To the Chief Executive Officers of All State Member Banks, Bank Holding Companies, Edge and Agreement Corporations, and State-Licensed Branches and Agencies of Foreign Banks, in the Second Federal Reserve District:

The following is from a statement by the Board of Governors of the Federal Reserve System:

The Federal Reserve has issued examination guidance cautioning against possible relaxation of credit discipline at banks. Although at this time loan portfolios remain sound overall, indications of departures from proven sound lending practices - in particular, over-reliance on optimistic views of the borrowers' prospects and favorable economic and financial conditions - have been a recurring theme emerging from recent supervisory reviews of bank credit quality.

At the same time, over the past several quarters the volume of weak or potentially weak loans - that is, those falling into the classified or special mention categories used by supervisors - has risen at some institutions. Although the increases are generally attributable to industry-specific or global economic developments, these increases are significant because they have appeared despite the continued favorable economic and financial climate in the United States.

Supervisory reviews indicate that the vulnerability of these loans was heightened in some cases by weak underwriting practices. The guidance, contained in a supervisory letter sent to Federal Reserve bank examiners and supervisors as well as banking organizations supervised by the Federal Reserve, describes three key areas in which some banks may have strayed from historically sound lending practice:

Approving loans based on a very optimistic assessment of a borrower's operating prospects or on the assumption a borrower will always have ready access to financial markets.

Failing to perform meaningful stress tests - or, if performed, to take such tests adequately into account - of a borrower's ability to withstand events such as unexpected shocks to operating revenue.

Weakening internal controls critical to maintaining the rigor and discipline of lending decisions.

"While loan portfolios are currently sound at the vast majority of banks, any trends toward laxity need to be reversed where they exist to ensure that the banking system remains strong and vibrant and retains the ability to lend to sound borrowers in good times and bad," wrote Richard Spillenkothen, director of the Board's Division of Banking Supervision and Regulation.

The guidance instructs Federal Reserve examiners and supervisors to be alert for indications that undue reliance on favorable assumptions about borrowers or the economy and financial markets more generally has led banks to reduce the rigor of their credit decisions or delay recognition of emerging loan weakness. If examiners observe such undue reliance, delays in recognition of problem loans or significant weakening of internal risk management processes, they should carefully consider whether these developments warrant a downgrade in one or more elements of the bank's overall supervisory rating for safety and soundness.

Supervisory letters are the Federal Reserve's primary means of communicating key policy directives to its examiners, supervisory staff, and the banking industry.

The supervisory letter is available at the Board's web site. Questions on this matter may be directed, at this Bank, to any member of the team responsible for supervising your institution.