New Pandemic Safety and Soundness Standards for Banks

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In June, financial regulators jointly issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions.” In addition to existing rating systems such as CAMELS, examiners will also assess management’s responsiveness to Covid-19 stresses. With this in mind, CLA is offering financial institutions our interpretation of, and key takeaways from, the guidance.

Asset quality
Asset quality will be a primary focus for all examiners. Safety and soundness exam standards have not changed despite the impacts of Covid-19. Assess and document the changing risk in your loan portfolio and appropriately respond with necessary changes to policies, procedures and programs that help customers, borrowers and communities.

Credit classification and credit risk review
The rise in credit risk due to the pandemic is widespread; no community or financial institution is untouched. As such, the June guidance emphasizes that you should reevaluate assigned credit ratings on the regulatory credit risk rating scale to assess if a change is necessary due to coronavirus-related challenges.

An objective credit risk review will help validate assigned ratings and eliminate “surprises” that could occur during your regulatory examination. In May, regulators released the “Interagency Guidance on Credit Risk Review Systems” and re-emphasized the fundamental concept of an independent credit risk review, which echoes the significance of the process at a critical time.

Credit modifications
Regulators continue to emphasize their support for banks working prudently with borrowers through the pandemic. In August, the Federal Financial Institutions Examination Council explored the need for additional accommodations for certain borrowers via loan modifications. While working with borrowers, banks should obtain current financial information to assess the viability of additional accommodations. Establishing and documenting a systematic approach to loan modifications is prudent and shows what, if any, considerations are being made to the credit risk rating as multiple modifications continue.

Earnings
Despite strong earnings in recent years, the guidance clearly communicates a distinct possibility that bank core earnings could be reduced by the pandemic. Analyze the pandemic’s impact on your current year earnings, how it will detract or enhance your earnings potential, and document accordingly.

Capital
Strong capital and a well-developed plan lead to enhanced viability. Loan growth, deposit growth, and inflows from government stimulus have happened quickly, without an opportunity to fully assess the capital impact. Regulators have even encouraged the use of capital buffers to promote lending activities. Given the pandemic-related changes, updating your capital plan and previously established limits and triggers is essential. Additionally, a current assessment of your overall risk profile and forecasted risks allows you to develop relevant strategies that address risk in your capital.

Liquidity
Most financial institutions have been liquid since the last recession, with less dependency on third parties for funding. Also, as happened during the last recession, there has been an inflow of funds from consumer savings due to economic uncertainty. The guidance readily admits liquidity profiles for financial institutions remain uncertain due to the coronavirus; yet, amid the uncertainty, expectations to employ smart strategies remain — which only places greater emphasis on your overall funding strategy and contingency plans.

Sensitivity to market risk
Earnings and capital evaluations require an assessment of sensitivity to market risk, primarily in the form of interest rate risk. Reassess your asset liability management (ALM) policies and related models to address changes that have occurred to your interest rate risk profile. Decipher between risks that are temporary and risks that will have longer-term effects.

These points will impact assumptions and data incorporated in ALM models, including the impact of loan modifications, payment timing and deposit growth. Additionally, stress testing models are important tools during the pandemic. Incorporate stress scenarios such as fluctuations in unemployment and the impact of possible future shutdowns to manage your risk. Like credit review, banks should strongly consider engaging independent verification of these models to confirm integrity, accuracy and reasonableness.

Management
Management should serve as the driving navigational force during this time of uncertainty. The guidance specifically states examiners will evaluate management’s actions in response to the pandemic. Management can demonstrate responsiveness by fostering open lines of internal communication on a day-to-day basis, and by engaging with the board of directors to obtain a different perspective that could enhance your risk assessment process. Prioritize documentation, which includes an assessment of what policies, procedures and risk assessments need to be revised based on decisions made in response to the pandemic.

Scaling Quality Customer Service in the Pandemic Era

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Since February 2020, the pandemic has reshaped everyone’s daily reality, creating a perfect storm of financial challenges.

In early March 2020, the economy was thriving. Six weeks later, over 30 million U.S. workers had filed for unemployment. The pandemic has exacerbated already–crushing consumer debt loads. At the end of the first quarter, nearly 11% of the $1.54 trillion student loan debt was over 90 days past due. Emergency lending programs like the Small Business Administration’s Paycheck Protection Program have not been renewed.  

Guiding consumers, especially millennials and Gen Z, to financial wellness is critical to the future of financial institutions. These demographics bring long-term value to banks, given their combined spending power of over $3 trillion.

But the banking support system is straining under incredible demand from millions of consumers, and it feels broken for many. Consumers are scrambling for help from their banks; their banks are failing them. With hold times ranging from 20 minutes to three hours, compared with an average of 41 seconds in normal times, customers are having an increasingly aggravating experience. And website content isn’t helping either. Often too generic or laced with confusing jargon like “forbearance,” customers can’t get advice that is relevant to their unique situation and  make good financial choices.

All this comes at a time of restricted branch access. Gone are the days when customers could easily walk into their local branch for product advice. Afraid of coronavirus exposure, most consumers have gone digital. Moreover, many branches are closed, reduced hours or use appointments due to the pandemic. No wonder digital has become an urgent imperative.

How can community banks scale high-quality service and advice cost-effectively in the pandemic era and beyond? The answer lies in a new breed of technology, pioneered by digital engagement automation, powered by artificial intelligence and knowledge. Here is what you can do with it.

Deliver smarter digital services. AI-automated digital self-service enables banks to deliver service to more customers, while lowering costs. For example, next-gen chatbots are often just as effective as human assistance for solving a broad range of basic banking queries, such as bill payments, money transfers and disputed charges. The average cost per agent call could be as high as $35; an AI-powered chatbot session costs only a few pennies, according to industry analysts.

Provide instant access to help. The next generation of chatbots go beyond “meet and greet” and can solve customer issues through AI and knowledge-guided conversations. This capability takes more load off the contact center. Chatbots can walk customers through a dialog to best understand their situation and deliver the most relevant guidance and financial health tips. Where needed, they transition the conversation to human agents with all the context, captured from the self-service conversation for a seamless experience.

Satisfy digital natives. Enhancing digital services is also critical to attracting and keeping younger, digital-native customers. Millennials and Gen Z prefer to use digital touchpoints for service. But in the pandemic era, older consumers have also jumped on the bandwagon due to contact risk.

Many of blue-chip companies have scaled customer service and engagement effectively with digital engagement automation. A leading financial services company implemented our virtual assistant chatbot, which answers customer questions while looking for opportunities to sell premium advice, offered by human advisors. These advisors use our chat and co-browse solution to answer customer questions and help them fill forms collaboratively. The chatbot successfully resolved over 50% of incoming service queries.

The client then deployed the capability for their IT helpdesk, where it resolved 81% of the inquiries. Since then the client has rolled out additional domain-specific virtual assistants for other functional groups. Together, these virtual assistants processed over 2 million interactions in the last 12 months.

The economic road ahead will be rocky, and financial institutions cannot afford to lose customers. Digital engagement automation with AI and knowledge can help scale up customer service without sacrificing quality. So why not get going?

Four Traits That Will Define Successful Lenders in the Future

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Covid-19 and the Paycheck Protection Program have fundamentally changed the banking industry.

In just a few months, lenders were forced to learn how to process a year’s worth of loans in six weeks. Numerated worked with lenders to process nearly a quarter of a million PPP loans on our platform. We had a front-row seat to how the pandemic transformed lending and drove a technological reckoning (which we shared with Bank Director).

We’ve identified a number of strategies, perspectives and traits that contributed to lenders’ success during the crisis. Working with banks to shift their focus to a post-PPP world, we’re seeing how incorporating these key learnings from the program will separate the winners from the losers going forward.

As banks and credit unions pivot to the new normal, the most successful lenders will be those who accomplish these four things:

Successful lenders will lean in on digital. It goes without saying that in the middle of a pandemic, every bank needed to figure out how to serve customers with closed branches. Digital capabilities were put to the test — everyone quickly figured out where their digital footprint fell short. A lot of sensitive documents were emailed, workflow was lost and most processes wouldn’t have passed audits in normal times. Digitally-mature lenders and those who successfully adopted technology for PPP had efficient, secure processes that didn’t burn out their customers or employees. Technology will be key to keeping customers satisfied and employees happy during inevitable future crises or unexpected shifts in the industry.

Successful lenders will prioritize speed to market. When Congress first announced the PPP, lenders had to make a quick decision: lean in and figure out how to help their businesses or sit it out. One of the biggest differences in PPP performance we’ve identified was how quickly lenders got into the market.

Two client banks in California both did the same number of PPP loans — despite one being 10 times larger than the other. The smaller bank identified their needs, adopted our platform and rapidly rolled it out to their borrowers faster than their larger counterpart. This gave the smaller bank a foot up in the market. Some banks think committees and consensus mean they can’t move quickly. In 2021, successful banks will understand speed matters, crisis or not.

Successful lenders will achieve efficiency ratios not previously thought possible. The workflow on Small Business Administration loans is complicated; despite the SBA’s best efforts, this was true for PPP as well. The best lenders leveraged technology to get PPP loans done the same day as applications. They pre-filled applications, automated decisions, automatically generated and digitally executed loan documents, and used APIs to board to the SBA. Loans that would have taken a banker five to six hours were done in less than an hour.

At the height of PPP, we saw lenders processing nearly two loans a second — the equivalent of $250 million of PPP loans per hour. Banks will need to find radical efficiencies like these to grow earnings in a challenging 2021 budget season. The most successful lenders are already using PPP learnings to reengineer their normal loan operations.

Using data is key. In 2021 and beyond, it will no longer be enough for lenders to digitize their processes. Going beyond these commonplace efficiency gains will require using reliable, actionable data that can automate and eliminate work. Unfortunately, as anyone who’s worked with financial technology knows, bank data is a mess.

During PPP, we worked with the SBA to create a connection to their systems that let us detect errors in our banks’ data. There were many, many errors; enabling our banks to fix these data issues saved countless hours of rework. Successful lenders are finding ways to clean their data so that software can automate more of their normal lending processes. These conversations are integral to their 2021 plans.

As the pandemic still grips the nation and without further government assistance in the immediate future, banks find themselves in uncharted waters as they set their budgets for the new year.

One of Numerated’s investors is Patriot Financial Partners’ Kirk Wycoff — one of the most successful community bank investors in the United States. In a recent Numerated webinar, he shared his perspective that this year’s budget conversations will be more focused on technology than ever before. “We need to get that message across to senior leadership teams that for investment in technology, there needs to be a realization that the building’s on fire.”

The ability to put out that fire effectively will determine much of lenders’ success in 2021 and beyond.

Beware Third-Quarter Credit Risk

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Could credit quality finally crack in the third quarter?

Banks spent the summer and fall risk-rating loans that had been impacted by the coronavirus pandemic and recession at the same time they tightened credit and financial standards for second-round deferral requests. The result could be that second-round deferrals substantially fall just as nonaccruals and criticized assets begin increasing.

Bankers must stay vigilant to navigate these two diametric forces.

“We’re in a much better spot now, versus where we were when this thing first hit,” says Corey Goldblum, a principal in Deloitte’s risk and financial advisory practice. “But we tell our clients to continue proactively monitoring risk, making sure that they’re identifying any issues, concerns and exposures, thinking about what obligors will make it through and what happens if there’s another outbreak and shutdown.”

Eight months into the pandemic, the suspension of troubled loan reporting rules and widespread forbearance has made it difficult to ascertain the true state of credit quality. Noncurrent loan and net charge-off volumes stayed “relatively low” in the second quarter, even as provisions skyrocketed, the Federal Deposit Insurance Corp. noted in its quarterly banking profile.

The third quarter may finally reveal that nonperforming assets and net charge-offs are trending higher, after two quarters of proactive reserve builds, John Rodis, director of banks and thrifts at Janney Montgomery Scott, wrote in an Oct. 6 report. He added that the industry will be closely watching for continued updates on loan modifications.

Banks should continue performing “vulnerability assessments,” both across their loan portfolios and in particular subsets that may be more vulnerable, says James Watkins, senior managing director at the Isaac-Milstein Group. Watkins served at the FDIC for nearly 40 years as the senior deputy director of supervisory examinations, overseeing the agency’s risk management examination program.

“Banks need to ensure that they are actively having those conversations with their customers,” he says. “In areas that have some vulnerability, they need to take a look at fresh forecasts.”

Both Watkins and Goldblum recommend that banks conduct granular, loan-level credit reviews with the most current information, when possible. Goldblum says this is an area where institutions can leverage analytics, data and technology to increase the efficiency and effectiveness of these reviews.

Going forward, banks should use the experiences gained from navigating the credit uncertainty in the first and second quarter to prepare for any surprise subsequent weakening in credit. They should assess whether their concentrations are manageable, their monitoring programs are strong and their loan rating systems are responsive and realistic. They also should keep a watchful eye on currently performing loans where borrower financials may be under pressure.

It is paramount that banks continue to monitor the movement of these risks — and connect them to other variables within the bank. Should a bank defer a loan or foreclose? Is persistent excess liquidity a sign of customer surplus, or a warning sign that they’re holding onto cash? Is loan demand a sign of borrower strength or stress? The pandemic-induced recession is now eight months old and yet the industry still lacks clarity into its credit risk.

“All these things could mean anything,” Watkins says. “That’s why [banks need] strong monitoring and controls, to make sure that you’re really looking behind these trends and are prepared for that. We’re in uncertain and unprecedented times, and there will be important lessons that’ll come out of this crisis.”

Strategic Planning in an Age of Uncertainty

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How do you plan in an environment where the future is so uncertain?

If this was a bad joke, the answer might be “very carefully.” The real answer is more like “very nimbly.”

The Covid-19 pandemic has presented the banking industry with an almost-unprecedented set of challenges, including a deep recession and the necessity to manage a distributed work force. The variable that no one can predict is the pandemic.

Most economist agree that the U.S. economy won’t fully recover until the pandemic has been brought to heel — and that probably won’t occur until an effective vaccine has been widely distributed. Many banks are also reluctant to repatriate their remote employees in large numbers until it’s safe to do so.

Strategic planning in such a confused situation has to be different than at other times. In a webcast discussion for Bank Director’s AOBA Summer Series — a run-up to the 2021 Acquire or Be Acquired conference in January — Stephen Steinour, chairman and CEO at Huntington Bancshares in Columbus, Ohio, talked about the challenges of strategic planning today.

In an audio recording of that conversation with Editor-at-Large Jack Milligan, Steinour detailed some of the steps that Huntington has been taking through the pandemic, including processing tens of thousands of Paycheck Protection Program loans for its business customers and adapting to a virtual work arrangement for most of its employees.

Steinour also describes a new approach that Huntington’s senior management teams and board of directors is adopting toward strategic planning. Traditionally the bank has planned on a three to five-year cycle, but today’s uncertain environment requires a shorter time horizon.

“I think we’re going more into a continuous planning mode rather than a cyclical mode,” he says. “It requires us to be more nimble.”

Four Digital Lessons from the Pandemic

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2020, so far, is the year of digital interactions.

Without the ability to interact in the physical world, digital channels became the focal point of contact for everyone. Industries like retail and restaurants experienced a surge in the use of digital services like Instacart, DoorDash and others.

This trend is the same for banks and their customers. In a survey conducted by Aite Group, 63% of U.S. consumers log into financial accounts on a desktop or laptop computer to check accounts at least once a week, while 61% use a smartphone.

The coronavirus pandemic has certainly accelerated the move to the digital channel, as well. In a Fidelity National Information Services (FIS) survey, 45% of respondents report changing the way they interacted with their financial institution because of the pandemic. The increased adoption of the digital channel is here to stay: 30% of respondents from the same survey noting they plan to continue using online and mobile banking channels moving forward.

The same is true for payments. FIS finds that consumers are flocking to mobile wallets and contactless payment to minimize virus risks, with 45% reporting using a mobile wallet and 31% planning to continue using the payment method post-pandemic.

This pandemic-induced shift in consumer preferences provides a few important lessons:

1. Experience Matters
Customers’ experiences in other industries will inform what they come to expect from their bank. Marketing guru Warren Tomlin once said, “a person’s last experience is their new expectation.” No matter where it came from, a great digital experience sets the standard for all others.

Banks should look to other industries to see what solutions can offer a great customer experience in your online and mobile banking channels. Customers’ service experiences with companies like Amazon.com’s set the bar for how they expect to interact with you. Their experience making payments with tools from PayPal Holdings, like Venmo, may inform their impression of how to make payments through the bank.

2. Personalization is Key
Providing a personalized experience for customers is key to the success of your bank, both now and in the future. Your bank’s online and mobile tools must generate a personalized experience for each customer. This makes them feel valued and well served — regardless of whether they are inside a branch or transacting through a mobile app.

Technologies like artificial intelligence can learn each customer’s unique habits and anticipate specific needs they might have. In payments, this might look like learning bill pay habits and helping customers manage those funds wisely. AI can even make recommendations on how users can ensure they have enough funds to cover the month’s bills or save anything they have left over.

AI is also able to look at customer data and anticipate any services they might need next, like mortgages, car loans or saving accounts. It brings the personal banker experience to customers in the digital world.

3. Weave the Branch Into the Digital
The ability to interweave the personalized, in-branch experience into the digital world is crucial. There are positives and negatives in both the branch and digital channels. The challenge for banks is to take the best of both worlds and provide customers with an experience that shines.

Customers want to know that someone is looking out for them, whether they can see that person or not. A digital assistant keeps customers engaged with the bank and provides the peace of mind that, whether they are in the branch or 100 miles away, there is always someone looking out for their financial well-being.

4. Embrace the “Now” Normal
To state that the Covid-19 pandemic changed the world would be a big understatement. It has disrupted what we thought was “business as usual,” and irrevocably changed the future.

The “new normal” changes day by day, so much that we choose to more accurately refer to it as the “now normal.” The increased dependency on digital has made it critical to have the right infrastructure in place . You truly never know what is coming down the line.

Customers enjoy the ease of digital and, more than likely, will not go “back to normal” when it comes to banking and payments. Now, more than ever, is the time to examine the digital experiences that your bank offers to further ensure its prepared for this endless paradigm shift that is the “now normal.”

What Employers Need to Know about Coronavirus, Paid Leave

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From lobby closures to Paycheck Protection Program loans, the COVID-19 pandemic has thrown a lot at banks and other financial services providers during this pandemic. One more item to add to the list is the Families First Coronavirus Response Act (FFCRA).

The FFCRA is not one law but a suite of laws targeted at lessening the effects of the pandemic, including two laws that establish paid leave requirements on covered employers: the Emergency Family and Medical Leave Expansion Act (EFMLEA) and the Emergency Paid Sick Leave Act (EPSLA). As is the case with many employment laws and rules, a bank that fails to comply with the FFCRA paid leave requirements does so at its peril.

Who are covered employers?
The paid leave requirements generally apply to all private employers with fewer than 500 employees. There are limited exceptions to the Emergency Family and Medical Leave Expansion Act leave requirements for employers with fewer than 50 employees relating to leave for school and child care closures. A bank looking to take advantage of the EFMLEA exceptions should closely study the circumstances and the exception criteria. Further, while the federal rules apply only to small (under 500 employee) employers, some states’ paid leave laws cover large employers as well.

Who are eligible employees?
Employee eligibility is one area where Emergency Family and Medical Leave Expansion Act and Emergency Paid Sick Leave Act diverge. Paid leave under the EFMLEA is available to employees who have been employed for a minimum of 30 calendar days. For EPSLA related leave, all employees qualify, regardless of their length of employment. EFMLEA and EPSLA each apply to part-time as well as full-time employees and neither require an employer to provide paid leave to furloughed employees.

When can employees utilize paid leave benefits?
This is another area where the two statutes diverge. The EPSLA provides for paid leave if the employee is unable to work (or telework) because the employee:

  1. Is subject to a federal, state or local quarantine or isolation order.
  2. Has been advised by a health care provider to self-quarantine.
  3. Is experiencing symptoms of COVID-19 and is seeking a diagnosis.
  4. Is caring for an individual covered by (1) or (2) above.
  5. Is caring for a son or daughter whose school or place of care is closed or whose child care provider is unavailable due to COVID-19 precautions.
  6. Is experiencing any other substantially similar condition specified by the Secretary of Health and Human Services.

The Emergency Family and Medical Leave Expansion Act, as its name implies, is an expansion of the Family and Medical Leave Act and is triggered by the need for the employee to care for someone else, in this case the employee’s child. Specifically, EFMLEA provides for paid leave to employees who must care for a minor child because of a coronavirus-related school closure or childcare provider loss. EFMLEA benefits only are available if the employee is unable to work from home or telework. We should note, however, that employees who become ill with COVID-19 or are caring for family members who have COVID-19 may still be covered by the FMLA original unpaid “serious health condition” provision.

What are the paid leave benefits?
Under the Emergency Paid Sick Leave Act, full-time employees are entitled to 80 hours (i.e., 10 days) of emergency paid sick leave at either full-rate (reasons 1, 2 and 3 above) or two-thirds rate (reasons 4, 5 and 6 above). The benefit is capped at $511 per day when the employee is absent for reasons 1, 2 or 3, and $200 per day for reasons 4, 5 and 6. Part-time employees are entitled to receive a proportionately similar amount of leave based on their average hours worked in a two-week period.
For 10 weeks an eligible employee is entitled to receive up to two-thirds of their regular rate of pay, capped $200 per day under the EFMLEA. We should note here, that an employee can take advantage of the EPSLA benefit of up to $200 per day for the first 10 days of leave to care for a child due to school or childcare closing, bringing the maximum paid leave benefit to $12,000 for child care reasons.

How does a bank pay for this new requirement?
To soften the blow on banks and other employers of the mandatory paid leave under the FFCRA, the law provides for a dollar-for-dollar refundable tax credit for amounts paid by eligible employers. The refundable tax credit applies to all EPSLA and EFMLEA wages paid during the period from April 1 to Dec. 31, 2020. Compliance with the eligibility and record-keeping requirements of the law will be critical to the bank qualifying for the tax credit.

Reducing Contact Center Hold Times to Improve Service

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The continuing coronavirus pandemic is pushing banks to think even more productively about how they can help their customers.

American workers are increasingly concerned about their ability to stay current on credit card and mortgage payments as workplaces continue to close and more jobs are lost amid Covid-19 uncertainty. What products and services can banks offer customers to offset their financial burden and address or alleviate their worries? Plainly, there’s never been a better opportunity for banks to focus on deepening their relationship with the customer.

Today’s bank looks a bit different than the bank of six months ago. Six months ago, customers willingly moved in and out of bank branches, offering many touch points with which the bank could engage with them and vice versa. Now, branch foot traffic is declining significantly, and the contact center has become the dominant human touchpoint.

The shift in demand means that some banks are struggling to efficiently answer basic customer service queries, let alone deal with unique and complex scenarios. Many institutions are offering the most basic customer experience at best. At worst, they are offering a terrible experience, with customers complaining of hold times lasting hours during Covid-19’s onset.

This is a problem for banks for many reasons. Customers don’t want to sit on hold for an extended period (if at all) for nearly anything, especially to get an answer to a simple question. And most of the questions are in fact simple. Our call driver data shows that approximately 70% of customer service queries are basic or transactional: routine requests for information and actions on an existing customer account. Not surprisingly, the most common requests are account access issues — typically a password reset or login confusion.

The next largest group, making up 25% of all requests, are complex. These are customer specific problems or special cases that require detailed attention and assistance to resolve. In these circumstances, the customer often has already attempted other digital methods of finding the answer before reaching for live help. These situations offer the opportunity to provide personal service with a warm human touch, cementing customer loyalty to the institution. This is where customer experience reputations are made and where customer service agents can really shine.

But customers with routine requests are forced to sit on hold when they don’t want to, and those with complex requests who need to speak with an agent can’t do so efficiently because agents are stuck servicing routine requests, according to our recent data report. Banks can solve this problem in two ways: they could hire more customer service agents to reduce wait times or they can automate certain functions using AI.

Handling transactional queries with a conversational chatbot offers the highest value to the customer and to the bank. Instead of hiring more agents, banks can free up the time of existing agents by offloading routine tasks. Contact center agents can focus on more complex or high-value problems, supporting more consumers with the same resources. A large bank reported that their AI chatbot halves the average handling time for customer inquiries, saving customers an average of 12 minutes per chat when handled by the bot.

To get started, banks shouldn’t look at conversational banking as a niche channel but as an important part of their overall customer experience strategy. Consumers no longer decide where to bank based on whether there’s a branch nearby. Banks need to look deeper, creating meaningful engagement with their customers. Excellent customer service is the baseline.

Key Compensation Issues in a Turbulent Market

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As compensation committee chair, Susan knew 2020 was going to be an important year for the bank.

The compensation and governance committee had taken on the topic of environmental, social and governance (ESG) for the coming year. They had conducted an audit and knew where their gaps were; Susan knew it was going take time to address all the shortfalls. Fortunately, the bank was performing well, the stock was moving in the right direction and they had just approved the 2020 incentive plans. All in all, she was looking forward to the year as she put her finished notes on the February committee meeting.

Two months later, Susan had longed for the “good old days” of February. With the speed and forcefulness that Covid-19 impacted the country, states and areas the bank served, February seemed like a lifetime ago. The bank had implemented the credit loss standard at the end of March — due to the impact of the unemployment assumptions, the CECL provision effectively wiped out the 2020 profitability. This was on top of the non-branch employees working from home, and the bank doing whatever it could to serve its customers through the Paycheck Protection Program.

Does this sound familiar to your bank? The whirlwind of 2020 has brought a focus on a number of issues, not the least of which is executive compensation. Specifically, how are your bank’s plans fairing in light of such monumental volatility? We will briefly review annual and long-term performance plans as well as a construct for how to evaluate these programs.

The degree to which a bank’s annual and long-term incentive (LTI) plans have been impacted by Covid-19 hinge primarily on two factors. First, how much are the plans based upon GAAP bottom-line profitability? Second, and primarily for LTI plans, how much are the performance-based goals based upon absolute versus relative performance?

In reviewing annual incentive plans, approximately 90% of banks use bottom-line earnings in their annual scorecards. For approximately 50% of firms, the bottom-line metrics represent a majority of their goals for their annual incentive plans. These banks’ 2020 scorecards are at risk; they are evaluating how to address their annual plan for 2020. Do they change their goals? Do they utilize a discretionary overlay? And what are the disclosure implications if they are public?

There is a similar story playing out for long-term incentive plans — with a twist. The question for LTI plans is how much are performance-based goals based upon absolute versus peer relative profitability metrics? Two banks can have the same size with the same performance, and one bank’s LTI plan can be fine and the other may have three years of LTI grants at risk of not vesting, due to their performance goals all being based on an absolute basis. In the banking industry, slightly more than 60% of firms use absolute goals in their LTI plans and therefore have a very real issue on their hands, given the overall impact of Covid-19.

Firms that are impacted by absolute goals for their LTI plans have to navigate a myriad level of accounting and SEC disclosure issues. At the same time, they have to address disclosure to ensure that institutional investors both understand and hopefully support any contemplated changes. Everyone needs to be “eyes wide open” with respect to any potential changes being contemplated.

As firms evaluate any potential changes to their executive performance plans, they need to focus on principles, process and patience. How do any potential changes reconcile to changes for the entire staff on compensation? How are the executives setting the tone with their compensation changes that will be disclosed, at least for public companies? How are they utilizing a “two touch” process with the compensation committee to ensure time for proper review and discourse? Are there any ESG concerns or implications, given its growing importance?

Firms will need patience to see the “big picture” with respect to any changes that are done for 2020 and what that may mean for 2021 compensation.

Community Risks That Community Banks Should Address

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States and counties are starting to reopen after a prolonged period of sheltering in place due to the Covid-19 pandemic.

Many community banks that function as the primary lenders to small businesses in the rural Midwest have yet to see a significant negative financial impact because of the shutdown. In fact, many community banks stand to receive significant loan origination fees from the U.S. Small Business Administration for participating in the Paycheck Protection Program. They’re also flush with cash, report the community bank CEOs I’ve asked, as many borrowers haven’t used their PPP loan funds and consumers have been holding their stimulus payments in their checking accounts.

But just because things look stable from a financial perspective doesn’t mean there isn’t risk in your community and to your bank. Let’s take a brief look at some issues community banks should be monitoring today:

Increasing personal debt caused by prolonged unemployment. Unemployed Americans received an unprecedented amount of unemployment benefits that for the most part ended on July 31, 2020. What are Americans doing now? Some furloughed employees have been recalled, but others weren’t. When income is scarce, the use of credit cards, overdraft protection, and personal loans increases. What is your bank doing to monitor the increasing financial pressure of your individual borrowers and account holders?

Delayed business closures. Small businesses without a significant online presence are finding it difficult to operate in this new environment. “Nonessential” small businesses survived the shutdown by using government funds, furloughing employees, drawing on credit lines, or using personal savings. The lost sales may not have been deferred to a later date. Instead, they are truly lost and won’t be recaptured. Without a fast and heavy recovery for small businesses, they may be forced to close and may not be able to support their current debt load. How is your bank monitoring the performance of your small business customer?

Reduced need for office and retail space. With the increase in employees working remotely, especially at businesses that typically use commercial office space, the perceived need for office space is declining. Once a lease term expires, community banks should expect some commercial borrowers to experience reduced rental income as tenants negotiate for less square footage or overall lower rates. Are you tracking the going rate for rent per square foot in your market?

Increased fraud risk. When people experience all three sides of the fraud triangle (rationalization, opportunity, and pressure), they’re more likely to commit fraud. Identification of the fraud can be significantly delayed. A bookkeeping employee whose spouse has been laid off can rationalize the need for the company’s money, has the opportunity to take it, and feels the financial pressure to use it for personal needs. This person may be able to cover it for a short time; but, covering it becomes more difficult as it grows. That can happen within the bank or at any of your commercial borrowers.

Community banks have yet to see a dramatic increase in past dues or downgrades in loan ratings; it’s likely too early to see the financial stress. Several community banks are adding earmarked reserves to the allowance for loan losses in each loan category as “Covid-related.” However, community banks should carefully evaluate loans that were “on the bubble” prior to the shutdown, were granted some form of deferral by the bank, or are in certain industries like hospitality. Interagency guidelines permit banks to not account for these loans as troubled debt restructures (TDR) if they meet certain criteria, but banks are still responsible for maintaining a proper allowance. A loan in deferral may need an increased reserve, even if it isn’t accounted for as a TDR. The time it takes for that stress to show (called “loss emergence period” in accounting) is longer than many think.

Two other significant financial impacts to banks relate to overdraft fees and interchange fees. As spending decreased, so did overdrafts and associated fee income. And without the discretionary debit card swipes, interchange fees fell significantly as well.

How much of the above information will you use as you prepare the 2021 budgets this fall? What will your baseline for 2021 be: 2019 or 2020? Regardless, assess the risks to the bank and plan accordingly.

This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.