The Gap in the Three Lines of Credit Risk Management Defense

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I started my banking career in the credit management training program of a regional bank, where I later became the head of corporate banking. Subsequently, I became a chief credit officer and, ultimately, the CEO and board chairman of a community bank. This experience, coupled with 30 years of providing credit risk management services for banks from de novos to one of the 10 largest financial institutions in the world, has allowed me to see many changes in the way banks’ credit risk management (CRM) identifies, measures, monitors, controls and reports credit risk. There have been some very good improvements — along with some activities that miss the mark on best practices.

Strategy without execution is ineffective at best. Whether it is football or banking, execution is the key to success. Execution of strategy for CRM’s three lines of defense requires that each line must perform its job and communicate with the other two lines for the “team” to win.

What I have observed for many years now is that the members of the first line — like client-facing loan officers and relationship and portfolio managers — are often too focused on production and minimize their role as the first line of defense as it relates to credit risk issues and red flags. Communication with borrowers is often lacking or reactive, and isn’t documented, except in a sales capacity. This became more apparent during the early stages of the Covid-19 pandemic, when banks critically needed more information on their borrowers and the first line was often unprepared.

How can the second line of credit risk management defense — like credit officers, credit departments and loan approvers — do their job properly without up-to-date information? How can the third line — loan review, internal audit and compliance — do their job without up-to-date information? Quite simply, they can’t. If the key link in the chain does not perform to best practices, the chain breaks.

I once made a presentation to a bank board and a director took issue with my mentioning that the bank was not receiving borrower financial statements promptly and analyzing them. He told me that the bank was doing great, with no delinquencies or charge offs, and that getting financial statements was merely paperwork without any value. What he did not understand, of course, was that delinquencies and charge-offs were lagging indicators; the financial statements — or lack thereof — were leading indicators. This principle remains true today: Banks have better results in problem loan situations when they can detect problems early and deal with them before it is too late to effectively negotiate with the borrower.

For the safety and soundness of a bank’s asset quality, and the protection of all constituencies, better monitoring of borrowing relationships and their risk profiles by the first line makes all three lines more effective. This ultimately improves a bank’s portfolio performance, profitability and asset quality and can be accomplished without harming production, since additional borrower contact can also present new opportunities for sales. Bank management can promote this mindset with more focus on matching job descriptions and performance reviews to incentive compensation, with a significant component tied to continuous monitoring of borrowers. The now-frequently unused practice of a regular customer calling program, with documented call reports on substantive credit issues, could substantially improve the first line’s performance.

Now is the time for banks to act. The board and management team must emphasize and focus on this priority to all three lines, rather than waiting for the shoe to drop. Many borrowers may be under their institution’s radar, due to deferrals and Paycheck Protection Program loans masking their true operational and financial position. Every bank’s portfolio contains borrowers at risk as the economy continues reflecting the challenges of the past several years and deferrals expire. The first line can mitigate the potential damage through more intensive customer contact to detect issues of concern.

When it Comes to Loan Quality, Who Knows?

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Seven months into the Covid-19 pandemic, which has flipped the U.S. economy into a deep recession, it’s still difficult to make an accurate assessment of the banking industry’s loan quality.

When states locked down their economies and imposed shelter-in-place restrictions last spring, the impact on a wide range of companies and businesses was both immediate and profound. Federal bank regulators encouraged banks to offer troubled borrowers temporary loan forbearance deferring payments for 90 days or more.

The water was further muddied by passage of the $2.2 trillion CARES Act, which included the Paycheck Protection Program – aimed at a broad range of small business borrowers – as well as weekly $600 supplemental unemployment payments, which enabled individuals to continuing making their consumer loan repayments. The stimulus made it hard to discriminate between borrowers capable of weathering the storm on their own and those kept afloat by the federal government.

The CARES Act undoubtedly kept the recession from being even worse, but most of its benefits have expired, including the PPP and supplemental unemployment payments. Neither Congress nor President Donald Trump’s administration have been able to agree on another aid package, despite statements by Federal Reserve Chairman Jerome Powell and many economists that the economy will suffer even more damage without additional relief. And with the presidential election just two months away, it may be expecting too much for such a contentious issue to be resolved by then.

“We expect charge-offs to increase rapidly as borrowers leave forbearance and government stimulus programs [end],” says Andrea Usai, associate managing director at Moody’s Investors Service and co-author of the recent report, “High Volume of Payment Deferrals Clouds a True Assessment of Credit Quality.”

Usai reasons that if there’s not a CARES Act II in the offing, banks will become more selective in granting loan forbearance to their business borrowers. Initially, banks were strongly encouraged by their regulators to offer these temporary accommodations to soften the blow to the economy. “And the impression that we have is that the lenders were quite generous in granting some short-term relief because of the very, very acute challenges that households and other borrowers were facing,” Usai says.

But without another fiscal relief package to help keep some of these businesses from failing, banks may start cutting their losses. That doesn’t necessarily mean the end of loan forbearance. “They will continue to do that, but will be a little more careful about which clients they are going to further grant this type of concessions to,” he says.

For analysts like Usai, getting a true fix on a bank’s asset quality is complicated by the differences in disclosure and forbearance activity from one institution to another.  “Disclosure varies widely, further limiting direct comparisons of practices and risk,” the report explains. “Disclosure of consumer forbearance levels was more comprehensive than that of commercial forbearance levels, but some banks reported by number of accounts and others by balance. Also, some lenders reported cumulative levels versus the current level as of the end of the quarter.”

Usai cites Ally Financial, which reported that 21% of its auto loans were in forbearance in the second quarter, compared to 12.7% for PNC Financial Services Group and 10% for Wells Fargo & Co. Usai says that Ally was very proactive in reaching out to its borrowers and offering them forbearance, which could partially explain its higher percentage.

“The difference could reflect a different credit quality of the loan book,” he says. “But also, this approach might have helped them materially increase the percentage of loans in forbearance.” Without being able to compare how aggressively the other banks offered their borrowers loan forbearance, it’s impossible to know whether you’re comparing apples to apples — or apples to oranges.

If loan charge-offs do begin to rise in the third and fourth quarters of this year, it doesn’t necessarily mean that bank profits will decline as a result. The impact to profitability occurs when a bank establishes a loss reserve. When a charge-off occurs, a debit is made against that reserve.

But a change in accounting for loss reserves has further clouded the asset quality picture for banks. Many larger institutions opted to adopt the new current expected credit losses (CECL) methodology at the beginning of the year. Under the previous approach, banks would establish a reserve after a loan had become non-performing and there was a reasonable expectation that a loss would occur. Under CECL, banks must establish a reserve when a loan is first made. This forces them to estimate ahead of time the likelihood of a loss based on a reasonable and supportable future forecast and historical data.

Unfortunately, banks that implemented CECL this year made their estimates just when the U.S. economy was experiencing its sharpest decline since the Great Depression and there was little historical data on loan performance to rely upon. “If their assumptions about the future are much more pessimistic then they were in the previous quarter, you might have additional [loan loss] provisions being taken,” Usai says.

And that could mean that bank profitability will take additional hits in coming quarters.

The Measure of a “Good” Deal

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What makes a good bank deal? Depends on who you ask.

Mergers and acquisitions are a vital strategic undertaking for banks, and consolidation trends continue to shape the industry. To that end, I asked four presenters speaking at Bank Director’s 2020 Acquire or Be Acquired Conference the same question: “What is the most important metric of a bank deal? And what is the most important thing that can’t be measured?”

The response of the interviewees — a community bank CEO, two attorneys and an investment banker — were kept secret from each other. Their unique and varied responses belie their perspectives and experiences when it comes to bank M&A, and hopefully can shed some light on how others in the industry think about, and measure, a “good” deal.

Before Announcement
For Curtis Carpenter, principal and head of investment banking at Sheshunoff & Co. Investment Banking, the most important criteria to getting a good deal done comes down to location. “Geography is the most reliable characteristic to getting the deal done in today’s market. Where a bank is located is driving deals more than ever,” he says.

He points out that institutions in high-growth areas have a “high probability” of commanding a strong price, whereas a robust, profitable bank in a rural area with declining demographics may be challenged to get a deal done at a reasonable valuation.

For buyers, coming up with a reasonable purchase price and accurately assessing a seller’s asset quality are the most important elements in a good deal, says Bob Monroe, a partner at Stinson LLP.

“If you buy a bunch of junk, you’re going to get a bunch of junk, and you generally won’t have a successful deal,” he quips.

To account for the uncertain performance of acquired loans, Monroe says buyers will either not acquire certain assets or set up an escrow account that is equal to the present value of the assets in question so they can get worked out.

Frank Sorrentino III, chairman and CEO of ConnectOne Bancorp in Englewood Cliffs, New Jersey, says it was difficult to try to nail down an answer, even though “I knew what the question was going to be.”

Sorrentino has guided the $6.2 billion bank through three deals since 2014, and initially felt that a good deal can be measured by the market’s response. But he says the market might pan some deals that it doesn’t “fully digest or understand” because the deal may not generate immediate value at announcement.

For Sorrentino, good deals are ones that provide better internal opportunities for the pro forma bank and create additional value.

“I don’t care which metric you use, I don’t care what spreadsheet you use for your modeling — at the end of the day, are you creating more value? There are various components to values: some are financial, some are nonfinancial, but I think it really comes down to value,” he says. “Are you adding 1 and 1 and getting something north of 2?”

At, and After, Announcement
During Day 1 of the conference, Keefe, Bruyette & Woods President and CEO Tom Michaud highlighted that the premium that acquirers have offered sellers has declined since 2010. Part of that decline has come from a decline in potential buyers, but he added that investor concern around the pro forma company’s earnings per share and tangible book value growth has imposed discipline on deals.

One metric that Carpenter says can indicate a good deal is the performance of the buyer’s stock after the merger is announced, relative to the valuation the seller received.

“The most measurable tangible metric for grading the success of a bank sale would be price to tangible book value, and then how that stock performs in the 12 months after announcement,” he says. This is especially important for prospective sellers that would consider a merger that includes stock.

Peter Weinstock, a partner at Hunton Andrews Kurth, extends this to the second full year after a merger is consummated. Weinstock wrote in an email that the most important metric is the pro forma bank’s earnings per share accretion in that second year.

“While tangible book value earn-back is much ballyhooed — and has lately been a metric that has led to some good deals not being done — the true success of the deal is measured in what it does for the acquirer’s profitability once the majority of cost savings and synergies are achieved,” he wrote.

Sorrentino cautions that value creation doesn’t always carry a time stamp, and that bankers should resist short-term thinking or relying solely on metrics when assessing the value of a company or a deal.

“Sometimes the value is not necessarily created on financial terms. There could be value created [in a deal] because of talent, or because of the business lines you’re taking on,” Sorrentino says, adding that technological capabilities, efficiencies and cultural elements can also be acquired in a deal. “Everyone wants to look at the EPS accretion at announcement or tangible book value dilution. It may not be that simple.”

After Close
There is some agreement as to the most important unmeasurable aspect of a good deal. The consensus coalesces around integration and the cultural fit of the two banks. Buyers must manage the deal integration in a way that incentivizes and excites the seller’s employees, lest they look for other opportunities.

“Being able to fit your culture in with the seller’s culture is extremely important, because otherwise you’ll have a flat tire running down the road,” Monroe says. “It won’t be smooth.”

Adding to that, Weinstock wrote that the buyer’s “willing[ness] to spend the leadership time, devote the financial resources and risk overcommunicating” in order to integrate the banks’ operations, vision and culture is the most important immeasurable metric of a good deal.

For sellers, the hardest thing for banks to measure in a deal is how it will affect their employees, Carpenter says. Executives at selling banks often hope that a deal only furthers the opportunities and careers of its employees, as well as benefits the selling bank’s community. One way prospective buyers can help sellers with this concern is by putting the prospective seller in touch with former CEOs of previously acquired banks.

“More often than not in this environment, [deals] really come down to one buyer courting a seller, or you’ve reduced the number of bidders down. The seller is wondering ‘Is this a good deal? Can we trust this guy?’” Carpenter says. “The buyer can offer up, ‘Here’s two people that ran banks we bought, call them and asked them how it went.’”

Michaud says banks considering engaging in M&A should “start at the end,” identifying what they want a deal to achieve.

“It needs to be all of these things to work: well-priced, strategic merit and be logical, earn-back that fits within the barrier. It can’t be complex and have a lot of noise, it must be accretive or investors will want to know why you did it, and it needs to be well-structured too so everyone stays in their seat and is there to execute,” he says. “If you do all of these things, you can create a lot of shareholder value.”

Why Growth Matters for CRE Concentration Risk

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Community banks are contending with the increasing risk profile of and regulatory scrutiny around commercial real estate (CRE) concentrations. Indeed, the regulatory community telegraphed in December 2015 their intentions of focusing bank examinations on concentration management, and since then, the FDIC has noted an increase in matters requiring board attention (MRBAs) associated with concentrated loan exposures. Additionally, the Office of the Comptroller of the Currency raised its regulatory stance on CRE lending from “monitoring status” to “an area of additional emphasis.” To explain their renewed attention, the regulators cited intense loan growth, sharp rent-rate and valuation increases, competitive pressures and an easing in underwriting standards eerily similar to the lead-up to the Great Recession—during which many community bank failures were driven by construction & development (C&D) and CRE concentrations.

While there is evidence that this renewed attention has shifted many banks’ CRE underwriting stance to a net tightening position, this has yet to have a material impact on C&D and CRE loan outstandings. A trend analysis across all commercial and savings banks shows intense increases in both C&D and non-C&D regulatory CRE.

Growth Rates By Type of Asset for All Commercial and Savings InstitutionsCRE-loans-small.png

Note the sharp difference between C&D (red) and non-C&D Regulatory CRE (orange): the Great Recession saw a precipitous drop in C&D balances, but multifamily and other property (i.e., non-owner-occupied CRE) increased in total outstandings during and after the Great Recession with growth since the recession of 142.5 percent and 49.3 percent respectively.

It is constructive to highlight that growth rates—while sometimes overlooked—are explicitly part of the 2006 CRE regulatory guidelines. Those guidelines stipulate that an institution is only in excess of the CRE guideline if CRE as a percent of capital is greater than or equal to 300 percent and the institution’s CRE portfolio has increased by 50 percent or more during the prior three years.

The regulators have repeatedly pointed out that—unlike many other regulatory prescriptions and proscriptions—the CRE guidelines are not limits. The FDIC has noted that because “community banks typically serve a relatively small market area and generally specialize in a limited number of loan types, concentration risks are a part of doing business” and the OCC specifically caveated that the “guidance does not establish specific limits on CRE lending; rather, it describes sound risk management practices that will enable institutions to pursue CRE lending in a safe and sound manner.”

In this context, growth may be the most important element of the CRE guidelines because it quantifies the potential that portfolio size may outstrip the risk management infrastructure (spanning credit, capital, strategic, compliance and operational components) to support that lending. In cases of aggressive growth (whether you are above or below the other regulatory CRE criteria), it is that much more important to establish proactive and robust credit risk monitoring and management.

Luckily, as the CRE guidance is now quite mature, industry-wide best practices exist to aid in this exercise:

  1. Monitor the risk for all of your bank’s credit concentrations—not just CRE and C&D.
  2. Analyze and segment your entire portfolio by at least the “regulatory big three” of product, geography and industry. It is also constructive to slice-and-dice by vintage, underwriting bands, branch, etc.
  3. For each segment, calculate and monitor growth rates along with percent of risk-based capital and asset quality (and consider establishing management triggers and thresholds on these key risk indicators).
  4. Analyze your portfolio hierarchically so high-level trends are digestible for boards of directors while the detail can be drilled through so the results are tactically relevant to management and even individual loan officers. Banking is a relationship business, and risk analytics should lead to action that may start with a borrower conversation.
  5. Especially in the current relatively benign credit environment and in situations where loan growth may obfuscate asset quality deterioration, monitor leading indicators of risk like underwriting policy exceptions, loan review downgrades, covenant violations, valuation trends and average underwriting attributes.
  6. Perform portfolio and firm-wide loss stress testing to quantify the loss potential under hypothetical and severe conditions. Roll such stress test results through your balance sheet and income statement to assess the impact on earnings and capital adequacy.
  7. Where your portfolio analytics or portfolio-wide stress tests identify sensitive concentrations, perform loan-level stress testing.
  8. Incorporate credit concentration risk within your allowance for loan losses (ALLL)—remember that concentration risk is one of the nine subjective qualitative and environmental risk factors laid out by the 2006 Interagency Guidance on the ALLL and reaffirmed by FASB’s CECL standards update.

Three Secrets to Running a High Performance Bank

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bank-performance-9-22-15.pngEvery year for the last several years, Bank Director magazine has published the Bank Performance Scorecard, a ranking of the largest U.S. publicly traded banks and thrifts. The most recent version, which appears in our third quarter issue, ranked all banks and thrifts listed on the New York Stock Exchange and Nasdaq OMX. We sorted them into three separate asset categories: $1 billion to $5 billion, $50 billion to $50 billion and $50 billion and above. And we ranked them using a set of metrics that measured profitability, capitalization and asset quality based on 2014 calendar year data.

Having gone through this exercise a number of times now, I can make three observations about what the ranking reveals. First, it tends to favor banks that are well balanced across all of the performance metrics rather than dominating just one of them. One of the built-in tensions in this ranking is between return on average equity (ROAE), which measures a company’s effective use of investor capital, and capitalization itself, using the ratio of tangible common equity (TCE) to tangible assets. The higher your bank’s TCE ratio, the more difficult it becomes to also post a high ROAE. The reason is simple math: Return on equity is calculated by dividing net income (the numerator) by shareholder equity (the denominator). All things being equal, the higher the denominator (shareholder equity), the higher the numerator (net income) has to be to produce the same result.

Clearly, banks that are able to generate a high level of profitability on a strong capital base have an advantage in our ranking. And a perfect example is $6.7 billion asset Bank of the Ozarks Inc. in Little Rock, Arkansas, which placed first in the $5 billion to $50 billion category. Ozarks had the third best ROAE out of the 102 banks in its asset category—but also the 12th best TCE ratio—which is an extremely powerful combination.

A second observation is that a core group of banks seem to score well on the ranking year after year. With $92.8 billion in assets, Cleveland-based KeyCorp placed second in the $50 billion and above category this year, and fourth in 2013 and 2014. Ozarks placed first in the $1 billion to $5 billion category in 2013 and 2014, then moved up to the midsize $5 billion to $50 billion category in 2015 following a spate of acquisitions—where it won again, edging out Abilene, Texas-based First Financial Corp. by 1.5 points in the final ranking. This was no small accomplishment because First Financial was the top ranked midsize bank in 2014, and previously dominated the $1 billion to $5 billion category going back to 2009.

When a group of banks perform at such a consistently high level (and there are other banks that I could highlight as well), they invariably benefit from strong executive leadership—and that is certainly true in this case. Beth Mooney at KeyCorp, George Gleason at Bank of the Ozarks and Scott Dueser at First Financial are among the banking industry’s most accomplished CEOs, and they are backed by first rate management teams. It is an obvious but inescapable truth that sustaining a high level of profitability in such a competitive industry like banking is exceedingly difficult without talented leadership.

But just having good managers isn’t enough. You also need to have a good business plan, and the third observation that I would make is that the banks that perform well on the Scorecard have well developed strategies that set them apart from their peers. Most banking products tend to be commodities that are available at any number of bank and nonbank providers. Although they are very different, the three category winners in 2015 all benefited from strategic focus. Capital One Financial Corp., the winner of the $50 billion-plus category, has a large credit card operation that helps drive its profitability. Ozarks’ profitability was driven by an ambitious nationwide commercial real estate lending business, as well as an active mergers and acquisition program. And the top ranked bank in the $1 billion to $5 billion category, $2 billion asset Preferred Bank, which is headquartered in Los Angeles, focuses almost exclusively on businesses and wealthy individuals in that market.

Being all things to all people might be a winning strategy in politics, but it rarely succeeds in banking.

Report from Audit Conference: Banking Still Faces Headwinds

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asset-quality-6-11-15.pngSure, banks have seen asset quality improve. Profitability is higher than it was during the recession. The SNL U.S. Bank and Thrift Index of publicly traded banks has risen 88 percent since the start of 2012. But all is not happy-go-lucky in bank land.

Speakers at Bank Director’s Bank Audit and Risk Committees Conference discussed the slow economic recovery and the headwinds banks are facing as a result. The banking industry’s compound annual loan growth rate during the last few years of 3 percent is down from the average of 7 percent from 1993 to 2007, said Steve Hovde, president and CEO of the Chicago-based investment bank Hovde Group. Net interest margins are 50 basis points lower than they were at the start of the decade. Combined with low interest rates, weak loan demand is hurting growth and profitability. Banks are stretching for loans and pricing competition is difficult. The median return on average assets (ROAA) was .93 percent in the first quarter of 2015, even though half of the banking industry made an ROAA of 1 percent or better pre-recession, Hovde said.

“In this environment, net interest margins are the lowest point they’ve been in 25 years,’’ Hovde said. “Clearly, if we had a more vibrant economy, banks could go back to making more money.”

With the Federal Reserve keeping rates low for the foreseeable future, and all the pricing competition, bubbles could be forming in some sectors, Hovde said. He specifically mentioned multi-family housing and junk bonds as possibilities.

Even stock prices aren’t that great from a historical perspective. The SNL U.S. Bank and Thrift Index has only climbed 4.2 percent since the start of 2000, compared to 40.7 percent for the S&P 500 during that time.

And what about the economic forecast for housing, a significant economic driver and source of revenue for many banks? 

Doug Duncan, the chief economist for Fannie Mae, said the housing market is in no way back to pre-recession levels. Although he expects an increase in mortgage originations in 2015 and 2016, refinancing volume is down. 

Households are still deleveraging in the aftermath from the Great Recession, but that has stabilized somewhat. Consumer spending in this economic recovery has been “incredibly weak,’’ Duncan said. Only recently have consumers in surveys reported an expectation for future income gains. 

Household growth, or the rate at which people are forming new households, has been depressed, as young adults have not been leaving the nest and getting their own apartments or buying homes in large numbers. Large numbers of adult children live at home. Millennials, burdened by college debt and the aftermath of the recession, are forming households at a slower pace than previous generations, and their real incomes are lower than the same generation a decade ago. It’s not that they don’t want to own houses, Duncan said. He said 76 percent of them think owning a house is a good idea financially. It’s just that they can’t afford it. 

But household formation is expected to rebound in 2015 to 2020, as the economy continues to improve and employment grows, he said. 

2011 Banker and Board Poll: More acquisitions ahead

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Still, M&A pricing may never return to pre-crisis levels

One of the best ways to see where banking is headed is to ask bankers and bank directors. That’s what Bank Director does every year at our annual Acquire or Be Acquired conference in Arizona, which got underway this year January 30.

In this year’s Banker & Board Poll, sponsored by BMO Capital Markets, more than 550 people were surveyed, mostly bank directors and CEOs representing a variety of bank sizes. The survey showed a distinct change in the outlook for banking and acquisitions compared to prior years. For one, asset quality is looking a whole lot better, so much so that generating loans has become the number one concern, rather than asset quality. More banks see growth opportunities ahead than in prior years, mostly through acquisition. And most expect the number of banks in the country to dwindle by the thousands.

For more detail on the survey results, see our full report.