What Are Underwriting Standards?
Underwriting standards are guidelines established to ensure that safe and secure loans are issued and maintained. The underwriting standards in place help to set benchmarks for how much debt may be issued to a person, the terms of the loans, how much debt a specific company is willing to issue, and what interest rates will be charged.
- Underwriting standards are guidelines set by banks and lending institutions for determining whether a borrower is worthy of credit (i.e. a loan).
- Underwriting standards help set how much debt should be issued, terms, and interest rates.
- These standards help protect banks against excessive risk and losses.
- The Federal Deposit Insurance Corporation (FDIC) has previously published recommendations for underwriting standards, which included looking at credit history and assessing income sources.
How Underwriting Standards Work
Sound underwriting standards protect financial institutions from excessive risks that can lead to losses. History indicates that lending and underwriting standards are generally pro-cyclical. As competitive pressures increase for loan growth, banks may be enticed to ease underwriting standards to expand the loan portfolio in order to generate earnings. As conditions begin to deteriorate, this easing of underwriting standards, if carried too far, causes banks to face an increased risk that is followed by rising losses and an eventual tightening of underwriting standards.
For example, during the financial crisis of 2008-2009, some lenders reduced prepayment fees and offered heightened flexibility regarding the terms of the loans issued. At the same time, during that same crisis, many companies also tightened underwriting standards that had been one of the culprits in the downturn.
Requirements for Underwriting Standards
The choice to modify a financial institution's lending terms and underwriting standards usually result from the board and senior management decisions. Alternatively, subtle de facto revisions in policies can result from how standards and procedures are applied in practice. In both instances, appropriate risk management steps must be taken to ensure risks are properly identified, monitored and controlled, and that loan pricing, terms or other safeguards against nonperformance are appropriate for the risks being taken.
A 1998 study of lending practices outlined six core lending terms and underwriting standards for maintaining strong credit discipline and assuring smart credit decisions. Those standards include:
- Formal credit policies should communicate a bank’s risk appetite while providing specific guidance and measurement standards along with a consistent process for approving and monitoring exceptions.
- Formal credit approval processes should be independent of line lending functions.
- Standardized loan approval documents should be used that promote consistent financial analysis, collateral valuation, guarantor support, and covenant provisions.
- Use forward-looking tools to assess projections and various scenarios that focus on key determinants of performance.
- Use risk rating systems that accurately assess quantitative and qualitative considerations to evaluate credit risk at inception and during the life of the loan.
- Ensure management and lender information systems support the approval process and ongoing monitoring of portfolio composition and risk positions.
Example of Underwriting Standards
The Federal Deposit Insurance Corporation (FDIC) has its own recommended guidelines for underwriting standards for credit cards. Per the FDIC, underwriting standards help ensure credit cards offered to customers meet an acceptable level of risk. Some of the key underwriting standards that the FDIC recommend for credit cards include:
- Assessment of the applicant’s repayment willingness and capacity.
- Credit history and performance on past and existing obligations.
- Income assessments, such as self employment income, investment income, etc.
- Consideration of the borrower’s aggregate credit relationship with the bank.