LENDER POLICY DEVELOPMENT BEST PRACTICES

Ten Best Practices for Reducing Your Risk Exposure

“What are other institutions of our asset size doing in their environmental policies?

“Is our policy too stringent or not stringent enough?

“Will ours stand up to a visit by an examiner?

“What are other banks using as thresholds for requiring a Phase I environmental site assessment?

In today’s environment of intense scrutiny from regulators on risk management, environmental policies are in the spotlight. Virtually no bank was immune to some sort of regulatory examination in past few years, and environmental risk management was a component of more than half of them. So it should come as no surprise that EDR frequently receives questions from risk managers at financial institutions asking for industry benchmarks in environmental policy development.  Although the sophistication of environmental policies correlates closely with bank size, there are practices that have been embraced by large institutions and regional/community banks alike as more properties being filtered through lens of environmental risk.

Below is our list of ten best practices that institutions have incorporated into their policies to demonstrate proactive risk management and ensure that exposure to risk in commercial property lending is minimized. Every bank policy is obviously unique and should reflect the institution’s own risk tolerance, but these ten best practices are some of the most common elements of environmental risk management policies today.

1.    The 3 R’s: Review. Revise. Relay.
Regulations, industry practices and guidance documents for environmental risk management change all the time. Incorporate a process for reviewing your policy on an annual basis, make any necessary revisions and relay these changes throughout your institution to ensure that they are followed

2.    Eyes Wide Open.
FDIC. OCC. SBA. ASTM. EPA. The regulations, policies and guidance that govern lenders’ risk management practices in real estate lending are changing all the time, but not so fast that risk managers can’t keep up. ASTM is about to adopt a new version of its Standard Practice for Phase I environmental site assessments (E 1527-13). The OCC just adopted new guidance for the first time in 18 years. Policies should assign responsibility for tracking relevant policy changes to ensure that requirements are timely and reflect current practices and guidance.

3.    Use Outside Experts.
The larger the institution, the more likely it is that they have internal resources to manage environmental risk. At smaller community banks, it is much less likely that there’s anyone on staff with specialized environmental expertise. For institutions that look outside for environmental professionals, it is critical that policies define specific education and experience requirements to ensure that those making environmental risk assessments have the appropriate qualifications for doing so. The definition of EP in the U.S. EPA’s All Appropriate Inquiries rule (and the ASTM E 1527-05 and -13 standards) is the most commonly used benchmark for determining whether a consultant is qualified.

4.    One Size Does Not Fit All.
A new loan.  A property purchase by the bank. A foreclosure. A loan extension or refi. A strip mall in a suburb. An office building in an urban environment. A condo on a former mill. Institutions conduct environmental due diligence for all kinds of reasons on all types of properties in all types of areas. The associated risk of each situation can vary considerably—and so too should the robustness of the environmental investigation. This is why thousands of lender policies now contain decision matrices that dictate the type of due diligence required for different situations, ranging from a questionnaire to the SBA’s Records Search with Risk Assessment to a Phase I ESA and even a Phase II ESA for high-risk properties (e.g., gas stations, dry cleaners, etc.). The latest OCC guidance recommends a tiered approach. The SBA’s decision tree under SOP 50 10 5(e) guidance has been adopted by many institutions were comfortable enough to rely on it for non-SBA lending as well.

5.    No Loan Is Immune From Environmental Issues.
In the early days of awareness about environmental risk, environmental due diligence was only conducted on loans above a certain threshold: All loans above $1 million or $5 million required a Phase I ESA. Today, more property loans than ever are being scrutinized for environmental risk and it is more common that a property’s past use dictates the level of investigation required than just loan size. The FDIC prescribes an initial risk analysis” for all loans. The OCC just updated its guidance to require environmental risk management policies to include “a level of due diligence internally required in all real estate loan transactions.” In response, it is more common for policies to require some level of environmental scrutiny (e.g., questionnaire, desktop screen, etc.) even on smaller loans or loans with a perceived low-risk. Then if a “red flag” is raised, a decision can be made to proceed to a more advanced level of investigation (e.g., Phase I ESA or Phase II ESA).

6.    Incorporate EPA’s AAI Rule.
Back in 2005, the U.S. EPA issued the first federal rule dictating how a property purchaser could satisfy the requirements for conducting All Appropriate Inquiries necessary for qualifying for CERCLA liability protection. The latest FDIC and OCC guidance recommend that institutions include an AAI-compliant Phase I ESA requirement in their policies, and many lenders now require borrowers to comply with the AAI standard as part of the loan approval process. In addition, many government lending programs such as Fannie Mae, Freddie Mac, FHA, and the SBA all require AAI-compliant Phase I ESA reports. In instances when the institution is taking title to a property (e.g., foreclosure, property purchase, etc.), many policies require the bank to follow the AAI rule.

7.    Things Change. Monitor Properties Over Time.

A once-clean property can become contaminated. Leasing changes or operations on adjacent properties can impact the properties being used as collateral for an institution’s loans. There is much more awareness today of the impact on property value associated with contamination, and monitoring loans for changes in environmental status over time is easier than ever before. Federal regulators are encouraging lenders to include in their policies requirements for “monitoring potential environmental concerns for the duration of loans held in the bank’s loan portfolio. These guidelines should focus on changes in business activities that might result in an increased risk of environmental contamination associated with the property, thus adversely affecting the value of collateral (OCC handbook-August 2013).” Back in 2011, roughly one-third of policies included provisions for property monitoring. Today, that percentage has grown significantly as banks respond to new requirements that emphasize tracking changes in environmental profiles of the loans in their portfolios over time.

8.    Document. Document. Document.
Examiners visiting institutions are asking for proof that banks are exercising proper oversight over its environmental risk management practices. It is not enough to have a policy on the books. Risk managers are being called upon to show documentation and processes to ensure that policies are being followed, that the appropriate protocols are being followed, that environmental reports are being reviewed and records are being maintained to show consistent application of policy across the institution.

9.     The ABCs and 123s of Environmental Risk Management.
A policy is only as good as its execution so it is critical for institution to include requirements for ongoing training on environmental risk and proper due diligence protocols. Smaller banks routinely have environmental consultants provide this type of training. For a policy to be adequate for protecting the bank from risk, it is critical that loan officers, credit officers, senior bank staff and other stakeholders understand how environmental risk ties in with the overall lending process and how “red flags” will be treated during underwriting.

Training

10.    Pay attention to vapor-related risk.
Environmental due diligence traditionally focused on the risks associated with soil and groundwater contamination. Over the past several years, attention on the risks posed by vapor intrusion has grown considerably and with it, lender policy requirements to manage vapor risk. In 2008, just under 20 percent of institutions had policies that addressed vapor risk. By 2011, that percentage doubled and today, it’s higher still. There are a number of recent developments bringing vapor risk front and center: the U.S. EPA is updating its federal VI guidance for the first time in more than a decade, ASTM has added language to the E 1527-13 standard to clarify that vapor migration should be considered no differently than contaminated groundwater migration. The collective impact of these developments is a growing awareness of the risk posed by contaminated vapors and hence more of an emphasis on assessing vapor risk in bank policies. Some financial institutions require vapor screens on all Phase I ESAs, while others do so only on a case-by-case basis and others require vapor screens only when the bank is taking title to the policy.

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The real estate downturn has highlighted the need for financial institutions to strengthen their environmental due diligence—particularly at the community bank level—where there was low-level environmental due diligence (or nothing) being done before. As a result, lenders are: doing more different types of due diligence, relying on outside expertise, and screening more properties for environmental risk.