Banks must stay vigilant when it comes to minding their loan portfolios.

Years of improved credit and a desire to cut expenses to boost profit threaten to make bankers lax when conducting regular reviews of asset quality, especially for commercial loans.

Doing so would be a repeat of the run-up to the financial crisis, industry observers warn. There are also signs that credit standards are again starting to slip, bringing a new sense of urgency to conduct stringent reviews, industry observers said.

"Banks sometimes cut back on their credit risk management costs and they suffer later on," said T. Alexander Spratt, president and chief executive of Ardmore Banking Advisors. "It is a typical reaction that happens when they consider the portfolio review to be a cost rather than a strategic advantage."

To be sure, banks have generally improved their portfolio review practices, due largely to lessons learned from the last crisis and ever-increasing scrutiny from regulators.

The review process is "significantly better than it was eight to 10 years ago," said Lynn David, president of Community Bank Consulting Services. Before the crisis, "banks wouldn't stay up to date on their financials and they let people get overextended."

Net chargeoffs for the banking industry fell roughly 6% from a year earlier, to $8.7 billion, while noncurrent loans have declined for 22 consecutive quarters, according to the Federal Deposit Insurance Corp. Unfortunately, positive trends can often lull people into complacency.

FDIC Chairman Martin Gruenberg warned recently that increased loan growth has also brought about some "relaxation in underwriting standards." One area of concern, for instance, involves loans to leveraged commercial borrowers.

Loan reviews "can be more than a compliance tool," said Pam Easley, president and chief executive of Extensia Financial, which helps banks with portfolio evaluations. "It is a major management opportunity to get in front of potential problems and be proactive and validate what you know about your loan portfolio."

One of the biggest issue for loan reviews is missing documentation, such as a borrowers' financial statements or a property's updated insurance policies, said Douglas Cunningham, president of Synergy Partners, which assists with portfolio reviews. Requesting such information can take time.

The banks that "do the best job are the ones that lay down strict rules" about clients submitting documentation in a timely manner, David said. A bank, for instance, can decline to renew a commercial line of credit until it receives the necessary information, or it can tack on certain fees if deadlines aren't met.

First Sound Bank in Seattle prides itself on producing organized and complete loan files for its reviews, reflecting a lesson learned when the $132 million-asset bank suffered from significant levels of bad loans during the crisis.

Organization "inserts a discipline into our own process," said Patrick Fahey, First Sound's chairman and chief executive. "We can easily see if we have all of the proper documentation in place. It makes the job easier and reduces costs."

Covenant testing, where a bank regularly reviews a loan's compliance in areas such as debt service coverage or loan-to-value ratios, is an important, but often forgotten, exercise. Bankers would also be well served to periodically visit properties to check on the condition of their loans' underlying collateral, Easley said.

Bankers should also make the time to properly rate — and downgrade when necessary — distressed loans.

Small banks may rely on internal staff to adjust ratings. Doing so has advantages; people who are familiar with the bank, its policies and its culture are the ones conducting the evaluation. However, the same personnel could be biased or lack expertise.

Outside consultants can provide an unbiased opinion, but it's important to choose experience over cutting costs. External auditors can face push back from loan officers who don't want certain credits downgraded.

"Banks are trying to produce more profits, so they often don't look for a truly independent review from skilled lenders," Spratt said. "They're willing to take the least costly alternative. Whether it's internal or external, the people who review these loans should have the courage and ability to make sure the bank knows of any problems."

First Sound completes an internal review before bringing in an outside firm to confirm its findings. Internal reviews allow the bank's relationship managers keep tabs on the loans while providing a chance to give advice as needed.

"At the end of the day, it is all about managing your risk," said Jon Shelton, First Sound's chief credit officer. "We want to make sure we have run a clean shop to mitigate any unknown risks that might be out there."

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