How Smaller Banks Can Prepare for Climate-Related Credit Risks

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In 2021 and 2022, the nation’s financial regulators began sharing their future expectations for banks related to the growing concern of climate risk.

Their particular emphasis is focused on the impact of climate change on an institution’s credit risk. While the near-term direct impact is limited to the country’s largest institutions for now, there is an understanding that it’s only a matter of time until smaller banks will have to address similar regulatory expectations.

What can, and should, bankers at smaller banks be doing about climate risk in their portfolios? How can they prepare for future regulatory expectations? What information do they need to track?

Bank credit risk managers can start with understanding what types and levels of climate risk they have in their portfolios now, and how to track that going forward. It’s crucial they establish a baseline of their risk appetites and thresholds when looking at emerging risks.

Banking agencies are looking at rules intended to disclose how larger banks and other firms are incorporating climate risks into their risk management and overall business framework and strategies. That includes physical risks, such as the risk of financial losses from serious weather events like hurricanes and wildfires, and transition risk that come from shifting to a low-carbon economy and creating so-called “orphaned assets.”

To understanding a bank’s credit and risk exposure to climate sensitive and carbon sensitive assets, credit managers need to start with identifying, flagging and reporting on loans that are either in geographical areas that are more likely to be impacted by physical climate risks and those that are made to higher carbon industries representing potential transition risk.

How To Use Climate Information to Manage Climate Risk
Can smaller banks apply similar methods to manage their climate credit risk that they’ve used for previously identified emerging risks? Could a bank apply similar approaches it used for commercial real estate and Covid-19 concentrations to identify and track climate concentrations in a loan portfolio to get an overall view of the climate-related credit risk?

A banker could use standard industry codes, also called NAICS Codes, to identify high carbon business or industry concentrations and exposures. Some examples include coal, oil, mining, refining and supporting industries like trucking, drilling and refining, for a few examples.

To address acute climate physical risk a banker could look at using CRE property types like hotels, offices or multifamily for loans in riskier geographic areas like shore and waterways, as well as locations more prone to climate incidents like hurricane, wildfire and floods. There are a few different geo-location codes that can be leveraged for this type of concentration tracking: zip codes, counties, cities or MSA codes.

An example of a bank trying to get ahead of coding for climate is $36.6 billion BankUnited N.A., a regional bank headquartered in Miami Lakes, Florida. The bank’s third line of defense assurance group, credit review, wanted to begin broadly identifying climate exposure and climate related borrowers in their portfolios, to advance the consideration of climate impact from a credit perspective.

In 2022, they started by tagging any borrower reviewed by credit review within routine examinations focused on assessing risk grading and underwriting as “carbon sensitive.” The identification is subjective and is based on matters such as the loan borrower’s industry, business operations, inputs or by-products, location and collateral type and related potential repayment risk. Based on those data points, their analyst makes an assessment as to whether or not to tag the loan as “carbon sensitive.” An example would be a borrower with significant dependence on waterways that are currently experiencing profound and ongoing drought. They report the results at the examination level, as well as on a consolidated basis to management and the second line of defense.

Currently, there remains no plans for near-term regulatory requirements related to climate change or carbon sensitivity reporting or tracking for community banks. Regulators are only considering the largest banks for rules around climate asset management, climate risk management frameworks and policies.

But risk management techniques are always evolving. Forward-looking risk managers at banks of all sizes will want to continue momentum in 2023, to look forward and create a data-driven climate credit risk management program as tools improve and regulations and industry best practices mature. For now, directionally correct views of climate credit risk can potentially be a strategic risk management advantage for even the smallest bank.

Combating Complacency Through Strategic and Operational Planning

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For many banks, 2020 and 2021 had surprising results. Liquidity and capital were strong, loan growth escalated from pent-up demand and income levels were favorable.

These positive trends could lead many management teams to become complacent — which can lead to risk. In its 2022 Fiscal Year Bank Supervision Operating Plan, the Office of the Comptroller of the Currency (OCC) listed guarding against complacency as a top priority for examiners. Complacency, by definition, is a state where one’s satisfaction with their own achievements leads them to be unaware of potential danger. Heeding the OCC’s warning to address indications or perceptions of emerging risks, we’ve identified five focus areas for boards and management teams.

1. Strategic and Operational Planning
Executives and boards should evaluate strategic planning in the context of the current environment. Post-pandemic, banks have increased opportunities for growth including, but not limited to, mergers and acquisitions. The key to strategic planning is to be strategic. Shape your strategic planning sessions to consider new industry opportunities and threats. Approach each opportunity and threat methodically — whether succession planning, mergers or acquisitions, fintech partnerships, changing demographics, the shift in the regulatory perimeter or another area relevant to your institution.

Operational planning is just as critical. Crafting a well-established plan to profitably service your bank’s target markets remains a balancing act of priorities for directors. Consider new products and services to meet the needs and expectations of your evolving customer base. Thoughtfully evaluate your bank’s target market, planned growth, the potential for enhanced products and services and any prospective investments to maintain profitability. Allow talent, technology, and financial resource risk assessments to guide your institution’s operational planning process, asking, “Where is my bank growing and am I ready?”

2. Credit Risk
We continually hear about the great credit quality that banks have experienced thus far in the post-pandemic period. Yet, credit risk remains a critical priority for banks and regulators, especially since coronavirus relief funds may have dramatically changed the financial view for borrowers.

Covid-19 relief funds served a temporary purpose of keeping businesses operating during the peak of the pandemic. However, high levels of inflation and continuing labor and supply chain disruptions has put continued pressure on many small businesses and may have a yet-to-be-realized impact on the credit quality within your bank.

Now more than ever, remaining engaged with your borrowers and looking past traditional credit metrics to identify issues could reduce future losses for your financial institution. Credit risk monitoring tools like stress testing remain relevant with the prospective of rising interest rates.

3. Cybersecurity Risk
Cybersecurity risk, like credit risk, is here to stay. Executives must stay focused in this area as risks increase; the instances of public attacks across all industries reflect a relentless pursuit by cybercriminals to steal data for financial gain. The most recent reminder of this are Russian state-sponsored cyber threats. As banks gather and maintain more and more data, it’s paramount to have experienced talent and protocols for protection of customer data.

Bank management teams should be able to show evidence of their institution’s capability to respond or recover from destructive cyberattacks that are increasingly routine. The bank’s risk assessment process is a critical component of managing its cybersecurity risk, and should incorporate any processes or controls that may have changed as result of a new strategic or operational plan.

4. Compliance Risk
Compliance matters are always evolving, and regulatory emphasis on applicable laws and regulations is only increasing. The focus on Bank Secrecy Act and anti-money laundering rules, fair lending, Community Reinvestment Act and overall prioritization of compliance management are not shifting.

Compliance risk management requires banks to have a strong internal system. It also requires a deep understanding of the various rules and proficiency in identifying, implementing and auditing the changes. It has never been more critical for banks to have strong independent review systems to account for updated rules and regulations.

5. Management and Board Education
The operational and strategic landscape of banking is changing. Management team and board members must be informed and educated. As you decide how your bank will adjust to this new environment, identify industry-specific third parties to meet with your management team and board to provide a strong foundation to strategic planning.

We see numerous opportunities and areas of focus for banks in 2022. If we’ve learned anything during this time, it’s that banks need to look at risk differently in this ever-changing environment. Now is not the time to be complacent.

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. Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.

New Synergies in Risk Management for 2022

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The past two years have created massive, life changing challenges for just about everyone on the planet — and bank managers and board members are certainly no exception. While the public has been dealing with the Covid-19 nightmare, remote work challenges, child and elder care woes, and concerns about family physical and mental health, bank leadership has had to deal with increased internal risks (operational, cyber, staffing) and external ones (rapid market changes, stressed industries, and a lack of traditional financial measurements, since many businesses did not produce audited financial statements during much of 2020).

As we enter 2022, no one knows for certain how, or if, all of those daunting issues will be resolved. In recent statements, the banking regulatory agencies are suggesting cautious optimism in 2022, though they are wary of complacency and loosening credit underwriting standards. One of the key forces that drive innovation and change in the world is a crisis, and if nothing else, 2020 and 2021 have seen rapid change and massive innovation, including in banking. With this backdrop, let’s look at some of the related developments and some new trends in credit risk management that will likely take place in 2022.

One significant industry change preceded Covid, and that was another acronym that started with a “C,” which was CECL. The story behind the current expected credit losses accounting standard is long and tedious — but a by-product of that rule for most bankers was a newfound understanding of the value of their portfolio’s credit data and how that data ties directly to reserves, risk and profitability. Thanks to CECL’s requirement for vast amounts of historical data, including credit attributes like collateral types, delinquency, payments and segmentation, many banks invested a lot of time and resource gathering, inventorying and cleaning up their credit data for CECL compliance. A result of this activity was that like never before more banks have more information about their loan portfolios, borrowers and their historical and current behavior.

During the time that CECL implementations started, Covid hit and bank managers were challenged with remote work requirements along with addressing PPP and other fast-moving emergency credit programs — creating a need for innovation and automation. Many areas of the bank were suddenly faced with new processes, operations and technology tools that were unplanned. A result of this accelerated change was that areas like commercial lending, credit and loan review were forced to adopt new innovative ways to work. While some of these areas may return to “the old normal,” many will retain most, if not all, of the new improved processes and tools that were needed to survive the challenges of the Covid crisis.

Those two developments, along with a growing understanding of the importance of credit concentration management, are driving new opportunities and synergies in credit risk management in 2022. The concept of credit concentration management is not a new one in banking. Even before the Great Recession of 2007-2009, the agencies made it clear that concentrations could be “bank killers,” with subprime lending and investor-owned commercial real estate (CRE) clear priorities. But now, the combination of more readily available, relevant credit concentration data and new tools and automation have made it significantly easier for banks of all sizes to proactively manage their concentrations.

A very obvious but valuable case study on the importance of concentration management is going on right now at the start of 2022 within the retail, office and the hospitality industry segments. Suddenly understanding exposure to these industries and property type segments is a high priority. Unlike the past, this time banks are much better positioned with improved data, tools and a more automated approach. The next use case to look at in 2022 is portfolio concentrations based on exposure to acute environmental threats like forest fires, hurricanes and flooding. That will likely be an early first step as more banks incorporate the environmental, social and governance framework into their risk management programs.

Another often neglected, proactive credit risk management process that has gotten a lot more attention during the past two years is portfolio stress testing, or “shocking segments of the portfolio.” This practice was used widely in banking during the end of the Great Recession to effectively monitor CRE risk, but by 2015, most smaller banks performed only annual tests, most of which were not looked at as having much, if any, strategic value. Part of the issue was that the banks simply weren’t collecting enough credit data to perform meaningful testing, and there was a sense that money for stress testing tools could be better spent elsewhere.

Now with additional risk management tools and better data, stressing concentrations simply makes sense and is achievable for most banks. New stress testing programs for concentrations like restaurants and business hotels are the norm, while more comprehensive, and strategic programs are starting to be put in place in banks of all sizes.

As we look back at the years of the Covid crisis, it is only natural to think of the disruption, challenges and uncertainty that banks faced, some of which are still being faced today. But thanks to the forces that drove the challenges in 2020 and 2021, bankers rapidly embraced automation and performed proactive credit data management leveraging innovative practices. Banks need to seize those opportunities and continue to enhance their risk management processes, not letting those benefits pass them by. A 2022 with this more synergistic approach to credit risk management may make the future a little bit brighter for bank management.

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.

Pivoting to Offense to Endure the Covid-19 Economy

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Banks must plan for the economic conditions looming on the other side of Covid-19.

Banks must simultaneously figure out how to weather the public health crisis and serve their clients in almost entirely remote environments while preserving their financial health for months of economic uncertainty. The depth and longevity of this crisis requires banks to strategically reassess the immediate negative impacts, project probabilities of further disruption and re-engineer their delivery models.

We believe that the banks that take bold and decisive action around these key issues will emerge from this period with more-durable relationships, greater agility and resilience, steeper market growth and better profitability compared to their peers. Banks should prioritize a set of five stabilizing actions that will set the stage for resilience in any potential downturn. 

Help Customers Confront the Crisis
Adversity contains implicit opportunity for customer outreach. Banks should contact customers to communicate that their bank is open and available for support. They should devise strategic outreach programs to solidify customer confidence and build long-term relationships.

Banks should then immediately focus on helping customers find ways to ease cash flow constraints and shortfalls in working capital and liquidity reserves. They should consider relief programs and creative, beneficial adjustments to loan structures such as permitting deferred payments, interest-only payments, re-amortizing payments or waiving select fees. Aligning their clients’ new needs with bank solutions and products will establish a foundation for post-crisis revenue growth.

Surgical Expense Reductions
Often, the immediate reaction during economic turmoil is to cut staff without strategic approach. While this can lower costs by the next financial period, this approach fails to strategically position the bank for post-downturn recovery and risks misaligned skill-sets or understaffing.

We recommend that banks understand which levers can be strategically pulled to quickly reduce costs. These levers range from identifying and evaluating paper-based processes, robotic process automation and aligning operations and personnel to the revised sales volume estimates. There are significant cost savings available even in credit risk management — simply by optimizing credit processes and better leveraging data.

Credit Risk Management Tailored to the Crisis
Banks had no visibility into the recession, and must assess not only the immediate impact on borrower financial and implied repayment performances but also the delayed impact on various segments of the economy. Ensure your risk management strategy reflects the new credit reality:

  • Consider proactively managing the portfolio renewal cycle by implementing mass short-term extensions on lines of credit, re-evaluating credit policy exception limits and increasing monitoring through frequently conversations with borrowers.
  • Leverage data to scale the identification of emerging portfolio risk and related triggers.
  • Consider creating a Covid-19 financial health assessment to facilitate financial relief and to identify potential credit downgrades.
  • Assess industry-based impacts on your portfolio to predict deteriorating credits in order to right-size loan loss reserves. 
  • Increase the frequency and detail of credit monitoring procedures for sectors that have been immediately impacted and those that will be impacted in the near term.

Align Resources with Client Need
Changes in spending will impact the creditworthiness of many loan applicants, so banks must take a hard look at realistic expectations for new business goals in 2020 and 2021. Realign banker-relationship manager priorities and shift from new business development with prospective customers to selling deeper into the existing portfolio, where possible. Client engagement will enable banks to manage risk while providing the client with much-needed attention, solutions and assistance. 

It will also be critical to scale up certain operational functions quickly to meet shifting client demand. Realigning  branch staff to handle call center volume and line resources to assist with spiking credit action volumes allow you to redeploy and scale your workforce to the new reality.

Create a Balanced Remote Workplace Strategy
Banks must leverage all available tools not just to maintain, but further, customer relationships and generate new business activity where possible. Empower customers to make deposits digitally by providing remote deposit capture hardware and services and consider waiving a portion of RDC equipment or service fees for a trial period.

Proactively run and distribute bank statement reports through digitally secure methods, rather than requiring customers to create and distribute these reports. Collaborate with bank customers to send check payable files to the bank for check printing and distribution.

We believe a bank’s actions in the next 90 days are vital to the survival, sustainability and long-term positioning for regrowth. Responding to customers with needed outreach sets the stage for new levels of customer loyalty. Shifting the bank’s focus inward toward operations with a keen focus on streamlining processes, proactively changing procedures and aligning the right people to the right tasks will ultimately lead to both a sustained and improved financial ecosystem.

Directors’ Defense Against the Pandemic Impact on Credit

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Bank directors and management teams must prepare themselves and their institution for the potential for an economic crisis due to the COVID-19 outbreak.

This preparation process is different than how they would manage credit issues in more traditional economic downturns; traditional credit risk management tools and techniques may not apply or be as effective. Directors and others in bank management may need to consider new alternatives and act quickly and deliberately if they are going to be successful during this very difficult time.

The traditional three lines of defense against quickly elevating credit risk may not work to prevent the credit impact of the new coronavirus and its consequences. The “horse is out of the barn” and no existing, normal risk management system can prevent some level of losses. This pandemic is the proverbial black swan.

The real questions now are how can banks prepare to deal with the related issues and problems?

Some institutions are likely to be better prepared, including those with:

  • A strong capital base.
  • Good, conservative allowance reserve levels.
  • Realistic credit risk assessments and portfolio ratings prior to the pandemic.
  • Are poised to take part in a potential acquisition.
  • A good strategic approach that is not materially swayed by quarterly earning pressures.
  • A management and board that “tells it like it is” and is realistic.
  • Good relationship with regulators, CPA firms, professionals and investors.

What are a bank’s options when trying to assess and manage the pandemic’s impact?

  • Deny the problem and kick the can down the road.
  • Wait for the government and regulators to provide solutions or a playbook for the problems.
  • Sell the bank — most likely at a big discount if at all.
  • Liquidate the bank, likely only after expending capital, with assistance from the Federal Deposit Insurance Corp.
  • Be proactive and put in place processes to deal with the problem and consequences.

There are some steps a bank can take to be proactive:

  • Identify emerging and potential problems and the options to handle them, and then create a plan that is strategic, operational and provides the best financial result.
  • Commit to doing what’s right for the bank, its employees, customers and community.
  • Enhance or replace the current credit risk management system with a robust identification, measurement, monitoring, control and reporting program.
  • Adopt an “all hands-on deck” to improve focus and deal with material issues in a priority order, deferring things that do not move the needle.
  • Assess internal resources and consider moving qualified personnel into areas that require more focus.
  • Seek outside professional assistance, if needed, such as loan workout or portfolio analysis and planning.
  • Perform targeted reviews of portfolio segments that are or may become challenged because of the pandemic and potential fallout, along with others may have had weaker risk profiles before the pandemic.
  • Communicate the issues such as the magnitude of the financial challenge to employees, the market, regulators, CPAs and other professionals who provide risk management services to your bank.
  • Deal with problems head-on and decisively to maintain credibility and respect from various constituencies while achieving a superior result.

It is best for everyone in the bank to work together and act quickly, thoughtfully, honestly and strategically. There will, of course, be some expected and understood need in the short term for increases in allowance provisioning. If planning and actions are executed well, the long-term results will improve the bank’s performance and enhance its credibility with the market, regulators and all other professionals. Just as valuable as an outcome is that your bank’s reputation will be enhanced with your employees, who will be proud to have been part of the effort during these difficult times.

Understanding New and Emerging Credit Risks

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The crisis may be over, but the challenges of managing credit risk in a low interest rate environment and increasingly competitive marketplace are not. Traditional credit metrics improved significantly in 2013, including net charge offs and the allowance for loan losses. Similarly, the federal banking system set a new record level of net income in 2013. So, shouldn’t boards of directors be able to breathe a sigh of relief, knowing that their credit risk management systems have worked? Why then, do regulators, such as the Office of the Comptroller of the Currency, see signs of increasing credit risk and warn examiners to focus on underwriting standards, new product plans and risk management systems? David Shaw, director, Credit Risk Management Services at WeiserMazars LLP, discusses new credit risk concerns, the forces driving them and the need for enhanced risk management programs.

What are some of the factors in today’s banking environment causing increased credit risk?
In essence, banks feel a need to increase revenues and interest income in the face of a continuing low interest rate environment and an increasingly competitive marketplace. For larger institutions, this means competing first on price, then offering longer terms and eventually relaxing covenants for commercial loans. Community banks are also becoming more involved in the highly active commercial and industrial (C&I) loans market because many of them are seeking to diversify loan portfolios away from commercial real estate by adding other, less familiar loan types.

What are some of the signs or signals that have caught the attention of examiners and loan review providers?
Some banks are loosening underwriting standards, as evidenced by increases in exceptions to policies, including extending loan terms, excluding or weakening loan guarantees, increasing collateral advance rates, loosening reporting requirements, and offering fewer and less stringent covenants (sometimes known as covenant lite). Regulators are also reviewing new product offerings because they increase credit risk, either because the bank may not have experience with the offering or may not have considered its full impact on the bank’s risk profile.

Are there other signs that WeiserMazars has seen?
Yes, particularly in the community banking sector, there has been increased C&I lending, most notably commercial lines of credit supported by working capital assets. Of particular concern is the fact that many institutions have not recognized or adopted new policies, procedures, underwriting standards and monitoring systems for these types of loans. For example, many institutions continue to use EBITDA (earnings before interest, taxes, depreciation and amortization) as the sole measure of cash flow, ignoring the balance sheet and cash flow from operations, as if they were doing a commercial real estate loan. It is important to analyze periodic accounts receivable. Additional concerns include the level of experience of loan officers and the added resources and infrastructure needed to adequately monitor these loans.

What are the roles and responsibilities of directors to oversee these issues?
First, boards need to understand that new or expanded product lines add to strategic risk as well as credit risk. As a strategic decision, expansion of product lines will impact other areas of the bank, including capital requirements and ratios, risk thresholds, provisioning and the allowance for loan losses, as well as create a need for different and unfamiliar forms of stress testing. Second, boards need to ensure that the bank’s technology and staffing are adequate, and determine whether additional investments will need to be made in these areas. Finally, boards need to examine and understand any revisions to commercial underwriting policies and procedures, and track their impact on volume and credit quality metrics.

Should banks consider outsourcing some of the processes and administrative functions?
Banks can consider outside resources to draft or review new or revised underwriting standards and policies. A loan review firm or other consultants can review the underwriting documents to assess the analysis and compliance with policies. There are also outside firms that can perform the back-office functions of ongoing monitoring of commercial loans.