Operational Risk
Given the current credit environment there can be no margin for error in evaluating loan quality, the proper perfecting of a security interest or accessing of secured collateral in the event of a default.

Many institutions have become increasingly dependent on highly complex, untested financial instruments as they seek alternative sources of revenue. This path led banks to enter new businesses, new markets or introduce new services within existing lines of business in an attempt to drive significantly higher levels of activity and more complex financial products through increasingly sophisticated analytical systems.

In the face of this innovation, the exposure to operational risk has escalated substantially and has made many institutions more vulnerable to losses from “failed or inadequate internal processes, people and systems,” according to the Basel Committee on Banking Supervision, Consultative Document on Operational Risk.

From the perspective of risk managers, bank credit officers, shareholders and investors, the consequences of such failures are severe. Insured collateral protection represents an ideal risk mitigation tool by transferring operational risk exposures for commercial loan transactions from the lender to an insured product. An insured collateral position permits a bank’s credit and risk management officers to shift the risks of loss due to documentation defects, lien attachment, perfection and priority.

Regulatory Considerations
A brief review of the seriousness of bank capital requirements is helpful, and underscores that both regulators and banks need to be extremely sensitive to asset and collateral values in a highly unstable economic environment. As commercial loan quality deteriorates, and reliance collateral becomes increasingly important to banks, it raises the question, are uninsured capital and reserve requirements from past “normal” credit markets adequate to protect banks in “abnormal” market conditions?

Tier 1 Capital
Tier 1 is the bank's core equity capital (Book value of bank's stock —common plus preferred that is irredeemable/non-cumulative —plus retained earnings) ... it is the bank’s net worth —the difference between assets and liabilities, related to its risk-weighted assets. Under Basel l, the highest risk weight is for Commercial & Industrial, CRE credits, etc. at 1.0. The minimum Tier 1 ratio must be 4% of risk-weighted assets.

Tier 2 Capital
Tier 2 includes Tier 1 capital plus subordinated debt, provisions for loss and revaluation reserves. The minimum for the combined Tier 1 and Tier 2 total capital ratio must be 8% of risk-weighted assets.

Basel I
Basel I is the current system of bank capital standards adopted in 1988 that resulted in higher capital requirements internationally and introduced the link between a bank's capital and the bank's risk-taking appetite. It established risk weights with different assets (i.e., grouping assets according to perceived credit risks —the greater the asset risk weighting, the higher the capital required). For example, cash is considered risk-free and has a capital requirement of zero. It had various limitations. For example, it was not sensitive to changes in the economy and required banks to hold the same amount of capital in good times and in bad.

Basel II
Basel II was proposed to remedy deficiencies within the Basel I accord. For example, Basel I viewed all C&I loans as of the same quality and assigned a uniform risk weight of 1.0; it did not take into account the specific risk profile of the bank's C&I portfolio, deterioration in asset quality, risks of off-balance sheet transactions, or fee-based activities or actions taken to mitigate the risks. Basel II builds on risk management and risk measurement practices of each individual bank and links risk taking to capital adequacy.

Basel 1A
Only the largest banks were to be required to adopt the Basel II framework. Basel 1A was proposed by the U.S. regulatory authorities for most banks other than the largest banking organizations that have less sophisticated portfolios and less complex activities. The Fed issued the proposed Basel IA capital requirements for those institutions that are not subject to Basel II. Similar to Basel II, it is intended to be more risk sensitive than Basel I but it is less complex than Basel II. Major provisions include the "broader use of external credit ratings," an increase in the number of "risk-weight categories," an expanded "range of collateral and guarantors that may qualify an exposure for lower risk weights" and the elimination of the "50% limit on the risk weight that applies to certain derivatives.”

Given the significant deterioration in the health and stability of the banking industry and many corporate borrowers, increasing default rates and the rising insolvency of commercial borrowers will place substantial new pressure on the availability of properly perfected reliance collateral, which, notwithstanding the asset value, will be crucial in maximizing bank recoveries. Banks will require a renewed vigor and discipline in implementing underwriting measures to ensure that the bank’s collateral position is protected. This will take qualified “boots on the ground,” not complicated analytical programs.

The Case for Managing Risk
In today’s complex and threatening economic environment, evidenced by the well-known and documented meltdown of subprime-related credit quality and liquidity issues, hazards to a bank’s capital have been substantially elevated by the spreading of the recession to other loan segments.

Public policy makers should ask regulators: “What bubble is next for the nation’s economy?” Regulators and bank examiners may very well ask the same question of their banks. The failure to apply traditional real estate secured loan origination underwriting and risk management practices for commercial loans secured with personal property collateral is an outdated and unnecessary practice of holding too much risk.

Most lenders can and do reduce their risks in such transactions by developing and implementing formal internal lending policies that govern the size and type of loans, and the various classes of acceptable collateral to help ensure that loans are made with uniform rigor, based on objective criteria. Stringent loan review procedures that ensure the bank and its employees are in compliance with internal policies and control systems further reduce risk of errors and omissions. Recent history aside, most institutions strive to regularly examine existing economic and regulatory conditions to ensure that emerging risks are identified.

Lenders can also shift risk by engaging third parties. Traditionally, such third parties often include attorneys, who issue legal opinions on matters regarding borrower authority, attachment and ownership. On behalf of the borrower they also opine whether the security agreements are adequate, and whether perfection has been accomplished. Oftentimes the opinions are costly and highly conditioned with exceptions, exclusions and characterizations. They represent risk to the lawyer and his/her law firm, and generally add little to the quality or credit worthiness of the proposed transaction.

Lawyers should focus on negotiating and structuring transactions on behalf of their borrower clients, with risk shifted to a qualified and regulated third party to ensure and “insure” that all necessary and appropriate searches have been performed for the appropriate debtor(s) in the appropriate jurisdictions. The qualified and regulated third party, by definition, would insure that all crucial elements of a loan transaction, including the documents, searches and filings, provide for a policy that insures the lender’s security interest for validity, enforceability, attachment, perfection and priority. None of these issues are insured by a lawyer representing a borrower. Such risk to the nation’s banks, and by extension the taxpayers, is unnecessary, unacceptable and fully avoidable.

The Case for Shifting Risk
There is another path: UCC insurance. Recently introduced as a risk management tool for secured lenders, UCC insurance functions in much the same way that title insurance does in real estate transactions. For a reasonable one-time premium, a qualified and regulated insurance company steps in to indemnify lenders against the many common defects and errors that can occur when attempting to perfect a security interest and achieve first priority in personal property.

Just as title insurance replaced attorney opinions as the standard in real estate transactions, UCC should become the standard for commercial loans secured by Article 8 and Article 9 collateral. For example, the debt-rating service Moody’s recently began recommending the use of UCC insurance for Article 8 secured mezzanine finance transactions.

Major market commercial loan transactions have historically relied on legal opinions. Here are the advantages of UCC insurance over the traditional legal opinion:

1. Supported by published independent financial strength ratings and claims reserves;

2. Protections as to legal costs to defend a challenge to a lender’s security interest;

3. National coverage for multiple jurisdictions;

4. Indemnification as to loss occurring due to improper attachment, perfection and priority;

5. Coverage as to lender priority, including the “gap period;”

6. Coverage as to UCC search report inaccuracies, errors and omissions and financing statement inaccuracies;

7. Coverage against documentation defects;

8. Protection against fraud and forgery;

9. Coverage as to authenticity and authority of document signatories;

10. Protection as to proper attachment, perfection and priority;

11. Protection for life of loan benefiting original lender and successors-in-interest.

UCC insurance, available from the nation’s leading title insurance companies, insures the lender’s security interest for validity, enforceability, attachment, perfection and priority. Such insurance protecting the lender’s reliance collateral is crucial, particularly in an unstable economic environment subject to increasing defaults, bankruptcy filings and related challenges to the bank’s lien priority.

UCC insurance delivers an effective private-sector backstop that shifts risk and transfers it to a well-capitalized insurance company, helping in part to thaw frozen commercial credit markets and protect taxpayers from the potential of yet another government-funded intervention to protect or restore capital and solvency in the nation’s banks.

Next Steps —Recommendations
While the overall economy may be showing some signs of stabilization, absent a significant improvement in broad economic indicators, a robust recovery is not on the immediate horizon, and even a moderate recovery appears fragile. Despite positive signs of the housing market stabilizing, the percentage of defaults for commercial and industrial loans is soaring.

Regulators, bank examiners and rating agencies need to anticipate the next loan segment likely to experience the bursting of the bubble. Numerous recent court cases, suggest that collateral securing loans subject to the trend of defaults may be compromised by documentation defects, which leads to a bank’s loss of collateral in the event of third party challenge, foreclosure or liquidation. Reduced recoveries lead to an erosion of bank capital, liquidity and shareholder value

As citizen groups, shareholders, regulators, examiners, equity investors, rating agencies and public policy makers begin to examine the policies and processes that underpin the commercial loan industry in this unsteady economic environment, it is important to examine and update internal systems, test processes and personnel, and ensure all available risk management tools are being employed in the commercial loan underwriting and documentation process.

Regulatory officials should expect their member banks to utilize third-party service providers, including UCC insurers, whose primary function is to minimize and shift risk for the benefit of secured lenders. Commercial lenders, regulators, rating agencies, equity investors, shareholders, bondholders, government lending functions and government loan guarantors should incorporate this relatively new product into the commercial loan industry’s best practices, standards and procedures. The safety and soundness of the commercial lending process, and the associated health of the U.S. economy as a whole, would benefit substantially from this effective, low-cost, private- sector insurance protection.

In recent years, UCC insurance has often reduced loan origination costs, increased lender and investor transaction protections, eliminated UCC-related documentation defects and filing errors, and shifted risk from outside counsel with regard to the legal opinion. It has further served to enhance the strength and value of loans and loan portfolios securitized or otherwise sold into the secondary market.

Perhaps most crucial in today’s unstable economic environment is that UCC insurance allows lenders to improve internal credit quality, which supports appropriate levels of loan-loss reserves, consistent with best practices in today’s economic environment. Today’s market is substantially different from the environment in which many capital and reserve requirements were established. UCC insurance contributes to the demands of today’s credit quality requirements as it relates to properly risk-rated regulatory capital requirements.

Summation
The next economic bubble facing the nation’s fragile economy is anticipated by many to be the commercial loan market, evidenced by significant increases in delinquencies, defaults, charge-offs and losses, which serve to deplete bank capital. This depletion of bank capital may expose lenders, investors, shareholders, bondholders, government lending functions, government guarantors, government insurance agencies and taxpayers to significant liability. Simply put, UCC insurance can mitigate much of the pressure on lending institutions by protecting lien perfection and priority on reliance collateral, with the goal to maximize recoveries in the event of a third-party challenge, foreclosure or liquidation.

UCC insurance should be considered as an important “best practices” risk management tool for commercial loans. This is an effective and low-cost tool that should be utilized to identify measure and manage commercial loan-related risk.

Bank examiners should be familiar with this private-sector program, and should evaluate the benefits for adoption by all banks, including, in particular, those banks that are the beneficiary of direct government lending, government guarantees and taxpayer subsidy.

Theodore H. Sprink is senior vice president and director of Business Development of Fidelity National Financial, Inc.’s UCC Risk Management Program. He can be reached by e-mail at: tsprink@fnf.com.

Fidelity National Financial is a provider of real estate loan origination, closing and insurance services, operating through the Alamo Title, Chicago Title, Commonwealth Title, Fidelity National Title, Lawyer’s Title, Security Union and Ticor Title insurance brands. Fidelity National has an investment portfolio of approximately $5.5 billion and reserves for claims losses that exceeds $2.3 billion.

Theodore H. Sprink is senior vice president and director of Business Development of Fidelity National Financial, Inc.’s UCC Risk Management Program. He can be reached by e-mail at: tsprink@fnf.com.

Fidelity National Financial is the nation’s largest provider of real estate loan origination, closing and insurance services, operating through the Alamo Title, Chicago Title, Commonwealth Title, Fidelity National Title, Lawyer’s Title, Security Union and Ticor Title insurance brands. Fidelity National has an investment portfolio of approximately $5.5 billion and reserves for claims losses that exceeds $2.3 billion.