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.
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.
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.
For more information, please contact Bank Director’s Director of Marketing, Deahna Welcher, at email@example.com.
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.
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.
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.
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.
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 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.
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.
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.
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.
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 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.
Could credit quality finally crack in the third quarter?
Banks spent the summer and fall risk-rating loans that had been impacted by the coronavirus pandemic and recession at the same time they tightened credit and financial standards for second-round deferral requests. The result could be that second-round deferrals substantially fall just as nonaccruals and criticized assets begin increasing.
Bankers must stay vigilant to navigate these two diametric forces.
“We’re in a much better spot now, versus where we were when this thing first hit,” says Corey Goldblum, a principal in Deloitte’s risk and financial advisory practice. “But we tell our clients to continue proactively monitoring risk, making sure that they’re identifying any issues, concerns and exposures, thinking about what obligors will make it through and what happens if there’s another outbreak and shutdown.”
Eight months into the pandemic, the suspension of troubled loan reporting rules and widespread forbearance has made it difficult to ascertain the true state of credit quality. Noncurrent loan and net charge-off volumes stayed “relatively low” in the second quarter, even as provisions skyrocketed, the Federal Deposit Insurance Corp. noted in its quarterly banking profile.
The third quarter may finally reveal that nonperforming assets and net charge-offs are trending higher, after two quarters of proactive reserve builds, John Rodis, director of banks and thrifts at Janney Montgomery Scott, wrote in an Oct. 6 report. He added that the industry will be closely watching for continued updates on loan modifications.
Banks should continue performing “vulnerability assessments,” both across their loan portfolios and in particular subsets that may be more vulnerable, says James Watkins, senior managing director at the Isaac-Milstein Group. Watkins served at the FDIC for nearly 40 years as the senior deputy director of supervisory examinations, overseeing the agency’s risk management examination program.
“Banks need to ensure that they are actively having those conversations with their customers,” he says. “In areas that have some vulnerability, they need to take a look at fresh forecasts.”
Both Watkins and Goldblum recommend that banks conduct granular, loan-level credit reviews with the most current information, when possible. Goldblum says this is an area where institutions can leverage analytics, data and technology to increase the efficiency and effectiveness of these reviews.
Going forward, banks should use the experiences gained from navigating the credit uncertainty in the first and second quarter to prepare for any surprise subsequent weakening in credit. They should assess whether their concentrations are manageable, their monitoring programs are strong and their loan rating systems are responsive and realistic. They also should keep a watchful eye on currently performing loans where borrower financials may be under pressure.
It is paramount that banks continue to monitor the movement of these risks — and connect them to other variables within the bank. Should a bank defer a loan or foreclose? Is persistent excess liquidity a sign of customer surplus, or a warning sign that they’re holding onto cash? Is loan demand a sign of borrower strength or stress? The pandemic-induced recession is now eight months old and yet the industry still lacks clarity into its credit risk.
“All these things could mean anything,” Watkins says. “That’s why [banks need] strong monitoring and controls, to make sure that you’re really looking behind these trends and are prepared for that. We’re in uncertain and unprecedented times, and there will be important lessons that’ll come out of this crisis.”
Lending institutions face unique challenges in 2020.
Leading up to 2020, regulators and industry professionals voiced growing concerns related to the easing of underwriting, prolonged increasing of commercial real estate values, risk tolerance complacency, and how much longer the good times could continue — which the ongoing public health crisis answered.
Covid-19 propelled businesses and borrowers into a liquidity crisis like most have never experienced. Economists already have identified the start of a recession, but many lending institutions find themselves determining if — or when — the liquidity crisis has transitioned to a credit crisis.
The third and fourth quarters of 2020 will be most telling. Never has a bank’s loan review function been more important.
On May 8, interagency guidance was released on credit risk review systems. The guidance was well-timed given the pandemic but wasn’t impulsive, as the regulatory agencies began their review process in October 2019. The guidance focused on two key pieces of the puzzle needed for effective credit risk systems: a solid credit administration function and independent credit review.
The guidance highlighted the importance of a loan review policy and how it should incorporate the following areas:
- Qualifications of credit risk review personnel.
- Independence of credit risk review personnel.
- Frequency of reviews.
- Scope of reviews.
- Depth of reviews.
- Review of findings.
- Communication and distribution of results.
These policy areas are highlighted to help drive a successful function that provides the right level of independent challenge to the organization on issue identification, risk rating accuracy/timeliness, policy adherence, policy depth, trends, and management effectiveness. Independently reporting these observations to the board and all stakeholders provides an in-depth independent assessment to help verify the strength of internal controls and the timeliness of grading. It also provides assurance that management’s reporting and allowance levels are reasonable.
Fast forward one month to June 2020, and loan review was top of mind for these same regulatory agencies, which released “Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Financial Institutions” (FDIC PR-72-2020). This guidance looked to address the unique challenges to consider when conducting safety and soundness assessments in these unprecedented times.
The guidance memorialized how examiners will consider the unique, evolving, and potentially long-term nature of the issues confronting institutions and exercise appropriate flexibility in their supervisory response. It speaks specifically to credit risk review (loan review) by stating the following:
Credit risk review. Examiners will recognize that the rapidly changing environment and limited operational capacity might temporarily affect an institution’s ability to meet normal expectations of loan review (such as a schedule or scope of reviews). Examiners will assess the institution’s support for any delays or reductions in scope of credit risk reviews and consider management’s plan to complete appropriate reviews within a reasonable amount of time.
Classification of credits. The assessment of each loan should be based on the fundamental characteristics affecting the collectability of that particular credit, while acknowledging that supporting documentation might be limited and cash flow projections might be highly uncertain.
Loan portfolios are a lending institution’s lifeblood. Portfolios drive earnings but also can be the largest threat to an institution’s ongoing viability. In this rapidly moving environment, it is key to have a loan review function that is up to the challenge.
Operating an effective loan review function
Large- and medium-sized financial institutions often opt to maintain an in-house loan review department. While this decision makes sense for some institutions, establishing and maintaining an effective and credible internal loan review operation can present significant challenges.
Credit department responsibilities have grown increasingly complex in recent years, not only due to regulatory demands but also because of a rapidly changing credit environment and new types of credit products. With these heightened expectations, loan review functions are being pressured by regulators and external auditors to raise the bar. Is it time to step back and assess whether your loan review function has adjusted to the changing environment and the products you offer?
Answer these questions to help take a step back and determine if your institution has a robust loan review function that not only meets the demands of the regulatory guidance but is built to meet the demands of the future as well.