Underwriting Standards: Meaning, Overview, Example

What Are Underwriting Standards?

Underwriting standards are guidelines established to ensure safe and secure loans.

These standards set benchmarks for debt issuance, loan terms, company debt limits, and interest rates.

Key Takeaways

• Underwriting standards guide banks and lenders in determining creditworthiness.
• These standards protect against excessive risk and losses.
• The Federal Deposit Insurance Corporation (FDIC) provides recommendations for underwriting standards, including assessing credit history and income sources.

How Underwriting Standards Work

Sound underwriting standards protect financial institutions from risks and losses. In times of economic growth, banks may relax these standards to expand their loan portfolios and generate earnings. However, as conditions deteriorate, the relaxed standards can increase risk, leading to losses and eventually tighter underwriting standards.

During the 2008-2009 financial crisis, some lenders reduced prepayment fees and offered flexible loan terms. However, many companies tightened their underwriting standards during the crisis.

Requirements for Underwriting Standards

Modifying a financial institution’s lending terms and underwriting standards require board and senior management decisions. Risk management steps must be taken to identify, monitor, and control risks, ensuring appropriate loan pricing and safeguards against nonperformance.

A Federal Reserve study outlined six core lending terms and underwriting standards to maintain strong credit discipline and make smart credit decisions:

1. Credit policies should communicate risk appetite and provide specific guidance and measurement standards with a consistent process for approval and monitoring exceptions.
2. Credit approval processes should be independent of line lending functions.
3. Standardized loan approval documents should promote consistent financial analysis, collateral valuation, guarantor support, and covenant provisions.
4. Forward-looking tools should assess projections and key determinants of performance.
5. Risk rating systems should evaluate credit risk at inception and during the loan’s life.
6. Management and lender information systems should support the approval process and ongoing monitoring of portfolio composition and risk positions.

Example of Underwriting Standards

The FDIC provides recommended underwriting standards for credit cards to ensure an acceptable level of risk.

Some key underwriting standards for credit cards include:

• Assessing the applicant’s repayment willingness and capacity.
• Evaluating credit history and performance on past and existing obligations.
• Considering income sources, such as self-employment and investment income.
• Reviewing the borrower’s overall credit relationship with the bank.