Underwriting standards are crucial guidelines established to ensure safe and secure loans are issued and maintained. These standards help set benchmarks for the debt issuance process, including the terms, conditions, and interest rates applied to personal loans, as well as the amount of debt a company may be willing to issue.
Key Takeaways
- Assessment of Creditworthiness: Underwriting standards are used by banks and lending institutions to determine a borrower’s creditworthiness for loans.
- Setting Terms: They help stipulate how much debt should be issued, along with the terms, conditions, and interest rates.
- Risk Protection: These standards play a significant role in protecting banks against excessive risk and potential losses.
- Regulatory Guidance: Institutions like the Federal Deposit Insurance Corporation (FDIC) provide recommendations for underwriting standards, including credit history and income source evaluations.
How Underwriting Standards Work
Sound underwriting standards are essential to protect financial institutions from excessive risks leading to potential losses. Lending and underwriting practices are typically pro-cyclical, influenced by competitive pressures. As banks seek to increase loan portfolios and generate earnings, there may be a temptation to ease these standards, increasing risks especially as economic conditions deteriorate.
For instance, during the financial crisis of 2008-2009, certain lenders reduced prepayment fees and offered more flexible loan terms. Simultaneously, many companies tightened underwriting standards, effectively contributing to the economic downturn.
Requirements for Underwriting Standards
The decision to modify underwriting standards often originates from the board and senior management of financial institutions. Sometimes, subtle policy changes occur based on how procedures are practically applied. In all cases, proper risk management steps are crucial to identifying, monitoring, and controlling risks, ensuring that loan pricing and terms are appropriate.
A Federal Reserve study emphasized six core lending terms and underwriting standards for maintaining strong credit discipline:
- Risk Appetite Communication: Should highlight the bank’s risk appetite with specific guidance and measurement standards.
- Independent Credit Approval: Should ensure the approval process is separate from lending functions.
- Consistent Documentation: Use of standardized approval documents for consistent financial analysis and collateral valuation.
- Forward-Looking Assessment: Tools to evaluate projections and scenarios focusing on key performance determinants.
- Accurate Risk Rating Systems: These systems should incorporate both quantitative and qualitative evaluation of credit risk.
- Supportive Information Systems: Management and lender information systems should aid in the approval process and portfolio monitoring.
Example of Underwriting Standards
The FDIC provides recommended guidelines for credit card underwriting standards, ensuring these cards are offered with an acceptable level of risk. Key standards include:
- Repayment Capacity: Assessment of the applicant’s ability and willingness to repay.
- Credit History: Evaluation of past and present credit performance.
- Income Assessments: Including varied income sources like self-employment and investment income.
- Aggregate Credit Relationship: Considering the borrower’s overall credit relationship with the bank.
Related Terms: debt, financial crisis, credit history, risk management, lending policies.
References
- Federal Reserve Board of Governors. “SR 98-18: Lending Standards for Commercial Loans”.
- Minneapolis Federal Reserve Bank. “Underwriting Standards - Lessons From the Past”.
- FDIC. “Section 3-2: Loans”.
