The Issue Plaguing Banks These Days

Net interest margin lies at the very core of banking and is under substantial and unusual pressures that threaten to erode profitability and interest income for quarters to come. Community banks that can’t grow loans or defend their margins will face a number of complicated and difficult choices as they decide how to respond.

I chatted recently with Curtis Carpenter, senior managing director at the investment bank Hovde Group, ahead of his main stage session at Bank Director’s in-person Bank Board Training Forum today at the JW Marriott Nashville. He struck a concerned tone for the industry in our call. He says he has numerous questions about the long-term outlook of the industry, but most of them boil down to one fundamental one: How can banks defend their margins in this low rate, low loan growth environment?

Defending the margin will dominate boardroom and C-suite discussions for at least eight quarters, he predicts, and may drive a number of banks to consider deals to offset the decline. That fundamental challenge to bank profitability joins a number of persistent challenges that boards face, including attracting and retaining talent, finding the right fintech partners, defending customers from competitors and increasing shareholder value.

The trend of compressing margins has been a concern for banks even before the Federal Open Market Committee dropped rates to near zero in March 2020 as a response to the coronavirus pandemic, but it has become an increasingly urgent issue, Carpenter says. That’s because for more than a year, bank profitability was buffeted by mitigating factors like the rapid build-up in loan loss provisions and the subsequent drawdowns, noise from the Paycheck Protection Program, high demand for mortgages and refinancing, stimulus funds and enhanced unemployment benefits. Those have slowly ebbed away, leaving banks to face the reality: interest rates are at historic lows, their balance sheets are swollen with deposits and loan demand is tepid at best.

Complicating that further is that the Covid-19 pandemic, aided by the delta variant, stubbornly persists and could make a future economic rebound considerably lumpier. The Sept. 8 Beige Book from the Federal Reserve Board found that economic growth “downshifted slightly to a moderate pace” between early July and August. Growth slowed because of supply chain disruption, labor shortages and consumers pulling back on “dining out, travel, and tourism…  reflecting safety concerns due to the rise of the Delta variant.”

“It’s true that the net interest margin is always a focus, but this is an unusual interest rate environment,” Carpenter says. “For banks that are in rural areas that have lower loan demand, it’s an especially big threat. They have fewer options compared to banks in a more robust growth area.”

The cracks are already starting to form, according to the Quarterly Banking Profile of the second quarter from the Federal Deposit Insurance Corp. The average net interest margin for the nearly 5,000 insured banks shrank to 2.5% — the lowest level on record, according to the regulator, and down 31 basis points from a year ago. At community banks, as defined by the FDIC, net interest margin fell 26 basis points, to 3.25%. Net interest income fell by 1.7%, which totaled $2.2 billion in the second quarter, driven by the largest banks; three-fifths of all banks reported higher net interest income compared to a year ago. Carpenter believes that when it comes to net interest margin compression, the worst is yet to come.

“The full effect of the net interest margin squeeze is going to be seen in coming quarters,” he says, calling the pressure “profound.”

On the asset side, intense competition for scarce loan demand is driving down yields. Total loans grew only 0.3% from the first quarter, due to an increase in credit card balances and auto loans. Community banks saw a 0.5% decrease in loan balances from the first quarter, driven by PPP loan forgiveness and payoffs in commercial and industrial loans.

On the funding side, banks are hitting the floors on their cost of funds, no longer able to keep pace with the decline on earning assets. The continued pace of earning asset yield declines means that net interest margin compression may actually accelerate, Carpenter says.

Directors know that margin compression will define strategic planning and bank profitability over the next eight quarters, he says. They also know that without a rate increase, they have only a few options to combat those pressures outside of finding and growing loans organically.

Perhaps it’s not surprising that Carpenter, a long-time investment banker, sees mergers and acquisitions as an answer to the fundamental question of how to handle net interest margin compression. Of course, the choice to engage in M&A or decide to sell an institution is a major decision for boards, but some may find it the only way to meaningfully combat the forces facing their bank.

Banks in growth markets or that have built niche lending or fee business lines enjoy “real premiums” when it comes to potential partners, he adds. And conversations around mergers-of-equals, or MOEs, at larger banks are especially fluid and active — even more so than traditional buyer-seller discussions. So far, there have been 132 deals announced year-to-date through August, compared to 103 for all of 2020, according to a new analysis by S&P Global Market Intelligence.

For the time being, Carpenter recommends directors keep abreast of trends that could impact bank profitability and watch the value of their bank, especially if their prospects are dimmed over the next eight quarters.

“It seems like everybody’s talking to everybody these days,” he says.

Tailor Innovation With Fintech, Bank Collaborations

The Covid-19 pandemic reshaped the way that community banks think about their digital products and the expectations that consumers have for them. Digital transformation is no longer an option – it is a necessity.

In fact, 52% of consumers have used their financial institution’s digital banking services more since the start of the pandemic, according to BAI Banking Outlook. However, the research also found that only 61% of consumers feel their community bank understands their digital needs, compared to that 89% of direct bank consumers and 77% of large bank consumers.

As customers’ ever-growing expectations are not being met, banking teams are also concerned that their digital tools may be missing the mark. For many, the investments into digital solutions and tools are not having as wide as an impact as expected; on occasion, they do not hold any true benefit to their current and prospective account holders.

In addition, many community banks find themselves innovating for the sake of innovating, rather than solving real problems that exist within their target market. The communities that these banks serve are distinctive and can present unique challenges and opportunities, unlike those as little as a state away. Community banks must consider practical, powerful digital tools that benefit their one-of-a-kind customer base.

Rather than a product-driven approach to development, community banks must look to the niche needs within the market to discover areas to innovate. Identifying obstacles in the financial lives of existing customers and prospects ensures that community banks are working to solve a problem that will alleviate pain points for accountholders. But, with limited time and resources, how can this be accomplished?

Fintech-Bank Partnerships
Community banks can attract new customers, expand existing relationships and improve customer experience within the specific communities that they serve by implementing fintech solutions that are  specialized to the individual market or demographic.

It makes sense. Fintech-bank partnerships can pair a bank’s distinct market opportunities with technology that can effectively unlock niche verticals. We collaborated with five community banks who were searching for a responsive web app for digital commercial escrow and subaccounting that would eliminate the manual processes that limited their ability to handle commercial escrow and subaccounting accounts. Engaging with a fintech and leveraging extensive resources that are dedicated to developing and improving upon innovative technology gave these institutions a solution built with their companies in mind.

These partnerships between fintechs and banks are also more financially feasible — many community banks are unable to develop similar solutions in-house due to understaffing or lack of resources. With the help of a fintech, the institution can implement solutions faster and reach profitable clients sooner.

Fintech and bank collaborations are changing the way that community banks innovate. Together, they can expand the potential of a solution, both in its specialization and its capability, to better meet customer needs. Banking teams can provide the digital tools that their clients need and attract desirable clients that they hope to serve.

The Post-Pandemic Priorities for Audit and Risk Committees

Even as the Covid-19 pandemic continues to reshape the banking and financial services industries, forward-looking organizations are focusing on how they can adapt to a post-pandemic world. With many business processes and controls forever changed, boards of directors — including their audit and risk committees — acknowledge that their views on fundamental risk issues must change as well.

New Workplaces, New Risks
One of the pandemic’s most disruptive effects was the upheaval of the centralized workforce. For decades, employees gathered together in a central location to work. Businesses took great pride in these workplaces, even putting their names atop the buildings in which they were located.

However, the pandemic shattered that model — possibly permanently — along with the concept of regular office hours and the expectations that personal devices should not be used for company business. During the pandemic, employees worked from their kitchens and dining rooms, improvising as they adapted to new ways of operating that would have been impossible 20 years ago. Beyond the obvious physical, security and technical risks associated with this dispersal, board members should understand some of the less visible risks.

For example, corporate culture often is shaped from the ground up through casual workplace interactions, which can be lacking in a remote work arrangement. Similarly, if people cannot gather together physically to brainstorm ideas, innovation and creativity can suffer. Many executives also lament their inability to read body language, tone of voice and other nuances in employees’ behavior to spot potential problems.

These types of risks are inherently difficult to quantify. Nevertheless, risk committees should be aware of them and ascertain whether management is addressing them.

Of even more pressing concern, however, are the effects that a decentralized workforce has on a bank’s business processes and control environment. While the immediate responsibility for overseeing management’s response to these risks might be assigned to the audit and risk committees, ultimately all board members have oversight responsibility and should make a committed effort to understand these risks.

Audit and risk committee priorities
Previously, when audit committees addressed risks associated with business processes and controls, they had the advantage of operating in something like a laboratory. The bank controlled most of the variables such as access controls, approvals and validations. In the post-pandemic world, however, risk monitoring and mitigation efforts must address new variables outside the bank’s control.

One specific audit committee priority is the need to evaluate how a dispersed workforce affects the control environment. Controlling access to systems is an area of major risk; remote reconciliations, remote approvals and digital signatures also are important concerns.

While a virtual private network generally would be the preferred method of providing remote employee access, that capability often was unavailable during the pandemic. Other options became necessary. In addition, many controls had to be redesigned quickly, with little time for testing the adequacy of their design or the effectiveness of the implementation.

Now is the time for many audit committees to take a step back and look holistically at their banks’ control environments. In addition to system access, this overview should include controls governing the retention of sensitive data, timely execution of controls, coordination to resolve deficiencies and validation of secondary reviews.

In assessing such controls, committee members might be constrained by their limited understanding of the technology. Given the novel nature of today’s situation, audit committees should consider getting qualified technical assistance, independent of management, to evaluate the steps taken to accommodate the new work environment.

Strategic issues and board concerns
Both the risk committee and the full board should consider broader questions as well. At a strategic level, boards should explore whether management’s response to the pandemic is sustainable. In other words, should the new practices the bank established — including remote work arrangements — become permanent?

Bank management teams have issued many press releases recounting how successfully they responded to the crisis. As banks move into the post-pandemic world, board members should review these responses and ask whether the new practices will allow for growth and innovation so that their banks can thrive in the future while still maintaining a well-controlled work environment.

As they revisit documented policies, controls and procedures — and remeasure the associated risks — boards and management teams ultimately must decide whether the new control environment is consistent with the strategy of the bank and capable of sustaining its desired organizational culture.

Banking’s Vaccine Dilemma

David Findlay has witnessed several crises over his 37-year banking career, but he says the Covid-19 pandemic has been the most challenging — one that continues to redefine what it means to be a good employer.

“We took a very protective stance of our entire workforce,” says Findlay, the CEO of $6 billion Lakeland Financial Corp., based in Warsaw, Indiana. Lakeland’s subsidiary, Lake City Bank, has followed Centers for Disease Control and Prevention and health department guidance to sanitize branches, and closed lobbies as needed. Around one-third of employees worked remotely.

These early decisions were easy, Findlay adds. Encouraging employees to get vaccinated against Covid-19 has resulted in a new dilemma, due to “divisions between those [who] believe in the efficacy of the vaccine,” he says, “and those [who] don’t.”

Righting the economic ship has long hinged on successfully defeating the coronavirus through the development and broad adoption of one or — as came to pass — multiple vaccines. “Ultimately, the economic recovery depends on success in getting the pandemic under control, and vaccinations are critical to our ability to accomplish that,” Treasury Secretary Janet Yellen told the Senate Banking Committee in March.

Like all businesses, vaccinations allow banks to safely reopen branches and repatriate staff into offices. All three of the Covid-19 vaccines available in the U.S. are currently authorized for emergency use by the Federal Drug Administration; some Americans say they won’t get vaccinated until they receive full approval by the FDA.

In early May, Lakeland rolled out an organization-wide vaccination program, updating employees about Covid-19 cases, quarantines and vaccination efforts for the organization. Employees have had access to an on-site vaccination clinic, and the bank pays a $100 bonus to each vaccinated employee, with another $100 to the nonprofit of their choice.

The program was retroactive, so the roughly 40% of employees who were already fully vaccinated were rewarded, too. As of June 10, half of the bank’s employees reported that they had been vaccinated, which compares favorably to Indiana’s population, at 39%, and 30% for Lakeland’s home base in Kosciusko County.

We have made it clear that this is a personal choice and that we must all respect each other, regardless of [our] position on the vaccine,” says Findlay. “It has been a challenging 17 months, and we must all stick together so our culture can survive the pandemic.”

Carrots, not sticks, also drive the vaccination program at Pinnacle Financial Partners. “This is a personal decision, it’s a medical decision, so we don’t want to cross that line,” says Sarae Janes Lewis, director of associate and client experience at the $35 billion bank.

Pinnacle started communicating the benefits of the vaccine in December 2020 — around the time that the FDA first approved emergency use for the Pfizer and Moderna vaccines. It started its incentive program in March, after the vaccine became more broadly available. Employees get time off to get vaccinated — a half day per shot — and receive a $250 gift card to spend as they like. “We wanted to make the amount enough to incentivize people,” says Lewis, “but we didn’t want it to be so much that it felt like someone who had not made that decision yet would feel overly pressured.” Pinnacle includes a thank-you note with each gift card.

And they’re promoting the upsides of getting vaccinated. Vaccinated employees aren’t required to wear a mask, for example; those who haven’t yet gotten the vaccine are asked to mask up. Pinnacle isn’t policing its employees’ mask use.

When Lewis and I spoke, 64% of Pinnacle’s associates reported to the bank that they were fully vaccinated against Covid-19. That’s well ahead of the bank’s hometown of Nashville, at 44%, and home state of Tennessee, where roughly one-third of eligible individuals are fully vaccinated. An employee survey revealed that many of Pinnacle’s employees who are hesitant may reconsider once one or more of the vaccines receive full FDA approval. When that happens, Lewis says that the bank may ramp up communications again, and incentives will remain in place.

This high vaccination rate — and understanding the vaccination status of its employees — has helped Pinnacle reopen locations and get a little closer to normal operations. “If there does happen to be an exposure, we’re not having to close offices anymore,” Lewis says. “It’s been pretty amazing to have that stability.”

Lake City and Pinnacle both boast above-average vaccination rates compared to their communities, but they’re still below President Joe Biden’s goal for 70% of American adults to be partially or fully vaccinated by the Fourth of July. So, should banks help close this gap by requiring that employees get vaccinated?

Companies can do that, according to guidance from the Equal Employment Opportunity Commission that was updated in late May.

Adam Maier, a partner at the law firm Stinson LLP, believes banks like Pinnacle and Lake City, that focus on education and modest incentives, have the right approach. The EEOC guidance is “fraught with uncertainties,” he adds. “It’s such a tightrope to be walking to mandate vaccines and also make sure you’re not doing it on a discriminatory basis, or with a discriminatory outcome.” Companies still must comply with the Americans with Disabilities Act and Title VII of the Civil Rights Act, which prohibits discrimination based on race, color, religion, gender, pregnancy or national origin. Incentives also can’t be coercive.

Both Lake City and Pinnacle emphasize their respect for employee choice, and that appears to be a consistent theme for the industry. Bank of America Corp. CEO Brian Moynihan was asked in the company’s April shareholder call if the board would “commit to not coercing our employees into getting the COVID vaccine.” Moynihan responded that the bank emphasized communication and education — and the right for each employee to come to their own decision.

The megabank asks employees to update their vaccination status through an online portal. Requesting an employee’s vaccine status — confidentially — is clearly permitted by the guidance, Maier confirms.

“Whatever your approach is, just try to be respectful,” advises Maier. “Be reasonable and rational, and don’t get caught up in any individual employee’s decision.”

The Community Bank Advantage to Helping Small Businesses Recover

While the Covid-19 vaccination rollout is progressing steadily and several portions of the country are making steps toward reopening and establishing a new normal, it is still too early to gauge how many small businesses will survive the pandemic’s impacts.

In a 2020 study of small firms by McKinsey & Co., it was initially estimated between 1.4 million to 2.1 million of the country’s 31 million small businesses could fail because of the events experienced in 2020 and 2021. However, a more recent report from the Federal Reserve revealed that bankruptcies during 2020 were not as bad as originally feared — with around 200,000 more business failures than average. Simply put, the true impact of the pandemic’s interruptions cannot be known until later this year or even next.

A PwC study on bankruptcy activity across the broader business sectors reveals which industries were impacted the most. Of the bankruptcies in 2020 where total obligations exceeded $10 million, retail and consumer sectors led the way, followed by energy and real estate. Together, these three sectors accounted for 63% of all bankruptcies.

Reimagining Small Business Success
While a lack of revenue has been the most critical issue for small business owners, they are also suffering from other challenges like a lack of time and guidance. Business owners have faced tremendous pressure to meet local and national guidelines and restrictions around interacting with the public, many even having to transform their business models to reach customers remotely. Such burdens often leave business owners meeting operational needs during nights and weekends.

This creates a timely opportunity for community banks to better support business customers’ recovery from this period of economic stress. Financial instituions can provide anytime, anywhere access to their accounts and financial tools, more-effective cash flow management capabilities and personalized digital advisory services to meet evolving needs. These tailored services can be supported with personal digital support to revitalize the service and relationships that have always been a competitive advantage of community institutions.

Putting Humans at the Center
A 2021 study by Deloitte’s Doblin revealed five ways financial services firms can support their business customers post-pandemic, including demonstrate that they know the customer, help them save time, guide them with expertise, prepare them for the unexpected and share the same values. These findings provide insight into how business owners prefer to bank and what they look for in a bank partner. In fact, 62% of small businesses were most interested in receiving financial advice from their financial institutions.

The Doblin study goes on to explore the activities that institutions can engage in to better serve the small business marketplace. Top findings included enabling an easier lending journey, investing in innovative, digital-led initiatives and offering personalized, context-rich engagement. These areas have been priorities for community banks, and the pandemic has accelerated the timeline for adopting a strong digital strategy. Compared to competitors including national banks, digital banks and nontraditional players, community banks are uniquely positioned to help local businesses recover by combining digital solutions with services that center the human connections within the banking relationship.

As business owners look to finance their road to recovery, it’s been repeatedly shown that they prefer a relationship lender who understands their holistic financial picture and can connect them to the right products, rather than shopping around. Business owners want a trusted partner who uses technology to make things easy and convenient and is available to talk in their moments of need. The best financial technologies strengthen human connections during the process of fulfilling transactions. These technologies automate redundant tasks and streamline workflows to reduce the mundane and maximize the meaningful interactions. When done right, this strategy creates an enhanced borrower experience as well as happier, more productive bank employees.

There’s a clear sense that the events of 2020 and 2021 will permanently shape the delivery of financial services, as well as the expectations of small business owners. The year has been a crisis-induced stress test for how technology is used; more importantly, how that technology can be improved in the months and years ahead. The pandemic, as challenging and destructive at it has been, generated a significant opportunity to reimagine the future, including the ways bankers and small businesses interact. Those community institutions that take the lessons learned and find ways to build and maintain human relationships within digital channels will be well positioned to serve their communities and succeed.

Risk Practices For Today’s Economy

Organizations’ ability to strategically navigate change proved crucial during the Covid-19 pandemic, which required financial institutions to respond to a health and economic crisis. The resiliency of bank teams proved to be a silver lining in 2020, but banks can’t take their eye off the ball just yet.

Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP,  focuses on the key risks facing banks today and how the industry will emerge from the pandemic environment. In this video, Craig Sanders, a partner in the financial services practice at Moss Adams, shares his perspective and expertise on these issues.

  • Managing Credit Uncertainty
  • More Eyes on Business Continuity
  • Cybersecurity Today

A Lending Platform Prepared for Pandemic Pitfalls

Managing a loan portfolio requires meticulous review, careful documentation and multiple levels of signoff.

That can often mean tedious duplication and other labor-intensive tasks that tie up credit administration staffers. So, when Michael Bucher, chief credit officer at Lawton, Oklahoma-based Liberty National Bank, came across a demonstration of Teslar Software’s portfolio management system, he couldn’t believe it. The system effortlessly combined the most labor-intensive and duplicative processes of loan management, stored documents, tracked exceptions and generated reports that allowed loan and credit officers to chart trends across borrowers. The $738 million bank signed a contract at the end of 2019 and began implementation in February 2020.

That was fortuitous timing.

Teslar Software’s partnership with institutions like Liberty National, along with its efforts to assist banks and borrowers with applications for the Small Business Administration’s Paycheck Protection Program, earned it the top spot in the lending category in Bank Director’s 2021 Best of FinXTech Awards. Finalists included Numerated — a business loan platform that was another outperformer during the PPP rollout — and SavvyMoney, which helps banks and credit unions offer pre-qualified loans through their digital channels. You can read more about Bank Director’s awards methodology and judging panel here.

Prior to implementing Teslar Software, Liberty National used a standalone platform to track every time a loan didn’t meet the bank’s requirements. It was an adequate way to keep track of loan exceptions when the bank was smaller, but it left him wondering if it would serve the bank’s needs as it continued to grow. The old platform didn’t communicate with the bank’s Fiserv Premier core, which meant that when the bank booked a new loan, a staffer would need to manually input that information into the system. The bank employed one person full-time to keep the loan tracking system up-to-date, reconcile it with the core and upload any newly cleared exceptions on various loans.

Bucher says it was immediately apparent that Teslar Software offered efficiency gains. Its system can integrate with several major cores and is refreshed daily. It collects documentation that different areas within the bank, like commercial loan officers and credit administration staff, can access, allows the bank to set loan exceptions, clears them and finalizes the documentation so it can be imaged and stored in the correct location. Staffers that devoted an entire day to cumbersome reconciliation tasks now spend a few hours reviewing documentation.

Bucher was also impressed by the fintech’s approach to implementation and post-launch partnership. The bank is close enough to Teslar Software’s headquarters in Springdale, Arkansas, that founder and CEO Joe Ehrhardt participated in the bank’s implementation kickoff. Teslar Software’s team is comprised of former bankers who leveraged that familiarity in designing the user’s experience. Between February and June of 2020, the earliest months of the coronavirus pandemic, Teslar Software built the loan performance reports that Liberty National needed, and made sure the core and platform communicated correctly. Weekly calls ensured that implementation was on track and the reports populated the correct data.

Teslar Software’s platform went live at Liberty National in June — missing the bulk of the bank’s first-round PPP loan issuance. But Teslar Software partnered with Jill Castilla, CEO of Citizens Bank of Edmond, and tech entrepreneur and NBA Dallas Mavericks owner Mark Cuban to power a separate website called PPP.bank, a free, secure resource for multiple banks to serve PPP borrowers.

“Teslar Software came to the rescue when they provided their Paycheck Protection Program application tool to all community banks during a period of extreme uncertainty for small businesses due to the Covid-19 pandemic,” Castilla says in a statement to Bank Director. “The partnership we forged with them and Mark Cuban was a game changer for so many that were in distress.”

And Liberty National was able to use Teslar Software’s platform to create and process forgiveness applications for the 500 first-round PPP loans it made. Bucher says the forgiveness application platform is similar to the tax preparation software TurboTax — it breaks the complex application down into digestible sections and prompts borrowers to submit required documents to a secure portal. The bank needs only one employee to review these applications.

“We had such a good experience with the forgiveness side that for PPP in 2021, we partnered with them to handle the front end and the back end of PPP [application],” he says. “It’s now all centralized within Teslar so that when we move on to forgiveness, everything is going to be there. I’m expecting the next round of forgiveness to go a lot smoother than the previous round.”

Outside of PPP, Teslar Software has allowed Liberty National’s credit administration team to manage its current workload, even as staffing decreased from 10 people to six. Instead of taking a full day to review and verify loan exceptions, it takes only a few hours. Bucher says the bank is exploring an expanded relationship with the fintech to add additional workflow modules that would reduce duplication and eliminate the use of email to share documents.

Fraud Attempts on the Rise Since Pandemic’s Start

As Covid-19 passes its one year anniversary in the United States, businesses are still adjusting to the pandemic’s impacts on their industry.

Banking is no exception. While banks have quickly adjusted to new initiatives like the Small Business Administration’s Paycheck Protection Program, the most notable impact to financial institutions has been the demand for online capabilities. Banks needed to adjust their offerings to ensure they didn’t lose their client base.

“ATM activity is up, drive-through banking is up 10% to 20% and deposits made through our mobile app are up 40%,” said Dale Oberkfell, president and CFO of Midwest Bank Centre last June.

The shift to digital account openings has been drastic. The chart below looks at the percent change in cumulative number of evaluations from 2019 to 2020 for a cohort of Alloy customers, limited to organizations that were clients for both years. Since the onset of the pandemic, digital account opening has increased year-over-year by at least 25%.

Although the shift to digital was necessary to meet consumer demands, online banking opens up the possibility of new types of fraud. To study the pandemic’s impact on fraudulent applications, we took a closer look at changes in consumer risk scores since the onset of the pandemic. Similar to credit scores, risk scores predict the likelihood of identity or synthetic fraud based on discrepancies in information provided, behavioral characteristics and consortium data about past fraud activity.

Comparing the pandemic months of March 2020 to December 2020 to the same period in 2019, Alloy clients saw a dramatic rise in high-risk applications. Total high-risk applications increased by 137%, driven both by overall growth in digital application volume and a comparatively riskier population of applicants.

There are several ways for you to protect your organization against this growing threat. One way is to use multiple data sources to create a more holistic understanding of your applicants and identify risky behaviors. It also ensures that you are not falling victim to compromised data from any one source. It’s a universal best practice; Alloy customers use, on average, at least 4 data sources.

Another way for you to protect your institution is by using an identity decisioning platform to understand and report on trends in your customer’s application data. Many data providers will return the values that triggered higher fraud scores, such as email and device type. An identity decisioning platform can store that data for future reference. So, even if a risky application is approved at onboarding, you can continue to monitor it throughout its lifetime with you.

Digital banking adoption and usage is expected to only increase in the future. Banks need to ensure that their processes for online capabilities are continuously improving. If your organization is spending too much time running manual reviews or using an in-house technology, it may be time for an upgrade. Click here to see how an identity decisioning platform can improve your process and help you on-board more legitimate customers.

A New Look at Problem Loan Management

Regardless of how you describe 2020, change was the common theme.

Not only did the coronavirus pandemic and economic contaction in 2020 change the way the banking industy identifies problem loans, it changed the way it approaches them. As 2020 unfolded, CLA continued to encourage institutions to evaluate policies and procedures, given that most were written for normal operating environments. A problem loan is a credit that cannot be repaid according to the terms of the initial agreement, or in an otherwise acceptable manner. In a time when payment deferrals and modifications are numerous and widespread, and government-assisted credit is necessary, how does problem loans identification change?

Risk Identification
The first step in problem loan management (PLM) is an effective risk identification program, which includes proper monitoring and continually applying appropriate risk ratings. Management teams can use internal reviews performed periodically or annually to assist with early risk detection.

Monitoring
Frequent monitoring of the portfolio remains one of the critical pillars of PLM. This requires collecting updated financials and information to monitor the wherewithal of the borrower, guarantor and related entities on a standalone and combined basis. Increased monitoring is warranted, especially for vulnerable industries.

Resources
Who leads your bank’s PLM program? Many lenders have not been exposed to a PLM process, or have not been in the industry long enough to experience an economic downturn. The art of PLM involves objective parties, including a group independent of the loan officer, to manage the loans effectively.

Evaluation of performance
Financials for 2020 will include unusual items, and completing year-over-year comparisons will require eliminating “extraordinary” items. For example, removing funds received through the Small Business Administration’s Paycheck Protection Program will be essential to ascertain and review the performance of core operations. Banks will need to consider how a borrower’s core performance would have met the requirements of the original loan terms without modifications. It is pertinent to remove these items and evaluate how the borrower is functioning at its core.

Action plans
The routine nature of completing a quarterly problem loan action report deserves a new look. Banks of all sizes must address problem loans and develop plans to mitigate exposure. Action plans are a way for management to track and document each borrower’s circumstances and next steps to reduce credit risk exposure.

Problem Loan Action Plan Considerations

  • Borrower identification and history — Identify the obligor(s) (direct and indirect), ownership composition, type of business, underlying debt(s), and operational changes over the past few years or as a result of COVID-19.
  • Communication — If the borrower remains communicative, address commitments made, if any, and all legal correspondence.
  • Financial analysis — Update financial information with a look at historical trend on standalone and global basis and impact of COVID-19.
  • Repayment history — Review payment status, including any late payments or 30/60/90-day history. Discuss modifications.
  • Collateral valuation and analysis — Evaluate need for updated values given changes in market, property type, or other pertinent factors.
  • Risk rating — Consider current and recommended risk rating changes, if any.
  • Impairment analysis — Clearly document the analysis or testing for impairment to support quarterly Allowance for Loan and Lease Losses analysis.
  • Progress update — Address actionable items from the last review. Is workout plan effective?
  • Next steps — Detail steps the borrower and institution will take to improve the status of the loan. Establish clear and quantifiable objectives and timeframes for both parties and document results as the plan progresses.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.

CLA exists to create opportunities for our clients, our people, and our communities through our industry-focused wealth advisory, outsourcing, audit, tax, and consulting services. Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.

Strengthening Stress Tests After Covid-19

Banks below $50 billion in assets aren’t required to conduct an annual stress test, following regulatory relief passed by Congress in May 2018. But most banks still conduct one or more annual tests, according to Bank Director’s 2021 Risk Survey.

A stress test determines whether a bank would have adequate capital or liquidity to survive an adverse event, based on historical or hypothetical scenarios. Financial institutions found value in the practice through the Covid-19 pandemic and related economic events, which created significant uncertainty around credit — particularly around commercial real estate loans and loans made to the hospitality sector, which includes hotels and restaurants.

“It gives you a peace of mind that we are prepared for some pretty big disasters,” says Craig Dwight, chair and CEO at $5.9 billion Horizon Bancorp, based in Michigan City, Indiana. Horizon disclosed its stress test results in third quarter 2020 to reassure its investors, as well as regulators, customers and its communities, about the safety and soundness of the bank. “We were well-capitalized, even under two-times the worst-case scenario,” he says. “[T]hat was an important message to deliver.”

Horizon Bancorp has been stress testing for years now. The two-times worst case scenario he mentions refers to loss history data from the Office of the Comptroller of the Currency; the bank examines the worst losses in that data, and then doubles those losses in a separate analysis. Horizon also looks at its own loan loss history.

The bank includes other data sets, as well. Dwight’s a big fan of the national and Midwest leading indicators provided by the Federal Reserve Bank of Chicago; each of those include roughly 18 indicators. “It takes into consideration unemployment, bankruptcy trends, the money supply and the velocity of money,” he says.

It’s a credit to the widespread adoption of stress testing in the years following the financial crisis of 2008-09. “All the infrastructure’s in place, so [bank management teams] can turn on their thinking fairly quickly, and [they] aren’t disconnected [from] what’s happening in the world,” says Steve Turner, managing director at Empyrean Solutions, a technology provider focused on financial risk management.

However, Covid-19 revealed the deficiencies of an exercise that relies on historical data and economic models that didn’t have the unexpected — like a global pandemic — in mind. In response, 60% of survey respondents whose bank conducts an annual stress test say they’ve expanded the quantity and/or depth of economic scenarios examined in this analysis.

“We have tested pandemics, but we really haven’t tested a shutdown of the economy,” says Dwight. “This pandemic was unforeseen by us.”

Getting Granular
The specific pain points felt by the pandemic — which injured some industries and left others thriving — had banks getting more granular about their loan portfolios. This should continue, says Craig Sanders, a partner at Moss Adams LLP. Moss Adams sponsored Bank Director’s 2021 Risk Survey.

Sanders and Turner offer several suggestions of how to strengthen stress testing in the wake of the pandemic. “[D]issect the portfolio … and understand where the risks are based on lending type or lending category,” says Sanders. “It’s going to require the banks to partner a little more closely with their clients and understand their business, and be an advisor to them and apply some data analytics to the client’s business model.” How will shifting behaviors affect the viability of the business? How does the business need to adjust in response?

He recommends an annual analysis of the entire portfolio, but then stratifying it based on the level of risk. High risk areas should be examined more frequently. “You’re focusing that time, energy and capital on the higher-risk areas of the bank,” says Sanders.

The survey finds two-thirds of respondents concerned about overconcentrations in their bank’s loan portfolio, and 43% of respondents worried specifically about commercial real estate loan concentrations. This represents a sharp — but expected — increase from the prior year, which found 78% expressing no concerns about portfolio concentrations.

We’re still not out of the woods yet. Many companies are now discussing what their workplace looks like in the new environment, which could have them reducing office spaces to accommodate remote workers. If a bank’s client has a loan on an office space, which they then rent to other businesses, will they be able to fill the building with new tenants?

If this leads to defaults in 2021-22, then banks need to understand the value of any loan collateral, says Sanders. “Is the collateral still worth what we think it was worth when we wrote the loan?”

It’s hard to predict the future, but Sanders says executives and boards need to evaluate and discuss other long-term effects of the pandemic on the loan portfolio. Today’s underlying issues may rise to the surface in the next couple of years.

Knowing What Will Break Your Bank
Stress testing doesn’t tend to focus on low-probability events — like the pandemic, which (we hope) will prove to be a once-in-a-lifetime occurrence. Turners says bank leaders need to bring a broader, more strategic focus to events that could “break” their bank. That could have been the pandemic, without the passage of government support like the CARES Act.

It’s a practice called reverse stress testing.

Reverse stress testing helps to explore so-called ‘break the bank’ situations, allowing a banking organization to set aside the issue of estimating the likelihood of severe events and to focus more on what kinds of events could threaten the viability of the banking organization,” according to guidance issued by the Federal Reserve, Federal Deposit Insurance Corp. and OCC in 2012. The practice “helps a banking organization evaluate the combined effect of several types of extreme events and circumstances that might threaten the survival of the banking organization, even if in isolation each of the effects might be manageable.”

Statistical models that rely on historical norms are less useful in an unforeseen event, says Turner. “[I]f someone told you in February of 2020 that you should be running a stress test where the entire economy shuts down, you’d say, ‘Nah!’” he says. “What are the events, what are the scenarios that could happen that will break me? And that way I don’t have to rely on my statistical models to explore that space.”

Testing for black swan events that are rare but can have devastating consequences adds another layer to a bank’s stress testing approach, says Turner. These discussions deal in hypotheticals, but they should be data driven. And they shouldn’t replace statistical modeling around the impact of more statistically normal events on the balance sheet. “It’s not, ‘what do we replace,’” says Turner, “but, ‘what do we add?’”

With stress testing, less isn’t more. “My advice is to run multiple scenarios, not just one stress test. For me, it’s gotta be the worst-case stress test,” says Dwight. And stress testing can’t simply check a box. “Can you sleep at night with that worst case scenario, or do you have a plan?”

Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP, 188 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $50 billion in assets. The survey was conducted in January 2021, and focuses on the key risks facing the industry today and how banks will emerge from the pandemic environment.

Bank Director has published several recent articles and videos about stress testing, including an Online Training Series unit on stress testing. You may also consider reading “Recalibrating Bank Stress Tests to a New Reality.”