Bank Loan-Underwriting Practices: Can Examiners' Risk Assessments Contribute to Early-Warning Systems?

Abstract

Loan underwriting practices are the primary determinant of bank credit risk and bank credit availability. For this reason, U.S. bank supervisors conduct periodic surveys to assess bank underwriting practices and their riskiness. In early 1995 the Federal Deposit Insurance Corporation (FDIC)introduced a comprehensive examination questionnaire, or survey, of bank underwriting practices at FDIC-supervised banks; FDIC bank examiners complete the survey at the end of each FDIC-supervised bank examination. The survey covers lending practices both in general and in specific loan categories. This study investigates (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. We find that higher (lower) risk in underwriting practices is associated with subsequent increases (decreases) in nonperforming assets generally. We also find that assessments of underwriting risk contribute to off-site surveillance models that predict safetyand-soundness examination ratings. However, this contribution is largely subsumed by that of concurrent safety-and-soundness examinations ratings. Thus, underwriting survey data are best used as diagnostic measures of the sources of financial distress.