Turning Income Tax Payable Into Earnings

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

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

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.

Bank Compensation Survey Results: Findings Released

NASHVILLE, TENN., June 21, 2022 – Bank Director, the leading information resource for directors and officers of financial institutions nationwide, today released the results of its 2022 Compensation Survey, sponsored by Newcleus Compensation Advisors. The findings confirm that intensifying competition for talent is forcing banks to pay up for both new hires and existing employees.

The 2022 Compensation Survey finds that 78% of responding directors, human resources officers, CEOs and other senior executives of U.S. banks say that it was harder in 2021 to attract and keep talent compared to past years. In response to this increased pressure, 98% say their organization raised non-executive pay in 2021, and 85% increased executive compensation. Overall, compensation increased by a median 5%, according to participants.

“Banks are challenged to find specialized talent like commercial lenders and technology personnel, but they’re also struggling to hire branch staff and fill entry-level roles,” says Emily McCormick, Bank Director’s vice president of research. “In this quest for talent, community banks are competing with big banks like Bank of America Corp., which recently raised its minimum wage to $22 an hour. But community banks are also competing against other industries that have been raising pay. How can financial institutions stand out as employers of choice in their markets?”

Asked about specific challenges in attracting talent, respondents cite an insufficient number of qualified applicants (76%) and unwillingness among candidates to commute for at least some of their schedule (28%), in addition to rising wages. Three-quarters indicate that remote or hybrid work options are offered to at least some staff.

“It is obvious from the survey results that talent is the primary focus for community banks,” says Flynt Gallagher, president of Newcleus Compensation Advisors. “Recruiting and retaining talent has become a key focus for most community banks, surpassing other concerns that occupied the top spot in prior surveys — namely tying compensation to performance. It is paramount for community banks to step up their game when it comes to understanding what their employees value and improving their reputation and presence on social media. Otherwise, financial institutions will continue to struggle finding and keeping the people they need to succeed.”

Key Findings Also Include:

Banks Pay Up
Banks almost universally report increased pay for employees and executives. Of these, almost half believe that increased compensation expense has had an overall positive effect on their company’s profitability and performance. Forty-three percent say the impact has been neutral.

Commercial Bankers in Demand
Seventy-one percent expect to add commercial bankers in 2022. Over half of respondents say their bank did not adjust its incentive plan for commercial lenders in 2022, but 34% have adjusted it in anticipation of more demand.

Additional Talent Needs
Banks also plan to add technology talent (39%), risk and compliance personnel (29%) and branch staff (25%) in 2022. Respondents also indicate that commercial lenders, branch and entry-level staff, and technology professionals were the most difficult positions to fill in 2020-21.

Strengthening Reputations as Employers
Forty percent of respondents say their organization monitors its reputation on job-posting platforms such as Indeed or Glassdoor. Further, 59% say they promote their company and brand across social media to build a reputation as an employer of choice, while just 20% use Glassdoor, Indeed or similar platforms in this manner. Banks are more likely to let dollars build their reputation: Almost three-quarters have raised starting pay for entry-level roles.

Low Concerns About CEO Turnover
Sixty-one percent of respondents indicate that they’re not worried about their CEO leaving for a competing financial institution, while a third report low to moderate levels of concern. More than half say their CEO is under the age of 60. Respondents report a median total compensation spend for the CEO at just over $600,000.

Remote Work Persists
Three quarters of respondents say they continue to offer remote work options for at least some of their staff, and the same percentage also believe that remote work options help to retain employees. Thirty-eight percent of respondents believe that remote work hasn’t changed their company’s culture, while 31% each say it has had either a positive or negative impact.

The survey includes the views of 307 independent directors, CEOs, HROs and other senior executives of U.S. banks below $100 billion in assets. Compensation data for directors, non-executive chairs and CEOs was also collected from the proxy statements of 96 publicly traded banks. Full survey results are now available online at BankDirector.com.

About Bank Director
Bank Director reaches the leaders of the institutions that comprise America’s banking industry. Since 1991, Bank Director has provided board-level research, peer-insights and in-depth executive and board services. Built for banks, Bank Director extends into and beyond the boardroom by providing timely and relevant information through Bank Director magazine, board training services and the financial industry’s premier event, Acquire or Be Acquired. For more information, please visit www.BankDirector.com.

About Newcleus
Newcleus powers organizations as the leading designer and administrator of compensation, benefit, investment and finance strategies. The personalized product selections, carrier solutions and talent retention programs are curated to optimize benefits and improve ROI. www.newcleus.com.

Source:
For more information, please contact Bank Director’s Director of Marketing, Deahna Welcher, at dwelcher@bankdirector.com.

Advice to Bank Directors: Don’t Be Reactive on Credit Quality

With credit quality metrics at generationally stellar levels, concern about credit risk in 2022 may seem unwarranted, making any deployed defensive strategies appear premature.

For decades, banking has evolved into an orientation that takes most of its risk management cues from external stakeholders, including investors, trusted vendors, market conditions — and regulators in particular. Undoubtedly, becoming defensive prematurely can add challenges for management teams at a time when loan growth is still a main strategic objective. But waiting until credit metrics pivot is sure to add risk and potential pain. Banks have four key reasons to be more vigilant in 2022 and the next couple of years. These, and the suggested steps that prudent management teams should take in their wake, are below.

1. The Covid-19 sugar high has turned sour.
All of the government largesse and regulatory respites in response to Covid-19 helped unleash 40-year-high inflation levels. In response, the Federal Reserve has begun ramping up interest rates at potential intervals not experienced in decades. These factors are proven to precede higher credit stress. Continuing supply chain disruptions further contribute and strengthen the insidious inflation psychology that weighs on the economy.

Recommendation: Bankers must be more proactive in identifying borrowers who are particularly vulnerable to growing marketplace pressures by using portfolio analytics to identify credit hotspots, increased stress testing and more robust loan reviews.

2. Post-booking credit servicing is struggling across the industry.
From IntelliCredit’s perspective, garnered through conducting current loan reviews and merger and acquisition due diligence, the post-booking credit servicing area is where most portfolio management deficiencies occur. Reasons include borrowers who lag behind in providing current financials or — even worse — banks experiencing depletions in the credit administration staff that normally performs annual reviews. These talent shortages reflect broader recruitment and retention challenges, and are exacerbated by growing salary inflation.

Recommendation: A new storefront concept may be emerging in community banking. Customer-facing services and products are handled by the bank, and back-shop operational and risk assessment responsibilities are supported in a co-opt style by correspondent banking groups or vendors that are specifically equipped to deliver this type of administrative support.

3. Chasing needed loan growth during a credit cycle shift is risky.
Coming out of the pandemic, community banks have lagged behind larger institutions with regards to robust organic loan growth, net of Paycheck Protection Program loans. Even at the Bank Director 2022 Acquire or Be Acquired Conference, investment bankers reminded commercial bankers of the critical link between sustainable loan growth and their profitability and valuation models. However, the risk-management axiom of “Loans made late in a benign credit cycle are the most toxic” has become a valuable lesson on loan vintages — especially after the credit quality issues that banks experienced during the Great Recession.

Recommendation: Lending, not unlike banking itself, is a balancing game. This should be the time when management teams and boards rededicate themselves to concurrent growth and risk management credit strategies, ensuring that any growth initiatives the bank undertakes are complemented by appropriate risk due diligence.

4. Stakeholders may overreact to any uptick in credit stress.
Given the current risk quality metrics, banker complacency is predictable and understandable. But regulators know, and bankers should understand, that these metrics are trailing indicators, and do not reflect the future impact of emerging, post-pandemic red flags that suggest heightened economic challenges ahead. A second, unexpected consequence resulting from more than a decade of good credit quality is the potential for unwarranted overreactions to a bank’s first signs of credit degradation, no matter how incremental.

Recommendation: It would be better for investors, peers and certainly regulators to temper their instincts to overreact — particularly given the banking industry’s substantial cushion of post Dodd-Frank capital and reserves.

In summary, no one knows the extent of credit challenges to come. Still, respected industry leaders are uttering the word “recession” with increasing frequency. Regarding its two mandates to manage employment and inflation, the Fed right now is clearly biased towards the latter. In the meantime, this strategy could sacrifice banks’ credit quality. With that possibility in mind, my advice is for directors and management teams to position your bank ahead of the curve, and be prepared to write your own credit risk management scripts — before outside stakeholders do it for you.

4 Key Risks Facing Banks

Cybersecurity continues to be the top risk identified in Bank Director’s 2022 Risk Survey, sponsored by Moss Adams. But other risk areas have also grown increasingly prominent for the bank executives and board members responding to the survey, particularly interest rate risk. In this video, Moss Adams Partner Craig Sanders shares areas where banks can strengthen their weaknesses on cybersecurity. He also addresses the impact of fintechs on bank strategies and the rising prominence of environmental, social and governance (ESG) matters.

Topics addressed include:

  • Cyber Preparedness
  • Proactive Vendor Risk Management
  • Strategic Risks to Consider
  • Rising Interest Rates
  • Focusing on ESG

The 2022 Risk Survey explores several important risk areas, including credit risk, cybersecurity and emerging issues such as ESG. The survey results are also explored in the 2nd quarter 2022 issue of Bank Director magazine.

Complacency Becomes a Major Risk

One word seems to encapsulate concerns about banker attitudes’ toward risk in 2022: complacency.

As the economy slowly — and haltingly — normalizes from the impact of the coronavirus pandemic, bankers must ensure they hew to risk management fundamentals as they navigate the next part of the business cycle. Boards and executives must remain vigilant against embedded and emerging credit risks, and carefully consider how they will respond to slow loan growth, according to prepared remarks from presenters at Bank Director’s Bank Audit & Risk Committees Conference, which opens this week at the Swissotel Chicago. Regulators, too, want executives and directors to shift out of crisis mode back to the essentials of risk management. In other words, complacency might be the biggest danger facing bank boards and executives going into 2022.

The combination of government stimulus and bailouts, coupled with the regulatory respite during the worst of the pandemic, is “a formula for complacency” as the industry enters the next phase of the business cycle, says David Ruffin, principal at IntelliCredit, a division of QwickRate that helps financial institutions with credit risk management and loan review. Credit losses remained stable throughout the pandemic, but bankers must stay vigilant, as that could change.

“There is an inevitability that more shakeouts occur,” Ruffin says. A number of service and hospitality industries are still struggling with labor shortages and inconsistent demand. The retail sector is grappling with the accelerated shift to online purchasing and it is too soon to say how office and commercial real estate will perform long term. It’s paramount that bankers use rigorous assessments of loan performance and borrower viability to stay abreast of any changes.

Bankers that remain complacent may encounter heightened scrutiny from regulators. Guarding against complacency was the first bullet point and a new item on the Office of the Comptroller of the Currency’s supervisory operating plan for fiscal year 2022, which was released in mid-October. Examiners are instructed to focus on “strategic and operational planning” for bank safety and soundness, especially as it concerns capital, the allowance, net interest margins and earnings.

“Examiners should ensure banks remain vigilant when considering growth and new profit opportunities and will assess management’s and the board’s understanding of the impact of new activities on the bank’s financial performance, strategic planning process, and risk profile,” the OCC wrote.

“Frankly, I’m delighted that the regulators are using the term ‘complacency,’” Ruffin says. “That’s exactly where I think some of the traps are being set: Being too complacent.”

Gary Bronstein, a partner at the law firm Kilpatrick Townsend & Stockton, also connected the risk of banker complacency to credit — but in underwriting new loans. Banks are under immense pressure to grow loans, as the Paycheck Protection Program winds down and margins suffer under a mountain of deposits. Tepid demand has led to competition, which could lead bankers to lower credit underwriting standards or take other risks, he says.

“It may not be apparent today — it may be later that it becomes more apparent — but those kinds of risks ought to be carefully looked at by the board, as part of their oversight process,” he says.

For their part, OCC examiners will be evaluating how banks are managing credit risk in light of “changes in market condition, termination of pandemic-related forbearance, uncertainties in the economy, and the lasting impacts of the Covid-19 pandemic,” along with underwriting for signs of easing structure or terms.

The good news for banks is that loan loss allowances remain high compared to historical levels and that could mitigate the impact of increasing charge-offs, points out David Heneke, principal at the audit, tax and consulting firm CliftonLarsonAllen. Banks could even grow into their allowances if they find quality borrowers. And just because they didn’t book massive losses during the earliest days of the pandemic doesn’t mean there aren’t lessons for banks to learn, he adds. Financial institutions will want to carefully consider their ongoing concentration risk in certain industries, explore data analytics capabilities to glean greater insights about customer profitability and bank performance and continue investing in digital capabilities to reflect customers’ changed transaction habits.

Tackling Credit Risk Uncertainty Head On

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

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

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

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

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

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

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

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

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

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

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

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

New Pandemic Safety and Soundness Standards for Banks

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

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

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

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

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

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

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

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

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

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

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