How to Manage Deposit Risk in the Modern Age

Customers react to changing markets and create liquidity and credit risk for their banks. Technology innovations simply increase the speed and ease of their transactions. Banks must adopt technology to keep up with customer demands, even if doing so increases the risks they face. Banks performing both top-down and bottom-up risk management have the best understanding of their risk, its sources, and options to manage it.

Top-down measurement, analysis and management of market, liquidity and credit risk has improved significantly since the Great Recession. However, banks continue to perform risk measurement and analysis separately and often myopically, making overall risk management more difficult. The divide of risk measurement and analysis is partially driven by the specialized expertise required by diverse risk disciplines and by continued use of disparate legacy systems versus a fully integrated and automated system. Fully integrated and automated risk systems ingest all data once, compute all scenarios in a single engine, and report the results via a common reporting tool. They also enable comprehensive and near-instantaneous ad hoc scenario modeling, the single best management tool bank executives and boards have for surviving rapidly changing economic conditions.

Recent history shows balance sheet compositions now change in a matter of minutes and hours not days, weeks and months as they did prior to 2009. Many risk managers have never experienced rapidly changing market rates until now. These risk managers should research interest rate and balance sheet composition changes from the 1980s to help develop stress scenarios to apply to current balance sheets. They should increase the speed and magnitude of these scenarios until their balance sheet reaches a breaking point, paying particular attention to hedges and their effectiveness in each scenario. They should investigate mitigation strategies with various derivatives and ensure all combinations and types are being modeled correctly and documented. If there is no written policy and approval process for derivative usage, they should create one that focuses on the derivative’s purpose, making usage transparent, and keeping the policies simple to understand and follow. If you serve on a bank board, educate yourself on derivative policies and how they will help meet the increasing regulatory demand for strong balance sheet management.

Top-down risk management represents one side of the risk management coin; now, let’s look at bottom-up. Risk enters bank balance sheets with every customer originating a new account and continues with their transactions. While both management decisions and market changes can drive banks to fail, customers drive runs on deposits and loan defaults. Risks from customer behaviors must be analyzed, quantified and qualified, and strategies must be developed to keep customers from causing severe or irreparable harm. This level of customer analytics is only possible with a risk adjusted management information system (RAMIS) built at the instrument and transaction level and used across the bank by executives, staff and the front-line.

Front-line relationship managers using the system are key to providing the earliest warning of a gathering storm, especially when equipped with the proper tools. Relationship managers using a RAMIS quickly learn their key customers’ behaviors, transaction patterns and tools, and are among the first to recognize significant changes in them. Just as top-down scenario analytics should be performed with the same discipline and vigor as credit underwriting, so should customer behavior analytics, especially for sophisticated deposit customers. Establishing limit management reporting to quickly identify sudden changes among these customers is critical, given the speed with which they can execute transactions. But don’t just identify and quantify them; create a proactive plan to retain these customers and their balances through a looming crisis.

Early indications of growing crises are very important benefits from a RAMIS, but crises exist in the tips of the curve. A broader benefit of a RAMIS solution is the ability to identify all the profitable and unprofitable customers of the bank. Profitable customers keep the bank open, but also represent the greater risk as they are the most able to move to another bank, instantaneously. It’s also important to identify the customers who lose money and demonstrate how and where money is lost.

The final benefit of a RAMIS is that it enables merging disparate risk measurement and management functions and committees into a single, highly efficient and effective team, which is continuously informed about changing customer behaviors by their front-line managers. Managers quickly gain improved understanding of how one type of risk impacts other risks, and how customers react. Utilizing both top-down and bottom-up RAMIS functionality within a unified process creates the most effective approach for surviving crises and generates the greatest returns to your stakeholders.

Credit Quality Indicators for a Unique Cycle

“Bring back burn downs!”

This is a frequent request via phone or email since Silicon Valley Bank and Signature Bank failed in early March. Burn downs are statistical models generated during the 2007-08 financial crisis that recorded credit cycle losses on banks’ loan portfolios and determined what was left over after loans, reserves and capital were “burned down” for credit losses.

As a survivor of the financial crisis era, burn down models were not a pleasant experience for either the bank or the research analyst. Massive valuation deterioration and losses exceeded most banks’ capital and reserves, due to excess leverage from the credit extended on land and other construction properties. Weak earnings meant bank cash flows were little help to the credit recognition process. It was a terrible feedback loop that I prefer to forget. Perhaps forgetting is not realistic, since memory and learning from mistakes should be an analyst’s top skills.

Loan Loss Modeling
When the Covid-19 shutdown first unfolded in March 2020, Janney’s research team developed a new credit risk model to address how many loans could go bad and what losses should be assigned to these possible problem loans. We tried to be thoughtful: Not all loans would go bad. We argued that out of 100 loans, there were 10 to 15 that would have problems; many of those could be addressed in advance and often at small losses. Janney’s 2020 loss expectations were 2% to 3% across-the-cycle loss rates for banks. Fortunately, the Janney model proved fairly accurate, and actual losses were significantly less than we thought.

In 2023, we have a new credit cycle unfolding with three failed banks, a presumed recession starting soon and explosive predictions of commercial real estate loan losses galore. Hotel worries from 2020 have been replaced by office CRE in 2023 — credit mayhem is here! What should banks do to get ahead of the credit risk recognition cycle? How do banks ease investors’ fears of a charge-off surge and reduction in tangible book value per share? Bank management teams should take each issue seriously and address them immediately.

Updated Playbook
First, bank executives must speak clearly and plainly about their wide open disclosure on pass versus non-pass risk ratings that are standard in quarterly and episodic public filings, such as 8-Ks. The Federal Deposit Insurance Corp. still redacts these disclosures in call reports — public banks have a chance to provide investors with real data.

Given these disclosures, criticized loans are better understood in 2023 than in 2008. The 2.5% to 3% of non-pass rated loans at banks today are a fraction of criticized loans in 2009 and 2010. We encourage companies to disclose their criticized levels from 2009 and prior, which hit highs in the range of 10% to 12%. Investors may appreciate how bad it was then and how fortunate banks are today facing modest credit issues.

Next, we encourage bank managers to explain their long-run experience that loan defaults are limited, which can help combat investor negativity toward problem loans. Begin with statistical proof that supports how most loans are good and will repay as agreed. Then, share how your company mitigates potential problems in advance of a default or rating change to non-pass, including special mention or substandard rating.

Most investors have no idea how often loans encounter issues that are addressed by management long before becoming a charge-off. This leads to more reserves assigned to loans, broader loan categories and ultimately reduced loss exposure.

Finally — and perhaps most importantly — preach and shout about underwriting that features less leverage today compared to past cycles. Today’s loans have more equity, lower loan-to-value ratios and less dirt (little to no raw land) versus the similar loans made 15 years ago in the run up to the financial crisis. It is imperative that banks make explicit comparisons between a 2023 loan and a 2008 loan: how each could be resolved and what loss expectation occurs from each credit cycle. To analogize, investors and analysts tend to be from Missouri: “Show us!”

The bottom line is that credit issues in 2023-24 do exist. Banks must take ownership of current credit problems they may encounter and determine how they can be swiftly resolved and at what cost. Loss content should be far lower; providing specific data and examples will be critical to repairing the lost confidence from the recent bank failures.

Compensation Lessons in a Banking Crisis

Between March 10 and May 1, three regional U.S. banks failed. How were these bank failures similar, or different, than the bank failures of the Great Recession? We already know that there will be more regulatory pressure on banks, but what lessons can these failures teach directors about compensation? First, it is important to compare the Great Recession to the 2023 banking crisis.

Credit Versus Liquidity
The Great Recession was defined by a general deterioration in loan credit quality, incentive compensation that overly focused on loan production and a lack of a risk review process that incorporated the role incentives and compensation governance played.

Contrast that to 2023: Banks have upgraded credit processes and their risk review processes to evaluate the role of incentive compensation under the 2010 regulatory guidance of sound incentive compensation policies. Unfortunately, the banks that failed did not have enough liquidity to cover depositors who desired to move their money.

General Versus Unique
The three failed banks had unique patterns that responded dramatically to the increase in interest rates by the Federal Reserve and complicated each firm’s ability to fulfill depositor withdrawals. Silicon Valley Bank’s bond portfolio was long duration, and First Republic had a material portion of its portfolio tied to long-term residential mortgages. In contrast to the Great Recession, this banking crisis has more to do with business model and treasury management than actions of mortgage or commercial lenders.

Poor Risk Review
This is one area of commonality between the Great Recession and 2023. The Federal Reserve’s postmortem report on Silicon Valley Bank noted that the institution’s risk review processes were lacking. Specifically, the bank’s incentive plans lacked risk measures, and their incentive compensation risk review process was below expectations of a $200 billion bank.

“The incentive compensation arrangements and practices at [Silicon Valley Bank] encouraged excessive risk taking to maximize short-term financial metrics,” wrote the Fed in its postmortem report. This is a responsibility of the board of directors: Examiners review the board’s incentive risk review process as a part of their effectiveness evaluation, as well as a foundational principle of sound incentive compensation policies.

Going Forward
Lessons for the compensation committee must include considerations for what should be in place now versus what committees should be thinking about going forward. The compensation committee should have a robust process in place that examines all incentive compensation programs of the bank in accordance with regulatory guidance.

This process should evaluate each incentive compensation plan according to risk and reward, and monitor how each plan is balanced through risk mitigating measures. In addition, the incentive review process should be governed by a sound overall incentive compensation governance structure.

This structure is anchored by the compensation committee and works with a management incentive compensation oversight committee. It should dictate how plans are approved, how exceptions to plans are made and when the compensation committee is brought in for review and approval. As an example, if a major change is made to a commercial lender incentive compensation plan midyear, what is the process to review and ultimately approve the midyear change? Regulators expect those processes to exist today.

But all crises present new learnings to apply to the future. While there are a number of lessons related to a bank’s business model and treasury management, there are also takeaways for the compensation committee.

Going forward, banks need to move their mindset from credit risk mitigators to overall risk mitigators in incentive compensation. Credit risk metrics are often found within executive incentive plans as a result of the Great Recession. Banks should think how they can incorporate overall risk mitigators, beyond credit risk, and how those mitigators could affect executive incentive plans.

A risk modifier could cover risk issues such as credit, legal, capital, operational, reputational and liquidity risk factors. If all these risks rated “green,” the risk modifier would be at 100%; however, if credit or liquidity turned “yellow” or “red,” this modifier could apply a decrement to the annual incentive plan payout. In this way, a compensation committee can review all pertinent risks going forward and help ensure incentive compensation balances risk and reward.

As Interest Rates Rise, Loan Review Gets a Second Look

In 1978, David Ruffin got his first mortgage. The rate was 12% and he thought it was a bargain.

Not many people who remember those days are working in the banking industry, and that’s a concern. Ruffin, who is 74 years old, still is combing through loan files as an independent loan reviewer and principal of IntelliCredit. And he has a stark warning for bankers who haven’t seen a rising interest rate environment, such as this one, in more than 40 years.

“Credit has more hair on it than you would want to acknowledge,” Ruffin said recently at Bank Director’s Bank Audit & Risk Conference. “This is the biggest challenge you’re going to have in the next two to three years.”

Borrowers may not be accustomed to higher rates, and many loans are set to reprice. An estimated $270.4 billion in commercial mortgages held at banks will mature in 2023, according to a recent report from the data and analytics firm Trepp.

Nowadays, credit risk is low on the list of concerns. The Office of the Comptroller of the Currency described credit risk as moderate in its latest semiannual risk perspective, but noted that signs of stress are increasing, for example, in some segments of commercial real estate. Asset quality on bank portfolios have been mostly pristine. In a poll of the audience at the conference, only 9% said credit was a concern, while 51% said liquidity was.

But several speakers at the conference tried to impress on attendees that risk is buried in loan portfolios. Loan review can help find that risk. Management and the board need to explore how risk can bubble up so they’re ready to manage it proactively and minimize losses, he said. “The most toxic thing you could fall victim to is too many credit surprises,” he said.

Some banks, especially smaller ones, outsource loan review to third parties or hire third parties to independently conduct loan reviews alongside in-house teams. Peter Cherpack, a partner and executive vice president of credit technology at Ardmore Banking Advisors, is one of those third-party reviewers. He says internal loan review departments could be even more useful than they currently are.

“Sometimes [they’re] not even respected by the bank,” he says. “It’s [like] death-and-taxes. If [loan reviewers are] not part of the process, and they’re not part of the strategy, then they’re not going to be very effective.”

Be Independent
He thinks loan review officers shouldn’t report to credit or lending chiefs; instead, they should report directly to the audit or risk committee. The board should be able to make sense of their conclusions, with highlights and summaries of major risks and meaningful conclusions. Their reports to the board shouldn’t be too long — fewer than 10 pages, for example — and they shouldn’t just summarize how much work got done.

Loan review should communicate and collaborate with departments such as lending to find out about risk inside individual industries or types of loans, Cherpack says. “They should be asking [the loan department]: ‘What do you see out there?’ That’s the partnership that’s part of the three lines of defense.”

He adds, “if all they’re doing is flipping files, and commenting on underwriting quality, that’s valuable, but it’s in no way as valuable as being a true line of defense, where you’re observing what’s going on in the marketplace, and tailoring your reviews for those kinds of emerging risks.”

Targeted Reviews
Many banks are stress testing their loan portfolios with rising rates. Cherpack suggests loan review use those results to adjust their reviews accordingly. For instance, is the bank seeing higher risk for stress in the multifamily loan portfolio? What about all commercial real estate loans that are set to reprice in the next six to 18 months?

“If [loan review is] not effective, you’re wasting money,” Cherpack says. “You’re wasting opportunity to protect the bank. And I think as, as a director, you have a responsibility to make sure the bank’s doing everything it should be doing to protect its shareholders and depositors.”

Carlyn Belczyk is the audit chair for the $1.6 billion Washington Financial Bank in Washington, Pennsylvania. She said the mutual bank brings in a third-party for loan review twice a year. But Cherpack’s presentation at the conference brought up interesting questions for her, including trends in loans with repricing interest rates or that were made with exceptions to the bank’s loan policy. “I’m fairly comfortable with our credit, our loan losses are minimal, and we probably err on the side of being too conservative,” she said.

Ruffin doesn’t think coming credit problems will be as pronounced as they were during the 2007-08 financial crisis, but he has some words of advice for bank boards: “Weak processes are a telltale sign of weaknesses in credit.” he said.

Historically, periods of high loan growth lead to the worst loan originations from a credit standpoint, Ruffin said.

“We do an unimpressive job of really understanding what’s sitting in our portfolio,” he said.

This article has been updated to correct Ruffin’s initial mortgage rate.

What Drives a Bank’s Valuation?

With the rise of uncertainty amongst regional banks following the demise of Silicon Valley Bank, it’s an important time to understand how investors may value an institution and when board members should have a clear picture of that value.

“You should always understand what you’re worth,” says Kirk Hovde, managing principal and head of investment banking at Hovde Group. “Most banks say they aren’t for sale, but my view is most banks should operate as if they could be viewed … for sale.”

It can be easy to determine a public company’s valuation since it’s accessible through a brokerage, online resource or a tool like Bloomberg Terminal. For private companies, it’s something that requires further analysis. That can make planning difficult when weighing certain initiatives.

With valuations nearing Great Recession lows among public banks in 2023, according to research from the investment firm Janney Montgomery Scott, recognizing why and what investors use to come up with the numbers can be critical to how an organization responds. For banks, it’s required in many situations, such as when investors want to sell shares or the board needs to approve certain compensation packages.

Tangible book value (TBV) has become one of the most critical benchmarks that investors consider. This metric takes all the tangible assets the bank owns, including loans and buildings. The calculation excludes intangible assets like goodwill and debts — those would be removed from the balance sheet or paid out first during a liquidation event. This gives investors a sense of the value of the assets that can be liquidated if the bank suddenly goes bankrupt. They compare this figure to the stock price to calculate the bank’s price-to-tangible book value, which can be measured and benchmarked over time.

During times of sector strength, investors often look more at earnings growth instead of TBV. If earnings keep growing, then the bank looks stronger. Higher earnings during times of uncertainty can also make a bank look strong when others are weak. With bond portfolios struggling in the high interest rate environment, however, some banks may have to sell securities if earnings slow, says Hovde. This locks in losses.

“[Investors] have started to switch back to TBV currently, as they think about what losses might be recognized,” says Hovde.

Investors may also approach valuation by running a scenario called a “burn down analysis.” Essentially, this shows how quickly the bank would run out of funds if it had to pay creditors and cover liabilities immediately. This is a tactic that investors embraced during the financial crisis of 2008, says Christopher Marinac, director of research at Janney Montgomery Scott, who adds that investors have begun to run this type of analysis again due to the fears in the sector.

Investors often don’t take into consideration that banks typically have two to three years to pay down their entire credit cycle; a burn down analysis assumes the bank must pay all creditors immediately. As a result, it isn’t always accurate and can work to deflate the value of the bank.

“No one wants to see companies go away,” says Marinac. “There’s empathy in the credit risk process. Investors don’t think of it that way.”

While it’s important to understand a bank’s valuation from the investors’ perspective, directors also should have a sense of the institution’s value to weigh certain initiatives that could have sweeping impact across the institution.

It’s particularly important for directors to get a sense of their bank’s valuation in case it faces a potential liquidation event that no one expected. “Directors should be focused on liquidity and capital position to understand what the health of the bank really is,” says Hovde. “No one predicted the failures we have seen.”

Beyond liquidation, “there are a myriad of reasons” for bank directors to understand the valuation of their institution, and they’re not all for planning purposes, says Scott Gabehart, chief valuation officer at BizEquity, a valuation software developer.

Directors should have a sense of their bank’s valuation to make the right call when opting into a long-term plan. One example of this is when a private bank looks to implement an employee stock ownership plan (ESOP). These types of plans can serve as a retention tool by providing employees with a piece of the business that they work for.

When a company offers an ESOP, its employees can receive or buy shares of the organization, even if it’s a privately held. How many shares are available and whether the incentive tool will work depends, in part, on the valuation of the business. If it rises, employees can participate in the bank’s success.

Then there’s the fact that many bank executives receive stock options or grants as part of their compensation package. The options “must be valued at the time of granting,” says Gabehart. The valuation will incorporate other variables beyond earnings and TBV, like interest rates, volatility and other metrics. The perceived value that the executives receive from the options will depend, in part, on the valuation.

Finally, directors need to understand the bank’s valuation if they’re going to properly consider an acquisition or merger. Now, “it may be the best time to undertake an acquisition for expansion in that the multiples or costs to buying a bank [are] lower, all things equal,” says Gabehart. Of course, as Gabehart also acknowledges, it’s more difficult to fund an acquisition now, due to higher interest rates and weakened valuations for the buyer. Bank M&A activity slowed in 2022, with 164 bank acquisitions announced, according to S&P Global Market Intelligence. Through April 30, 2023, just 28 transactions had been announced for the year — down by half compared to the same period the year before.

“Before deciding how to finance an acquisition, it is always first necessary to know what the company is worth,” says Gabehart. Then leaders can determine the best funding tactic.

Beyond planning, there’s also the need for directors, as shareholders, to understand the value of the bank simply to sell their own shares. Understanding this valuation will ensure that whenever any other director sells shares, they will receive the best possible price — which benefits the entire organization.

The higher the valuation, the higher the sale price.

That’s not just good for the director. It’s great for the other bank investors as well.

Loan Review Best Practices: Key to Combating Credit Risk

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

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.

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

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

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

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.