstandings about the policies,
were inhibiting the extension of loans to sound, creditworthy
borrowers. The guidelines and clarifications contained in the
March 1st statement establish a framework, consistent with safe
and sound banking practices, within which banking organizations
can make loans to creditworthy borrowers and work in a
constructive and prudent fashion with borrowers experiencing
temporary financial difficulties. The statement was based upon
the principle that prudent lending practices on the part of banks
and timely and effective supervisory actions on the part of
regulators should not inhibit banking organizations from playing
an active role in financing the needs of creditworthy borrowers.
This letter supplements the contents of the March 1st
statement and provides guidance to supervisory and examination
personnel regarding certain supervisory policies or practices
that may have an impact on credit availability. As was true with
the earlier interagency statement, the guidance contained in this
letter is consistent with sound banking practices and generally
accepted accounting principles.
Supervisory asset assessments
Concerns have been expressed that problems broadly
associated with some sectors or segments of an industry, such as
certain commercial real estate markets, could lead to overly
pessimistic assessments of particular credits that are not
affected by the problems of the troubled sectors. The March 1st
statement reiterates that real estate loans should not be
assessed solely on the basis of the liquidation value of the
underlying collateral; rather, consideration should also be given
to a property's stabilized capacity to generate cash flow to
service its debt. Consistent with this principle and
longstanding supervisory practice, loans or credits that are
adequately protected by the current sound worth and debt-service
capacity of the borrower or the underlying collateral generally
should not be subject to examiner classification.
These principles hold for individual credits, even if
portions or segments of the industry to which the borrower
belongs are experiencing financial difficulties. The evaluation
of each credit should be based upon the fundamentals of the
particular credit, that is, the borrower's (or the collateral's)
current and stabilized cash flow, earning and debt service
capacity, financial performance, net worth, guarantees, future
prospects, and other factors relevant to the borrower's ability
to service and retire its debt.
Real estate construction and mini-perm loans
The March 1st guidance states that institutions that
have in place effective controls to manage and reduce undue
concentrations over time, need not refuse credit to sound
borrowers simply because of the borrower's industry or geographic
location. It is important to emphasize that this principle
applies to prudent loan renewals and rollovers, as well as to new
extensions of credit that are underwritten in a sound manner.
Many banks have made construction loans that upon
completion of the construction phase of the project will require
longer-term or take-out financing. In addition, during the 1980s
some banks made medium term (up to 7 years to maturity) loans to
finance commercial real estate after completion of the
construction phase. Many of these construction and so-called
"mini-perm" loans are now coming due or will be coming due over
the next 12 to 24 months.
Under current conditions, obligors on these loans may
continue to find it difficult to obtain adequate sources of long-term credit. In some cases, banks may determine that the most
desirable and prudent course is to rollover or renew loans to
those borrowers who have demonstrated an ability to pay interest
on their debts, but who may not be in a position, at the present
time, to obtain long-term financing for the principal. The act
of refinancing or renewing loans to sound borrowers, including
creditworthy commercial or residential real estate developers,
generally should not be subject to supervisory criticism in the
absence of well-defined weaknesses that jeopardize repayment of
the loans. Refinancings or renewals should be structured in a
manner that is consistent with sound banking, supervisory, and
accounting practices, and that protects the bank and improves its
prospects for collecting or recovering on the asset.
Assessment of asset concentrations
The March 1st statement indicates that while the
regulatory agencies have not established specific rules on asset
concentrations, depository institutions should establish and
adhere to policies that control concentration risk. One aspect
of such a system of risk control is the definition of asset
concentrations. Traditionally, loans to related groups of
borrowers, loans collateralized by a single security or
securities with common characteristics, and loans to borrowers
with common characteristics within an industry often have been
included in homogeneous risk groupings when assessing asset
concentrations.
In identifying asset concentrations, commercial real
estate loans and residential real estate loans can be viewed
separately when their performance is not subject to similar
economic or financial risks. In the same vein, commercial real
estate development loans need not necessarily be grouped with
residential real estate development loans, especially when the
residential developer has firm, reliable purchase contracts for
the sale of the homes upon completion. Even within the
commercial development and construction sector, distinctions for
concentration purposes may be made, when appropriate, between
those loans that have firm take out commitments and those that do
not. Groups or classes of real estate loans should, of course,
be combined and viewed as concentrations when they do share
significant common characteristics and are similarly affected by
adverse economic, financial, or business developments.
Institutions with asset concentrations are expected to
put in place effective internal policies, systems, and controls
to monitor and manage this risk. Concentrations that involve
excessive or undue risks require close scrutiny by the bank and
should be reduced over a reasonable period of time. Banking
organizations with a need to reduce asset concentrations are
normally expected to develop a plan that is realistic, prudent,
and achievable in view of the bank's particular circumstances and
market conditions. In situations where concentration levels have
been built up over an extended period, it may take time, in some
cases several years, to achieve a more balanced and diversified
portfolio mix. What is critical is that banking organizations
have in place adequate systems and controls for reducing undue or
excessive concentrations in accordance with a prudent plan,
strong credit policies and loan administration standards to
control the risks associated with new loans, and adequate capital
to protect the institution while its portfolio is being
restructured.
Issues relating to restructured debt and partially charged-off loans
Working in a prudent manner with borrowers experiencing
financial difficulties may involve formally restructuring loans
and taking other measures in recognition of the borrowers'
condition and repayment prospects. Such actions, if done in a
way that is consistent with prudent lending principles and
supervisory practices, can improve a bank's prospects for
collection. Generally accepted accounting principles (GAAP) and
regulatory reporting requirements, provide a framework for
reporting that, in some cases, may alleviate certain concerns
that lenders may have about working in a constructive fashion
with borrowers experiencing financial difficulties.
The March 1, 1991 interagency policy statement
presented a number of clarifications of supervisory policies
regarding issues relating to nonaccrual assets and restructured
loans. Three of these clarifications indicated that when certain
criteria are met, (i) interest payments on nonaccrual assets can
be recognized as income on a cash basis without first recovering
any prior partial charge-offs, (ii) nonaccrual assets can be
restored to accrual status when subject to formal restructurings
in accordance with Financial Accounting Standards Board (FASB)
Statement No. 15, and (iii) restructurings that yield a market
rate of interest would not have to be included in restructured
loan amounts reported in the years subsequent to the year of the
restructuring. These clarifications, which are consistent with
GAAP, have been fully incorporated into the instructions for the
Reports of Condition and Income ("Call Reports") filed by banks
and the "Y Reports" filed by bank holding companies, as of June
30, 1991. Additional clarifications on issues relating to the
restoration to accrual status of restructured debt and nonaccrual
assets with partial charge-offs are set forth below.
Nonaccrual assets subject to FASB Statement No. 15
restructurings
The March 1st policy statement indicated that a
loan or other debt instrument that has been formally restructured
so as to be reasonably assured of repayment and performance
according to its modified terms need not be maintained in
nonaccrual status. Furthermore, the interagency policy indicated
that in returning the asset to accrual status, sustained
historical payment performance for a reasonable time prior to the
restructuring may be taken into account.
For example, a loan may have been restructured, in
part, to reduce the amount of the borrower's contractual
payments. In so doing, the borrower's restructured terms may
require payments that do not exceed the amount and frequency that
have been demonstrated by the sustained historical payment
performance of the borrower for a reasonable time before the loan
was restructured. In this situation, assuming that the
restructured loan is reasonably assured of repayment and performance according to its modified terms, the loan can be
immediately restored to accrual status.
Clearly, a period of sustained performance, whether
prior to or subsequent to the date of the restructuring, is a
very important factor in determining whether there is reasonable
assurance of repayment and performance according to the loan's
modified terms. In certain circumstances, evidence may exist
regarding other characteristics of the borrower that may be
sufficient to demonstrate a relative improvement in the
borrower's condition and debt service capacity, thereby reducing
the degree of reliance on the borrower's performance to date in
assessing prospects for future performance and collectibility
under the modified terms. For example, substantial and reliable
sales, lease or rental contracts obtained by the borrower or
other important developments that are expected to significantly
increase the borrower's cash flow and debt service capacity and
strengthen the borrower's commitment to repay may be sufficient
to provide this assurance. In certain circumstances, a preponderance of such evidence, in and of itself, may be sufficient to
warrant returning a restructured loan to accrual status, provided
the loan under its restructured terms is reasonably assured of
performance and full collectibility.
It is imperative that the reasons for the restoration
of restructured debt to accrual status be documented. Such
actions should be supported by a current, well documented credit
evaluation of the borrower's financial condition and prospects
for repayment under the modified terms. This documentation will
be subject to review by examiners.
The formal restructuring of a loan or other debt
instrument should be undertaken in ways which improve the
likelihood that the credit will be repaid in full under the
modified terms in accordance with a reasonable repayment
schedule.1 When restructuring loans, regulatory reporting
requirements and GAAP do not require banking organizations to
grant excessive concessions, forgive principal, or take other
steps not commensurate with the borrower's ability to repay, in
order to use the reporting treatment specified in FASB Statement
No. 15. Furthermore, regulatory reporting requirements and GAAP
do not preclude institutions from including in the restructured
terms prudent contingent payment provisions that permit an institution to obtain appropriate recovery of concessions involved in
the restructuring should the borrower's condition substantially
improve.
Treatment of nonaccrual loans with partial charge-offs
Questions have been raised regarding whether partial charge-offs
associated with a nonaccrual loan (that has not been formally
restructured) must first be fully recovered before a loan can be
restored to accrual status. GAAP and regulatory reporting
requirements do not explicitly address this issue.
In accordance with the Call Report instructions,
restoration to accrual status is permitted when (a) the loan has
been brought fully current with respect to principal and interest
and (b) the bank expects that the full contractual balance of the
loan (including any amounts charged-off) plus interest will be
fully collectible under the terms of the loan.2 Thus, in
determining whether a partially charged-off loan that has been
brought fully current can be returned to accrual status, it is
important to determine whether the bank expects to receive the
full amount of principal and interest called for by the loan's
terms.
When a loan has been brought fully current with respect
to contractual principal and interest, and the borrower's financial condition and prospects for repayment have improved so that
the full amount of contractual principal (including any amounts
charged-off) and interest is expected to be repaid, the loan may
be restored to accrual status without having to first recover the
charge-off. On the other hand, this treatment would not be
appropriate when the charge-off is indicative of continuing doubt
regarding the collectibility of principal or interest. Since the
criteria for nonaccrual status include the requirement that loans
or other assets be placed in nonaccrual status when repayment in
full of principal or interest is not expected, such nonaccrual
loans could not be restored to accrual status.
It is imperative that the reasons for the restoration
of a partially charged-off loan to accrual status be documented.
Such actions should be supported by a current, well documented
credit evaluation of the borrower's financial condition and
prospects for full repayment of contractual principal (including
any amounts charged-off) and interest. This documentation will
be subject to review by examiners.
A nonaccrual loan or debt instrument may have been
formally restructured in accordance with FASB Statement No. 15 so
that it meets the criteria for restoration to accrual status
presented in the previous section (that addresses restructured
loans). Under GAAP, when a charge-off was taken prior to the
date of the restructuring, the charge-off does not have to be
recovered before the restructured loan can be restored to accrual
status. When a charge-off occurs after the date of the
restructuring, the considerations and treatments discussed in the
previous paragraphs in this section are applicable.
Deputy Associate Director
Footnotes 1. When a restructured loan is not reasonably assured of repayment and performance under its modified terms in accordance with a reasonable repayment schedule, the loan may not be restored to accrual status. Return to text 2. The instructions for the Call Reports and "Y Reports" discuss the criteria for restoration to accrual status in the glossary entries for "nonaccrual status." This guidance also permits restoration to accrual status for nonaccrual assets that are both well secured and in the process of collection. In addition, this guidance permits restoration to accrual status, when certain criteria are met, for formally restructured debt and acquired nonaccrual assets. Return to text |
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