Sba sop 51 00 On-Site Lender Reviews/Examinations Office of Lender Oversight
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7. Earnings Examination Componenta. IntroductionSome SBA Supervised Lenders are owned by larger firms, while others are owned by shareholders. Regardless, all owners look to the earnings of the SBA Supervised Lender to assess the quality of their investment. Earnings of impressive quantity and quality offset the risks of charge-offs, litigation costs, or fraud to lender’s capital. Confidence will not be built and dividends will not be paid if an SBA Supervised Lender cannot earn sufficient returns to provide a capital cushion that assures vitality. An SBA Supervised Lender’s principle sources of income are interest on loans remaining in their portfolios, gains realized from the sale of loans, and fees earned for origination and servicing. An SBA Supervised Lender’s ability to continue to extend credit profitably depends on its ability to build capital from solid earnings performance. Therefore, examiners must determine whether an SBA Supervised Lender is pricing its loans commensurate with the risk posed. In addition, SBA Supervised Lenders need to ensure the returns they obtain from loan sales are sufficient to cover costs and build retained earnings. It is also important for examiners to evaluate the expense structure of an SBA Supervised Lender. Any and all expenses incurred by an SBA Supervised Lender must be considered when an SBA Supervised Lender prices its products. In coordination with the examiner evaluating asset/liability management, a thorough evaluation of interest rate risk exposure must be conducted. Non-recurring earnings are those that are a one time event. Any one-time gains of this nature must be considered when an examiner evaluates the stability of earnings. An example would be if the SBA Supervised Lender sold the building it occupied and owned, then leased it from the new owner. The one time gain certainly improves year to date earnings, but does the gain really say anything about the SBA Supervised Lender’s ability to generate profits over an extended period? b. Examination CriteriaGiven that the interest and fees earned on loans and the profit from sales of loans are the primary ways that SBA Supervised Lenders generate earnings, examiners must evaluate the pricing decisions behind these activities. Each SBA Supervised Lender should have a business plan adopted by the BOD and a budget to carry it out. These are important documents for examiners to review as they often indicate targeted rates of return. Have the targets routinely been met? Were the targets appropriate given the risk absorbed? Given the SBA’s public mission, does the business plan indicate risk tolerance levels? Quantity of Earnings Key statistical measures used when evaluating earnings quantity are the return on average assets, return on equity, and net interest margin. The return on average assets ratio discloses the success a lender achieves using assets to generate income. The return on equity ratio measures the amount of income generated compared to the lender’s capital base. The net interest margin ratio is an indicator of loan pricing effectiveness. Another important factor an examiner must consider in evaluating the quantitative results is the SBA Supervised Lender’s capital position and needs. If capital is insufficient to support lender goals and risks, higher earnings would be the likely objective. On the other hand, an ample capital position may allow a lender to become a “best rate” leader in its territory. Quality of Earnings Examiners must also determine the quality of earnings. If an SBA Supervised Lender is getting an impressive return on its new loans, but the loans default, the quality of the earnings from interest earned would not be rated highly. Examiners should also evaluate whether the gains on the sale of loans contribute sufficient returns. It is also important to remember that SBA Supervised Lenders focusing on the sale of loans to fund their operations must be able to continue to make loans to sell. Will the market support this effort? Some SBA Supervised Lenders pay dividends to stockholders. Others pay distributions to their parent, while others pay interest and principle on subordinate notes. Are the earnings of the SBA Supervised Lenders sufficient in quantity and quality to meet the obligations? Stability of Earnings Each SBA Supervised Lender will adopt a product pricing policy that will ensure the consistent pricing of loans. Of course, any pricing strategy must consider the cost of funds available for lending. Adherence to the pricing strategy must be evaluated. Furthermore, history has shown that many lenders are disinclined to raise rates after a certain level on adjustable rate loans in a rising rate environment. Some stop when it appears that any further increase will threaten the borrower’s repayment capacity. Regardless of the reason, earnings will be under pressure if interest rates are rising and adjustable rate loans are capped or if a decision is made to cap them or to delay corresponding changes in rates charged. On the other hand, simply passing on the interest rate risk to the borrowers may effect earnings quality, since the increases could, in fact, result in borrowers’ default due to incapacity. The SBA Supervised Lenders ability to modify the interest rate terms depends on the financing source. Those SBA Supervised Lenders using the Secondary Market to finance the guaranteed portion will have limited ability to make changes to increase or decrease the interest rate or to control the timing of the change. There are other stability issues that must be evaluated. Are the interest bearing liabilities of the same duration as the interest bearing assets? If there is a disparity, the SBA Supervised Lender may have to take action to ensure a constant margin between the interest earned and the interest paid. Since the SBA Supervised Lenders have very limited, yet reliable, sources of funds, this should not be a difficult effort. Given the way SBA Supervised Lenders are funded, there should be no loan prepayment risk, nor should there be any significant mismatches in the duration of assets and liabilities. Many of the SBA Supervised Lenders securitize their loans or sell participations and retain the servicing responsibilities. The fees generated for servicing loans sold may be significant to the earnings of the SBA Supervised Lenders. Examiners should review the trend of such earnings to ensure earned fees are in accordance with any planned amounts. The examiner evaluating Loan Portfolio Management will be evaluating the quality of servicing. If buyers become dissatisfied, earnings may be threatened. Asset quality could certainly have an impact on the stability of earnings. For example, many loans placed on non-accrual will have a negative impact on earnings. This may even effect prior periods if interest accrued has to be backed out. SFAS 114 and SFAS 118 will also impact earnings if an SBA Supervised Lender chooses to declare any loans impaired. Any unexpected provisions to the allowance for loan losses would certainly impact the profit picture. Allowance reversals would have a positive effect, but the examiner of that area must ensure such an action is justified. Accordingly, a constant dialogue with the examiner(s) reviewing the loan portfolio and the allowance for loan losses would be prudent. c. Examination ObjectivesThe objectives of the Earnings component section are:
d. Examination ProceduresThe following are suggested procedures for examining earnings, given that the earnings evaluation can begin during the pre-examination phase. Consistent with risk-based principles, examiners may modify these procedures as the circumstances of the SBA Supervised Lender dictate.
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