How to Protect Against the Downside, Prepare for the Upside

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“If you’re left in a situation where you’re defending, where you’re shrinking your balance sheet, where you’re worried about your capital, where you’re continually cajoling shareholders, or clients to stick with you — you’re not focused on growing.”

Those are wise words from William Demchak, chief executive officer of PNC Financial Services Group. PNC is one of the largest banks in the U.S. and an OakNorth customer.

He said this in an interview with the Financial Times in May 2020 — a couple of months after the country had gone into lockdown under full force of the coronavirus pandemic. At the time, he was discussing PNC’s rationale for selling its stake in asset manager BlackRock, which was prompted in part by increasing concerns about the U.S. economy as a result of the Covid-19 pandemic.

But fast forward the clock two and a half years, and he could just as easily be speaking about the economic situation in the U.S. today. Increasing economic uncertainty and interest rates at their highest point since 2008, many commercial bankers are focused on protecting their downside risk. As a result, many are likely missing the upside opportunity.

Protecting Against Downside Risk

1. Granular data. Most banks tend to lump their borrowers into one of a dozen or so broad sectors: all restaurants, bars, hotels, golf clubs and spas, for example, will be classified as “hospitality and leisure.” This classification approach misses the fundamental differences between how these businesses operate and how their capital and operational expenditures may be impacted by changes in the economy. In order to quickly identify where the most vulnerable credits lie in their portfolio, banks need to get to much more granular industry view — even going as far down as 6-digit NAICS codes — in their analysis.

2. Forward-looking scenario analysis. Banks need to be able to run multiple macroeconomic scenarios on their loan book using forward-looking scenarios to explore how a borrower would perform at different financial and credit metric level. This gives them the ability to plan ahead for market changes such as rate rises and house price fluctuation by formulating targeted risk mitigation strategies that can reduce defaults and charge-offs and better manage capital requirements.

3. Proactive monitoring. Banks need to be able to identify potential credit issues faster and earlier, so they can take proactive steps to reduce the chances of negative outcomes during a downturn.

Effectively Navigating Upside Opportunities

1. Granular data. in an economic downturn, there are always winners and losers that emerge; more often than not, it’s specific businesses or sub-sectors rather than entire industries. As consumer confidence wanes and inflation tightens purse strings, it’s likely that budget retailers and discount stores will see increased demand while their high-end alternatives experience the opposite. Both are classified as “retail” but will have dramatically different experiences in an economic downturn. Banks need the right data and tools to identify businesses that may need additional capital to make it through the economic cycle from the businesses that need additional investment capital to pursue potential growth opportunities arising in it.

2. Forward-looking scenario analysis. Banks need to be able to create configurable scenarios that reflect their internal economic outlook by adjusting macroeconomic variables, such as interest rates and inflation, among others. This means they can make more informed decisions about high risk, high opportunity industries and borrowers in their loan book and adjust their activities accordingly.

3. Proactive monitoring. In times of turmoil, most banks tend to segment their portfolio from highest to lowest exposure, starting with their largest and working their way down. Not only is this approach incredibly time consuming, it also means a lot of team time is spent running analysis on credits that don’t end up presenting a credit issue. Banks need to be able to segment credits on a high to low risk spectrum within a matter of hours, so they can identify the credits that require intensive versus light touch reviews, freeing up resources to pursue new loan origination.

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.

Tackling Credit Risk Uncertainty Head On

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I’ve spoken to many bankers lately who know, intuitively, that “the other credit-quality shoe” will inevitably drop.

Despite federal stimulus initiatives, including the latest round of Paycheck Protection Program loans from the Small Business Administration, temporary regulatory relief and the advent of coronavirus vaccines and therapies, bankers realize that so-called credit tails always extend longer than the economic shocks that precipitate changing credit cycles. Although the Wall Street rebound has dominated U.S. business news, commercial bank credit lives on Main Street — and Main Street is in a recession.

During the Great Recession, the damaging impact on bank portfolios was largely focused on one sector of the housing industry: one-to-four family mortgages. Unlike that scenario, coronavirus’ most vexing legacy to bankers might be its effect throughout multiple, disparate businesses in loan portfolios. Bankers must now emphasize dealing with borrowers’ survivability than on growing their investment potential. Government actions during the pandemic averted an economic calamity. But they’ve also masked the true nature of credit quality within our portfolios. These moves created unmatched uncertainty among bank stakeholders — anathema to anyone managing credit risk.

Even amid the industry’s talk of renewed merger and acquisition activity this year, seasoned investment bankers bemoan this level of ambiguity. The temptation to use 2020’s defense that “it’s beyond our control” likely won’t cut it in 2021. All stakeholders — particularly regulators — will expect and demand that banks write their own credible narrative quantifying its unique credit risk profile. They expect bankers to be captain of their ships.

Effectively reducing uncertainty — if not eliminating it — will be priority one this year in response to those expectations. The key to accomplishing this goal will lie largely with your bank’s idiosyncratic, non-public loan data. Only you are privy to this internal information; external stakeholders and peers see your bank through the lens of public data such as call reports. In order to address this concern, I advise bankers to take five steps.

Recognize the trap of focusing on the credit metrics of the portfolio in its entirety.
While tempting, an overall credit perspective can miss the divergent economic forces at work within subsets of the portfolio. For every reassurance indicating that your bank’s credit is  performing well on the whole, there’s the caveat of focusing on the forest while the trees may show patches of trouble.

Create portfolio subsets to identify, isolate credit hotspots.
Employ practical and affordable tools that allow your credit team to identify potential credit hotspots with the same analytical representations you’d use in evaluating the total portfolio. For instance, where do bankers see the most problematic migrations within pass-rated risk grades? What danger signs are emerging in particular industries? Concentrated assessments of portfolio subsets are far more informative and predictive compared to the bluntness of the regulatory guidance on commercial real estate lending.

Drill down into suspect or troubled borrowers.
Any tool or analysis that provides aggregated trends, even within portfolio subsets, should produce an inventory of loans that make up those trends. Instantly peeling the onion down to the borrowers of most potential concern connects the quantitative data to qualitative issues that may need urgent attention and management.

Adopt an alternative servicing process for targeted loans.
These are not ordinary times. Redirecting credit servicing strategies to risk hotspots will prove beneficial. Regulators rightfully hold banks accountable for their policies; I recommend nuanced and enhanced servicing, stress testing and loan review protocols. And accordingly, banks should consider appropriate adjustments to their written procedures, as needed.

Write your own script for all of the above — the good and bad.
All outside stakeholders, especially regulators, must perceive banks as the experts on their credit risk profile. The above steps should enable banks, credibly, to write these scripts.

There is a proven correlation between the early detection of credit problems and two desired outcomes: reduced levels of loss and nonperformance, and greater flexibility to manage the problems out of the bank. Time is of the essence when ferreting out stressed credits. The magnitude of today’s credit uncertainties adds to the challenge of realizing this maxim — but they can be overcome.

IntelliCredit will present as part of Bank Director’s Inspired By Acquired or Be Acquired, an online board-level intelligence package for members of the board or C-suite. This live session is titled “How Best To Deal With 2021 Credit Uncertainties” and is February 9 at 2:00pm EDT. Click here to review program description.

Rates Are Lower for Longer: How Do I Find Yield for My Bank?

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BOLI-11-2-16.pngAs U.S. Treasury bond yields worsen, the banking industry finds itself in a familiar position. Bank portfolio managers would like better yield, but regulations restrict banks from going down the credit stack or out the curve to reach for yield. Net interest margins are at all-time lows and regulations compel us to manage regulatory risk first—price, rate and repayment risks are now secondary. Banking as we know it has changed, and not necessarily for the better. But there is a silver lining.

In December 2015, the Federal Reserve raised the funds rate 25 basis points. Immediately, foreign purchasers starving for yield drove prices to new highs, resulting in yields that were lower than before the Fed increased the rate. In early 2016, several countries moved to negative rates. Should the Fed raise rates again soon, more foreign deposits will find Treasury bonds even more compelling again.

Long term, given that the U.S. national debt stands at $19.5 trillion, the U.S. Treasury can’t afford rates to be appreciably higher. The recession of 2007, the war on terror and expansion of social programs has greatly limited options. Most economists agree that the treasury debt market will remain in the lower-for-longer phase for quite some time. Ouch. So, what to do?

Lending is the first most obvious answer but regulations remain confounding. Many bankers feel as if they are only able to grow by stealing market share. Multiple banks chasing the same high quality loans exacerbate spread compression. Agency debt and mortgage-backed securities have yields basically stuck in the 1.70 percent to 1.75 percent range. Municipals remain relatively attractive, but the laborious process, small sizes, ongoing care and price sensitivity make them less compelling.

The judicious use of Bank Owned Life Insurance (BOLI) could be a winning answer. Hear me out—with crediting rates (yield) at nearly 4 percent the concept has merit. Most money center banks and many super regionals maintain BOLI holdings at maximum allowable percentages. Yields are compelling, counterparty risk is stable and price risk is minimal. Interestingly, large banks are more likely than small banks to use the maximum allowable BOLI. Community bankers sometimes forget this break is available to all banks regardless of asset size.

BOLI has a positive effect upon your efficiency ratio as it provides additional tax-free dollars for employee benefits. Since efficiency ratio equals expenses divided by revenue, every additional dollar of revenue results in an ever-larger denominator, hence the ratio shows an immediate positive impact. BOLI is purchased at par and is always held at par eliminating price risk. Given the current cheapness of the asset, BOLI can be surrendered within a year (net of taxes and penalties) and still provide a higher return than mortgage-backed securities.

BOLI can be viewed as outsourcing a portion of your portfolio. Choose a provider that only uses insurance carriers that are A+ rated or better and that employ seasoned, capable portfolio managers. In the event of an untimely loss of an insured employee, the insurance payments help the family and assist the institution to pay for costs related to replacement.

Recently, I met with the president of an $8 billion asset bank who commented, “I really thought I didn’t want to discuss my BOLI holdings. Then I realized it’s a $100 million asset on my books and I’d better get interested in how to optimize it!” We are currently completing a review of his policy holdings.

In the current market, the BOLI asset is extraordinarily cheap. It is a high yielding, low risk asset with a superb degree of price stability. Does it solve every answer? No. Will BOLI always be this cheap? No. But given recent advancements by insurance carriers and asset managers, it is a financial tool that really demands a hard look.