The Watch List Report is a detailed loan report that represents the bank’s internal grading or assessment of quality of its loan portfolio. It is probably the most important credit quality report generated by a bank.

The loans included on the Watch List represent above normal credit risk and require close supervision by the bank. The Watch List is invaluable in determining the adequacy of a bank's capital and its allowance for loan and lease losses.

It is important to remember that the internal rating system used by your bank to generate the Watch List should be reconcilable to the loan grading system used by bank examiners. While both listings should correspond to one another, it is likely that the bank’s list will be more inclusive than the one independently generated by examiners. This is because the bank may have more extensive criteria for placing a loan on the Watch List than examiners have for classifying a loan. What do you know about your bank’s loan grading system? Review the Try This at Your Bank exercise for more information.

Despite any differences, the asset quality information generated by a bank’s regulator can provide a useful check on the adequacy of a bank’s loan grading system. If the bank’s Watch List does not correspond closely with the classified assets developed by examiners, management must be able to reconcile the differences. As a director you may want to ask management the basis for differences especially if examiners identify asset problems not detected by management. In such cases, it may be indicative of management inability to identify problem assets, their choosing to ignore asset problems and/or not being sufficiently knowledgeable about customers and their current circumstances to foresee problems. None of these possibilities reflect well on management.

Watch List information is used to calculate two important asset quality benchmark ratios, the total classification ratio and the weighted classification ratio. Together, these ratios show the ability of bank capital and the allowance for loan and lease losses to absorb problem loans.

Federal Reserve Bank examiners use these two ratios as part of their assessment of your bank’s asset quality. (It is important to note that examiners look at more than asset quality during their review of a bank’s lending function. They also evaluate the bank’s ability to assess, monitor and control credit risk. Thus, their findings present an all-encompassing view of a bank’s lending function.)

The total classification ratio is the ratio of a bank’s classified assets to its Tier 1 capital plus reserves. Values for this ratio above 40 to 50 percent often represent less than satisfactory asset quality.

Another useful ratio is the weighted classification ratio, an asset quality measure used only by the Federal Reserve System. The numerator for this ratio is the bank’s classified assets, weighted by the severity of their classification. The weights used are 20 percent for loans classified substandard, 50 percent for loans classified doubtful and 100 percent for loans classified loss. Weighted classification ratio values above 15 percent often represent unsatisfactory asset quality.

Review your Meeting Materials lesson for more information about Asset Quality Assessments