Loan Review Best Practices: Key to Combatting Credit Risk

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Despite current benign credit metrics, there’s a growing industry-wide sentiment that credit stress looms ahead.

There’s a proven correlation between early detection of emerging credit risk and reduced losses. Effective and efficient loan reviews can help your institution better understand the portfolio and identify potential risk exposures. Now is the time for banks to ensure their loan review, either in-house or external, can proactively identify potential credit weaknesses, gain deep knowledge about the subsegments of the portfolio, learn where the vulnerabilities exist and act to mitigate risk at the earliest opportunity. It’s time to emulate a whole new set of loan review best practices:

1. Trust your reviews to professionals with deep credit experience — not just junior CPAs.
Your reviewers should be seasoned experts that are skilled in the qualitative and quantitative axioms of credit, with hands-on experience in lending and risk management. Because their experience will drive better reviews and deliverables, it’s a good idea to ask for biographies of people assigned to your institution.

2. Confirm your review includes paralegal professionals to conduct separate documentation reviews.
It is essential that your loan reviews include specialists with technical expertise in regulatory and legal compliance, lending policy adherence, policies, collateral conveyances, servicing rules, among others — working in tandem with seasoned credit professionals.

3. Insist on smart, informed sampling.
To uncover vulnerabilities in specific segments of the portfolio, rely on a selection process that helps you choose very informed samples indicating possible emerging risk.

4. Quantify both pre- and cleared documentation, credit and policy exceptions.
In the best of times, many loan reviews show almost no bottom-line degradation in loan quality for the portfolio as a whole. On close examination, you may find significant numbers of technical and credit exceptions indicating that the quality of your lending process itself may need to be tweaked.

5. Understand your own bank’s DNA.
In this complex economic environment, it is imperative for institutions to analyze their own idiosyncratic loan data. Arm your loan review team with the ability to automatically drill down into the portfolio and easily examine trends and borrower types to inform risk gradings, assess industry and concentration risk, along with other variables. Seasoned reviewers will be incredibly valuable in this area.

6. Observe pricing based on risk grades, collateral valuations and loan vintages.
Loans originating around the same time and credits that tend to migrate as a group tend to share common risk characteristics. Isolating and analyzing those credits can answer the important question, “Are you being paid for the risk you’re taking?”

7. Pair loan reviews with companion stress testing.
Regulators are encouraging stress tests as a way for banks to learn where their risk may be embedded. Companioning the tests with loan reviews is a productive way to gain this knowledge. Start at the portfolio level and do loan-level tests where indicated.

8. Transparently report and clear exceptions in real time.
Banks can benefit from using fintech’s efficiency to remove huge amounts of time, team meetings and staff intrusions from the traditional process of reviewing loans. An online loan review solution gives teams a way to see exception activities and clearances as they happen.

9. Comply with workout plan requirements prescribed by interagency regulators.
Banks typically design workout plans to rehabilitate a troubled credit or to maximize the collected repayment. Regulators now require institutions to examine these plans independently as a standard loan review procedure that reflects a healthy degree of objectivity.

10. Deliver comprehensive management reports and appropriate high-level board reports with public/peer data.
Management should receive prompt and thorough loan review reports; board members should receive high-level reports with appropriate, but less detailed, information. Public data or analyses of your institution’s performance as compared to peers should accompany this reporting.

11. Conduct loan reviews as a highly collaborative and consultative exercise — counter to “just another audit.”
An effective loan review is not an internal audit experience. It’s an advisory process, and this approach is extremely important to its ultimate success. Substantive dialogue among participants with differences of opinion is key to favorable outcomes for the institution.

12. Take advantage of a technology platform to automate every possible aspect of the loan review process.
Best practices call for the efficiency that comes with automating the loan review process to the maximum extent possible, without sacrificing substance or quality. Technology enables faster and more complete early detection of vulnerabilities.

Loan reviews are critical to an institution’s risk-management strategy. It’s a one-two punch: Deeply qualified reviewers combined with automated technology that delivers a more efficient, less intrusive loan review process that will help combat the looming credit stress ahead.

Managing Credit Risk Without Overburdening Resources

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Increased labor costs and related challenges such as talent acquisition have affected all industries, including banks. Additionally, banks are facing potential deteriorating credit quality, growth challenges amid tightening credit standards and increased scrutiny from regulators and auditors.

Loan origination, portfolio management and credit quality reviews are key areas to successfully managing increasing credit risk. It’s critical that banks understand their risk appetite and credit risk profile prior to making any changes in these areas. You should also discuss any material changes you plan to implement with your regulatory agencies and board, to ensure these changes don’t create undue risks.

Lending
Originating new loans doesn’t have to be cumbersome and complex for both the bank and the client. The risk and rewards are a delicate balancing act. And not all loans require the same level of due diligence or documentation.

Banks might want to consider establishing minimum loan documentation requirements and underwriting parameters based on loan amounts. This can put them at a competitive advantage compared to financial institutions requiring more documentation that can increase the loan processing time.

Centralizing the loan origination process for less complex and smaller loan amounts can streamline the workflow, potentially helping with consistency and efficiency and allow less-experienced staff to process loans.

Automation may be useful if your bank has a high volume of loan origination requests. The board should consider conducting, or hiring a consultant to complete, a cost-benefit analysis that could consider automating various aspects of the underwriting process. You may find automation is not only cost effective but might reduce human errors and improve consistency in credit decisions.

Portfolio Management
Ongoing management of the loan portfolio also doesn’t have to be time consuming. Not all loans are created equal or create equal risk for the bank; ongoing management should correspond to the risk of the loan portfolio. Consider evaluating the frequency of the internal loan reviews based on various risk attributes, including risk ratings, loan amounts and other financial and non-financial factors.

Internal Credit Reviews
An annual internal credit review might be all that’s necessary for loans that have lower risk attributes, such as small-dollar loans, loans secured by readily liquid collateral and loans with strong risk ratings. Banks should instead conduct more-frequent internal reviews on larger loans, loans in higher-risk industries, highly leveraged loans, marginal performing loans and adversely risk rated loans.

When completing frequent reviews, focus on key ratios relevant to the borrower and monitor and identify financial trends. An internal review doesn’t necessarily require the same level of analysis as an annual review or effort performed at loan origination.

Payment performance or bulk risk rating could be an alternative for banks that have a high volume of small-dollar loans. These types of loans are low risk, monitored through frequent reporting that uses payment performance and require minimal oversight.

Finally, centralizing the portfolio management might be appropriate choice for a bank and can create efficiencies, consistencies in evaluation and reduce overhead expenses.

Credit Quality Reviews
From small borrowers to national corporate clients, there are many creative ways that banks can achieve loan coverage in credit quality reviews while retaining the ability to identify systemic risks.

Banks can accomplish this through a risk-based sampling methodology. Rather than selecting a single risk attribute or a random sample within the loan population, you may be able to get the same portfolio coverage and identify risks with the following selection process. Focus on selecting credits that have multiple risk attributes, such as:

  • Borrowers with large loan commitments, high line usage, unsecured or high loan-to-value, adversely risk rated and high-risk industries.
  • Select credits with a mix of newly originated and existing loans, new underwriters and relationship managers, various loan commitment sizes and property types and collateral.

Consider credits within the Pass range that may have marginal debt service coverage ratios — typically the most common multiple risk attributes for identifying risk rating discrepancies — or are highly leveraged, unsecured or lack guarantor support.

Targeted Review
More targeted reviews can offer banks additional portfolio coverage. These types of reviews require less time to complete, giving institutions the ability to also identify systemic trends. Below are some things to consider when selecting a targeted review.

  • Select a sample of loans with multiple risk attributes and confirm the risk ratings by reviewing the credit write-up for supporting evidence and analysis.
  • Complete a targeted review of issues identified in the previous risk-based sampling reviews.

Finally, for banks that have recently acquired a loan portfolio, review the two banks’ credit policies and procedures and determine where the are differences. Select loans that are outliers or don’t meet the acquirer’s loan risk appetite.

Modernizing Business Lending to Drive Growth

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Digitization has altered the business lending landscape and created competitive pressure that will continue to push solutions modernization — and consumers and businesses are ready.

Digital efficiency here is key and underpins lending success. Most importantly, it improves consumer retention, upsell, and cross-sell opportunities for lenders. As the future of business lending caters to the needs of younger entrepreneurs, financial institutions will want to add solutions that offer seamless experiences. This includes a fully contactless digital lending process: seamless digital applications all the way to fast, automated loan decisions. Financial institutions can jump-start and grow digital business lending by implementing advanced technology solutions to digitally engage borrowers and optimize lending processes.

Digital-First Mindset Drives Growth
Millennials are the largest drivers of new loans. This makes sense considering there were more than 166 million individuals under the age of 40 in the U.S. in 2020 — more than half of the U.S. population.

Financial institutions are feeling the pressure all around. Digital banking reigns supreme as consumers increasingly prefer to manage their finances digitally and loyalty is waning. Institutions need to offer innovate lending solutions and reconsider how they engage consumers. Already, digital-savvy financial institutions are scooping up this business. According to the Bain Retail Banking NPS Survey, 54% of loans and 50% of credit cards in the U.S are opened at providers that consumers do not consider their primary financial institution. And more than three-quarters of those surveyed who received a direct offer from a competitive institution said they would have purchased from their primary institution had they received a similar offer.

As more and more lenders provide digital-first experiences, consumer expectations have evolved. Processes that used to take days can now happen in minutes. Technology has decreased the operational effort required of financial institutions and enables demand creation, so institutions can reach new consumers and foster deeper relationships with existing ones.

Pressure to Modernize Business Lending Solutions
Institutions that have not modernized business lending processes are feeling the pressure. Those that still rely on manual and paper-based loan approval procedures find they are out of step with a digitized world, affected by:

  • Slower decision times.
  • Burdensome data management.
  • Time-intensive manual processes that span disparate systems.
  • Inefficient application processes and communications with the borrower.
  • Expensive wet signatures.
  • Difficult document collection, management and storage.

The cumulative effects of these inefficiencies are compounded by the evolving landscape in lending. Nearly nine in 10 financial institutions believe they will lose some business to stand-alone fintech companies over the next five years. That fear is not unfounded.

Managing Credit Risk in a New Era
The business credit framework has not changed. Lenders still consider credit profile and history, firmographics and cash flow analytics when evaluating debt capacity. This requires the ability to collect and analyze data like macroeconomic factors, industry trends, digital presence, credit performance, financials, bank accounts, POS transactions and business credit reports.

Solutions to manage risk, however, have modernized. Advancements in machine learning techniques have transformed risk analysis to consume thousands of data points and leverage insight and learning from decades of loan performance data. For business lenders, this means better, faster, more accurate and consistent decisions in compliance with the set credit policy. Digital-first lenders can:

  • Use superior workflow tools to aid in better decision-making and operational resiliency.
  • Leverage risk assessment techniques that cannot be performed by humans.
  • Improve accuracy and consistency of credit decisions.
  • Specialize and customize by industry based on business goals.
  • Leverage new data sources and decades of credit performance data.
  • Process large volumes of data in seconds alongside the ability to identify and focus on what matters most.

Financial institutions transitioning to digital channels enjoy more opportunities to better serve consumers, expand market share and drive more revenue.

What Silicon Valley Bank’s Failure Means for Incentive Compensation

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The day Silicon Valley Bank failed on March 10, the bank paid out millions in bonuses to senior executives for its 2022 performance, according to the Federal Reserve’s April postmortem analysis and the bank’s proxy statement. Those bonuses were paid despite ongoing regulatory issues, including a May 2022 enforcement action.

As details trickle out about Silicon Valley Bank’s and Signature Bank’s failures, it’s becoming clear that regulators are interested in greater regulation and scrutiny of incentive plans. 

Among key risk management gaps, Federal Reserve Vice Chair for Supervision Michael Barr found fault in Silicon Valley Bank’s board compensation committee, noting that holding company SVB Financial Group’s “senior management responded to the incentives approved by the board of directors; they were not compensated to manage the bank’s risk, and they did not do so effectively.” Further, he wrote in the Fed’s April report: “We should consider setting tougher minimum standards for incentive compensation programs and ensure banks comply with the standards we already have.” 

It’s likely that supervisors will revisit examinations for banks between $50 billion and $250 billion in assets, which received regulatory relief following the 2018 rollback, says Todd Leone, a partner at the compensation firm McLagan. But supervisors recognized deficiencies in SVB’s incentive compensation governance prior to its failure, Barr revealed. Changes — via legislation and enhanced supervision — may occur, along with the finalization of incentive compensation and clawback rules coming out of the 2010 Dodd-Frank Act. 

Following the failures of Silicon Valley Bank and Signature Bank, lawmakers including U.S. Sen. Gary Peters, D-Mich., urged regulators to finalize Section 956 of Dodd-Frank, which requires regulators to issue rules for institutions above $1 billion in assets around the prohibition of excessive incentive compensation arrangements that encourage inappropriate risks, and mandate disclosure of incentive compensation plans to a bank’s federal regulator. Leone says that the rule was proposed with credit risk in mind, but its application could be expanded to consider liquidity.

The agencies tasked with this joint rulemaking, which include the Federal Deposit Insurance Corp., Federal Reserve, and the U.S. Securities and Exchange Commission, issued a request for comment on a proposed rule in 2016.

For public banks, the SEC finally released its clawback rule tied to Dodd-Frank in 2022. Put simply, the rule will require public companies to adopt policies that allow for the recovery of compensation in certain scenarios, including earnings restatements. The policy must be disclosed. Troutman Pepper expects that companies will have to comply as early as August. Gregory Parisi, a partner at the law firm, believes additional scrutiny on clawback policies will trickle down through the industry to smaller banks.

Clawback policies should cover numerous scenarios. “If the only triggers you have are tied to financial restatements, then it’s probably not broad enough,” says Daniel Rodda, a partner at Meridian Compensation Partners.

U.S. Sen. Elizabeth Warren, D-Mass., and U.S. Rep. Josh Hawley, R-Mo., introduced legislation on March 29 that would authorize the FDIC to claw back compensation when a bank fails.

Beyond the Dodd-Frank rules, banks should consider how to strengthen their governance practices to better tie compensation to risk. “… Incentive compensation arrangements should be compatible with effective risk management and controls,” wrote Barr in April, citing the 2010 Interagency Guidance on Sound Incentive Compensation Policies. Those arrangements “should be supported by strong corporate governance practices, including active and effective oversight by boards of directors,” he added.

Barr also pointed out that SVB’s compensation committee didn’t receive performance evaluation materials from CEO Greg Becker, relying instead on his recommendations. 

“There can be times where [the board relies] on a verbal discussion around performance with the CEO,” says Rodda, “but having it documented in the materials and making sure that those performance evaluation materials include commentary from risk as part of the performance evaluation, those are certainly good processes to have in place.”

SVB said risk management was a “key component of compensation decisions” in its proxy statement filed on March 3, just days before the bank’s failure, but listed return on equity, total shareholder return and stock price appreciation as specific measurements for 2022 incentive payments. 

Rodda recommends that boards consider a combination of metrics that include capital ratios and risk-adjusted returns — not just profitability and growth — and incorporate qualitative approaches that could consider feedback from regulators and an overall view of risk management.

On May 31, 2022, supervisors flagged SVB’s incentive compensation process as a Matter Requiring Immediate Attention (MRIA) by the board, ordering the compensation committee to develop “mechanisms to hold senior management accountable for meeting risk management expectations.” SVB’s compensation committee was in the process of changing its incentive structure and approved bonuses in January 2023 that were paid out in March despite the bank’s dramatic deposit loss, according to the Barr report. 

“There should be a structured opportunity within the incentive program to evaluate the effectiveness of risk management,” says Rodda. “And if there are items that have been flagged by the regulators as critical and indicate that risk is not being managed well, then the committee should use its judgment to impact payouts based on that.”

Compensation issues like these will be covered during Bank Director’s Bank Board Training Forum in Nashville, Sept. 11-12, 2023.

This article was updated to correct a reference to Section 956.

Reduce Lending Risk in the Omnichannel Environment

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Credit risk and risk associated with digital origination and authentication have become top of mind for bank boards and executives. Banks that are able to optimize lending practices to give consumers faster and more efficient experiences and interactions throughout their digital lending journey are seeing greater pickup and success.

Today, many borrowers prefer application processes that accommodate both digital and staff-assisted capabilities when seeking a loan. To process loans in an omnichannel delivery ecosystem, banks are turning to lending options that have the ability to prospect, originate, underwrite, process and close secured and unsecured credit cards, lines of credit and installment loans.

Manually assessing an applicant, their collateral and whether the loan meets the bank’s compliance requirements and lending policies increases the risk of inconsistencies, oversights and unintended consequences. Automation provides institutions with consistent inputs, analysis, compliant processes and calculations, predetermined classifications, accurate risk-based pricing, consistent warnings for policy exceptions and predictable decisions and outcomes with greater speed and efficiency. It also improves the interpretation and analysis of the applicant, credit, debt obligations, collateral and the execution of the institution’s inclusion/exclusion policies, such as summing up debt totals and calculating ratios used in the underwriting process. It can calculate the proposed loan payment, annual percentage rate (APR), and ratios at the applicant, household, business, guarantor and loan levels. It can also calculate custom credit scores.

While banks receive many benefits from using digital channels to serve borrowers, they also face vulnerabilities and risks such as fraudulent applications and data privacy concerns. In addition, digital lending might require a bank to collaborate with numerous third-party fintechs, exposing both borrowers and the institution to new and heightened levels of risk.

Banks need more cost-effective processes and decision models to address qualification ratios associated with online lending. These models should employ analytics and automation that can decline, decision, and refer applications appropriately to maintain an institution’s profitability, mitigate risk and not overwhelm lenders.

Mitigating Credit Risk and Increasing Productivity
Technology simplifies the loan origination process for banks and customers by guiding customers through each step in the process. Technology and automation can eliminate errors and the need to rekey data, which streamlines operations and enables staff to focus on additional revenue-generating opportunities.

Institutions that would prefer to slowly test automated decisioning can start with automated decisioning for denials for applications that fall outside of loan policy. An instant denial allows loan teams to focus on profitable and better-qualified candidates. Decisioning analytics evaluate areas such as credit quality, borrower stability and collateral risk. A decision and rules engine applies industry standards, institution-specific rules and policies and custom attributes, such as credit report analysis, for automated decision support during the loan origination process.

Automated solutions can provide speedy decisions while meeting compliance standards. This can help boost employee productivity; the consolidated customer information and loan details provides a 360-degree view of the overall financial relationship and deal structure. Bank associates can manage and expand relationships and target product recommendations based on customer needs.

An Omnichannel Environment for Lending
The technology and analytics of an omnichannel environment gives banks a competitive advantage when it comes to loan origination. Applicants can shop and compare loan options, submit loan applications and receive real-time automated decisioning and status updates.

An omnichannel ecosystem provides seamless start, save and resume cross-channel application processing: customers can begin the research and application process on a mobile device, continue the application and upload documents on an alternate digital device, and engage live assistance from contact center or branch lending specialists without losing their progress. The technology can guide customers and staff members through each phase, improving customer engagement by triggering staff actions and automating workflows. Digital capabilities intertwined with human engagement increases staff productivity and efficiency through analytics and workflow.

The omnichannel approach balances technology and human resource allocation based on customer need and complexity. Technology automates business criteria to issue decisions in real time or have the loans manually reviewed by underwriters, if warranted. Applying decisioning analytics allows banks to strengthen governance, risk and compliance by establishing proof of process. An omnichannel delivery environment that drives the application and origination process gives banks a way to provide a seamless lending experience that meets customers’ needs.

Assessing the Value of Your Loan Review Department

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Bank directors know that while there are many risks that all banks face — including some serious emerging issues — the major, ever-present risk that causes the most bank failures is credit risk.

The question then becomes: how well do they know the key components of an effective credit risk management system that can protect the bank’s safety and soundness and minimize the liability of the directors? The loan review department is a key aspect of an effective risk management system — yet it may not be functioning effectively. While bank directors are justifiably concerned about future economic conditions and the potential impact on their loan portfolios, are their institutions’ loan review departments really effective “early warning systems” for credit risk?

Part of the loan review challenge today is the difficulty in finding and retaining credit risk professionals. Loan review analysts are not on a typical bank “career path;” finding people with the right skills who are interested in a loan review position is a growing challenge. Is a hybrid staffing model blended with outsourced loan review services a necessity to address staffing issues today?

Other relevant challenges for banks include a growing acceptance and desire for a remote work arrangement, which can minimize collaboration, peer exchange and interpersonal communications. Only now are affordable technology tools emerging to support the loan review function to assist remote workers. Are banks investing in automation of this area? How can directors determine if loan review is bringing in the value it should to you and your bank?

Bank-Specific Considerations
When assessing the value of a loan review department, including efficiency and effectiveness of their functions, a lot depends on the characteristics of the bank itself. Smaller banks may have no choice than to use an outsourced model or hybrid blend of resources due to a lack of available internal skilled resources. Much larger banks typically staff their department with internal resources, which can present different management and career path issues. A bank with a rapidly growing book of loans may face difficult decisions on their model.

The specific responsibilities of a loan review department differ depending on the institution’s history and credit culture. Some banks virtually re-underwrite their sampled loans during exams — including financial re-spreading and deep dive document compliance. Other banks focus on a current validation of the risk rating and potential risk of credit deterioration. In many banks, loan operations does quality control checking for loans booked and internal audit performs documentation reviews, while other banks consider such duties to be part of loan review. Obviously, each bank needs to assess and clarify its department’s structure and responsibilities scope, along with its staffing model.

Other areas that differentiate different loan review departments include sample penetration thresholds and goals. Some departments have goals to review 60% or more of all borrowers over a certain threshold of loan size, while other’s objectives have less volume and more “risk targeted” exams. A more forward-looking model in vogue today is using “continuous monitoring” to watch emerging risk patterns and trends.

When assessing the value of a loan review department, management and the board should thoroughly understand the current state and how these bank-specific characteristics factor into the model of their team. It’s appropriate to challenge the current model and question its business value. As part of their responsibilities to the bank, directors must perform their duty of care and “trust but verify” the effectiveness of their loan review department.

Banks today are looking at any and every opportunity to build efficiency and cut costs, even in important areas of risk control like loan review. Many institutions have not been considered the loan review department’s cost-effectiveness in years. While banking has seen rapid change in many operational areas, thanks to automation and process changes put in place during the pandemic, loan review has languished. Many departments today are doing running the same way they have been in the past. Rapid and meaningful assessment of the effectiveness and efficiency of the loan review department can bear significant fruit in two of the most important areas of banks today: risk management and operational efficiency. Now is a good time for the board to exercise its duty of care and assess the loan review department’s ability to deliver these benefits.

Turning Income Tax Payable Into Earnings

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The New Markets Tax Credit (NMTC) Program is a two decade old federal tax credit program administered by the Community Development Financial Institutions Fund designed to monetize credits awarded by Department of the Treasury for community revitalization.

A federal tax credit is a dollar-for-dollar reduction of federal income tax payable; it is a permanent reduction of tax in the year the credit is taken. If a bank can acquire them for less than $1, it ends up converting an income tax liability into an earning. The credit creates more net income by reducing the amount in taxes owed.

The CDFI Fund has awarded 18 rounds of NMTCs, totaling $71 billion in tax credit authority. As of October 2022, $60.4 billion in NMTCs have been invested in low-income communities, creating jobs from investments in manufacturing, retail and technology projects. NMTCs are a 39% tax credit paired with a leverage loan. The Office of the Comptroller of the Currency wrote in 2013 that these credits “can help banks meet their financial goals (competitive returns on their equity investments)….[m]eet CRA requirements….[a]nd are a critical tool in helping the credit needs of low-income communities.”2

Of course, as with any equity investment there are risks; risks associated with tax credits include recapture risk, default risk, reputation risk and a lack of liquidity. But these deals are structured with full forbearance from debt that makes the probability of a redemption event unlikely. There’s also less risk at the project level compared with other tax credit programs available to corporations. And a 2017 study found a very low recapture rate.

The average return associated with the NMTC Fund, as of November 2022, outperformed seven-year US Treasurys and seven-year investment grade bonds by more than 2.43x and 1.6x, respectively in 2022 on a pre-tax basis.

Returns represent the internal rate of return of each investment categorized as held-to-maturity. The seven-year investment grade bonds for 2022 was determined based on a benchmark interest rate of the same maturity, plus the ICE BofA US Corporate Investment Grade Option-Adjusted Index. NMTC Fund returns are based on recent pricing.

Accounting Options
Typically, banks use two options for GAAP accounting using ASC 740 provisions:

  • Flow Through Method: The NMTC amount reduces the income tax expense (below the line). Impairment of the investment balance is categorized as an other expense, impacting pretax income (above the line).
  • Deferral Method: The tax credit is recognized as a contra asset (deferred income liability) and amortized into income over the productive life of the investment.

The Financial Accounting Standards Board’s Emerging Issues Task Force is evaluating whether it should expand the proportional amortization method to investments in tax credits beyond LIHTC investments, including investments in NMTCs (below the line treatment), a change many expect to be adopted as early as the first quarter of 2023.

Momeni & Sons Case Study
In 2022, Momeni & Sons, a manufacturer and importer of area rugs, wall-to-wall carpeting and home décor, wanted to establish a 302,600 square foot warehouse and distribution facility in Adairsville, Georgia, to accommodate growing online sales and bring more economic opportunity to the Adairsville community.

Given the magnitude of the project’s size and the rising cost of construction materials, the company needed about  $18.7 million to finance the project; its lender also determined that the project could be supported by the NMTC program. With $14 million in NMTC allocation, Wayne, New Jersey-based Valley National Bancorp was able to provide the tax credit leverage loan and the equity in the deal.

Momeni’s new facility created 100 construction jobs and 98 full-time quality jobs at its completion in August 2022, boosting the local economy of Adairsville. The project provided skills training in conjunction with a local workforce development provider, creating high-quality training and instruction to the area; at least 65% of Momeni’s Adairsville labor force will be minority residents.

New Markets Tax Credits provide a lesser-known opportunity for banks to convert tax liability to earnings, while potentially providing Community Reinvestment Act benefits, deposits and loans. There are syndication options available, which eliminate the need for smaller banks to create an independent infrastructure around the NMTCs.

This overview is for informational purposes only and is intended for recipients having sufficient knowledge and experience to make an independent evaluation of the risks and merits of any financing. The New Markets Tax Credit program is extremely complex. Consult your legal counsel, tax counsel and accountant. This information and opinions included in this overview do not, and are not intended to, constitute legal or tax advice. Dudley Ventures makes no representations or warranties of any kind, express or implied, as to the accuracy or completeness of the information or opinions. © 2022 Dudley Ventures, LLC, a Delaware limited liability company. All rights reserved.

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.

3 M&A Risks to Consider

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One crucial component of the merger and acquisitions process is due diligence, which needs to be performed efficiently within a limited amount of time as opportunities arise. Senior management is primarily responsible for this task, but may need assistance from key areas such as compliance, and often uses third-party support. If your bank is considering an acquisition, consider these three risks and document them as part of your due diligence.

1. Credit Risk
Potential acquirers must perform rigorous due diligence on the target bank’s credit portfolio — it’s imperative to the success of any merger. Executives at the acquiring bank need to understand the loan portfolio, including the types of credits offered, underwriting practices and problem loan management. This includes reviewing sample credits, including the top borrowers, adversely classified loans, watch list loans, loans to insiders and a sample of loans of each collateral type, if possible.

While there is no required portfolio coverage for due diligence, executives should have a flavor for the lending practices at the target bank.

2. Financial Risk
As part of due diligence, executives need to gain an understanding of the balance sheet and income statement at the target bank. Consider:

As 2022 unfolds, the Federal Reserve indicated it will continue increasing rates in an attempt to reduce inflation, which has created significant unrealized losses in many bond portfolios. This is after many banks invested the flux of cash generated by pandemic-era programs into their bond portfolios in an effort to achieve some return throughout 2021.

Consider the impact this could have on bond portfolios in acquisitions, including the value in a sale of the full portfolio, the long-term market rate forecast or even hedging strategies.

Review significant on- and off-balance sheet liabilities, including major contracts such as the core system contract, employment contracts, equity plans or stock options. These contracts could result in additional liabilities for the acquiring bank.

Acquirers will need an independent valuation of the target bank, including an estimate of the goodwill, core deposit intangibles, fair value adjustments to loans and other fair value adjustments that will be considered as part of the transaction. This valuation should be fluid, starting with the preliminary stages of the merger discussions, and evolving and refining as the merger proceeds.

Executives should prepare pro forma and projected financial statements to depict what the combined organization will look like at the merger date and going forward. In addition, those financial statements should determine the rate of return on the acquisition and the earn-back period.

3. Reputational Risk
Many banks are heavily involved and invested in their local communities, including deep and long-standing relationships with many bank customers. The art of combining two institutions and selling the “new” institution to the existing customers takes planning and care.

In addition, the employees and branches of the target bank are part of that same community. If the transaction includes retaining all employees and branches, communicate that as part of the press releases. If necessary, consider stay bonuses to retain the talent of the target bank. The new combined entity will want to uphold a positive and strong reputation throughout the community.

Bonus: Cyber Risk
Here’s a bonus tip to consider during your due diligence process: Cyber risk continues to be top of mind for advisors and regulators alike. As part of the transaction, assess the target bank’s information technology environment. That includes reviewing any external reports or assessments, and understanding any findings and the related remediation. In addition, identify material gaps or issues in due diligence so the bank is not surprised by additional costs at merger consummation.

If mergers and acquisitions are part of your bank’s strategic plan, having a proper plan in place to direct due diligence can help you execute the transaction seamlessly and with success. Put together an internal team that can help you review those risks or explore external options to assist.

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.