Lending is not an exact science. Even banks that adhere to meticulous guidelines risk being saddled with underperforming loans that hurt the balance sheet.
The long-term consequences of carrying a higher percentage of classified assets include lower asset-quality ratios, more restricted capital for loan-loss reserves, and diminished regulator and investor confidence.
One of these - or worse, a chorus of all three - can affect performance dramatically.
Bankers traditionally have been reluctant to consider selling classified assets as a portfolio management strategy.
The shared national credit review report from September 2003 showed that classified assets had risen to 9.3% of total commitments among syndicated bank loans that year - the highest since a peak in the early 1990s. The increase in subperforming debt was attributed to aggressive loan growth, an increase in high-risk portfolios, and a lack of optimal credit policy controls.
But the 2004 SNC review painted a much-improved picture and suggested that many banks are actively implementing loan sale strategies. Those data show the ratio of classified loan commitments to the total at 4.8% - the lowest level since 2000. The decline was attributed partly to a rise in the sale of lower-quality loans in the secondary market.
Historically, banks respond to increased classified asset ratios with tighter credit policies in the hope of improving ratios over time. Unfortunately, underwriting is a subjective process, and tighter credit policies usually cause banks to reject good loans.
But loan sales can be applied selectively, and the benefits are direct and measurable. Selling classified loans removes the adversely rated ones and potential liability from the balance sheet, while relieving a bank of the risks associated with substandard assets.
By selling classified assets, banks can significantly improve their credit profile.
Selling loans that are on - or likely to go on - nonaccrual status allows banks to reinvest in earning assets. A sale frees up the loan-loss reserve associated with the asset, which enables the bank to redeploy funds and capital for investment in higher-return opportunities. In many cases, classified assets can be sold at small discounts to their principal balance.
Many banks can easily become concentrated in certain property types, geographic areas, or even individual borrowers. Selling is an effective way to reduce such concentrations and diversify portfolios.
Despite the benefits of selling classified assets, the use of this strategy has been mostly limited to large banks with SNC participation. Community banks have been slower to adopt the strategy.
Consequently, community banks may miss opportunities to rid themselves of substandard assets and to improve the health of their loan portfolio.
To maintain a solid market position, community banks must keep monitoring current and emerging risk issues associated with classified assets.
Adopting effective risk-management loan sales strategies will help ensure optimal portfolio performance, superior quality ratings, and customer and investor confidence.
