What Crypto’s Falling Dominoes Could Mean for Banks

On Nov. 11, the cryptocurrency exchange FTX declared bankruptcy. It’s a saga that’s played out through November, but here’s the bare bones of it: After a Nov. 2 CoinDesk article raised questions about FTX and a sister research firm, a rival exchange, Binance, announced on Nov. 6 its sale of $529 million of FTX’s cryptocurrency. In a panic, customers then sought to withdraw $6 billion and by Nov. 10, FTX CEO Sam Bankman-Fried was trying to raise $8 billion to keep the exchange alive.

This isn’t just a modern version of the old-fashioned bank run. FTX’s new CEO, John J. Ray III — who led the restructuring of Enron Corp. in 2001 — stated in a filing that he’s never seen such a “complete failure of corporate controls” in his 40 years of experience. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented,” he said.

The fallout promises serious ramifications for the digital assets space — and may impact some banks. BlockFi, another cryptocurrency exchange that was bailed out by FTX last summer, filed for bankruptcy protection on Nov. 28. Those two bankruptcies have impacted Memphis, Tennessee-based, $1.3 billion Evolve Bank & Trust, which operates a banking as a service platform for fintechs including FTX.

The bank stated its exposure to FTX was in deposit accounts for a limited number of FTX customers, whose funds would be released once Evolve gets approval from the bankruptcy court handling the FTX case. Evolve also issued credit cards for BlockFi customers through a relationship with Deserve; those accounts were suspended. “Evolve has no financial exposure to BlockFi or to the credit card program they marketed,’’ Evolve said in a statement Thursday.

“To be clear, Evolve did not lend to FTX or their affiliates; we do not have corporate or deposit accounts with FTX or their affiliates; we do not lend against crypto; we do not offer crypto custodial services; and, we do not trade crypto,” Evolve said in an earlier statement to customers. Evolve also said the bank has never invested or transacted in crypto.

A larger bank also appears to be impacted. La Jolla, California-based Silvergate Capital Corp., with $15.5 billion in assets, said in a statement that its FTX exposure was less than 10% of its $11.9 billion in digital assets deposits; it later said that BlockFi deposits comprised less than $20 million. However, funds from digital assets clients make up 86% of Silvergate’s deposit base, according to its most recent earnings presentation. The rest are brokered, explains Michael Perito, a managing director at Keefe, Bruyette & Woods. And now, he says, “their targeted core customer base is under a lot of stress.” As a result, Kroll Bond Ratings Agency placed Silvergate’s ratings on watch downgrade on Nov. 21.

“As the digital asset industry continues to transform, I want to reiterate that Silvergate’s platform was purpose-built to manage stress and volatility,” said Alan Lane, CEO of Silvergate, in a press release. The bank declined comment for this article.

FTX may be the worst but it’s not the only crypto-related incident this year; it’s not even the first bankruptcy. The volatility has resulted in what has been dubbed a crypto winter, marked by a steep decline in prices for digital assets. The price for bitcoin peaked on Nov. 8, 2021, at $67,567. As of Nov. 29, 2022, that value hovered just above $16,000, with a market cap of $316 billion.

Even if banks don’t hold cryptocurrency on their balance sheets, there are many ways that a chartered institution could be directly or indirectly connected. Erin Fonté, who co-chairs the financial institutions corporate and regulatory practice at Hunton Andrews Kurth, advises all banks to understand their potential exposure.

She also believes that crypto could be at an inflection point. “Some of the non-sexy elements of financial services are the ones that keep you safe and stable and able to operate,” says Fonté. “It’s the compliance function, it’s the legal function, it’s proper accounting and auditing, internal and external. It’s all those things that banks do day in and day out.”

That could result in more regulation around crypto, and more opportunities for banks. “A lot of people are getting hurt, and have gotten hurt this year,” says Lee Wetherington, senior director of corporate strategy at Jack Henry & Associates. “That gets legislative attention and that certainly gets regulatory attention.”

What Could Change
Legislation could target crypto exchanges directly, but legislators are also looking at the banking sector. In a Nov. 21 letter, the Senate Banking Committee urged bank regulators to continue monitoring banks engaged in digital assets. They specifically called out SoFi Technologies, which acquired a chartered bank in February 2022 and subsequently launched a no-fee cryptocurrency purchase option tied to direct deposits. “SoFi’s digital asset activities pose significant risks to both individual investors and safety and soundness,” wrote the legislators. “As we saw with the crypto meltdown this summer … contagion in the banking system was limited because of regulatory guardrails.”

In a statement on SoFi’s Twitter account, the company maintained that it has been “fully compliant” with banking laws. “Cryptocurrency remains a non-material component of our business,” SoFi continued. “We have no direct exposure to FTX, FTT token, Alameda Research, or [the digital asset brokerage] Genesis.”

Currently, the Federal Reserve and Federal Deposit Insurance Corp. require notification from banks engaged in crypto-related activities; the Office of the Comptroller of the Currency takes that a step further, requiring banks to receive a notice of non-objection from the agency. More regulation is likely, says Fonté, and could include investor and consumer protections along with clarity from the Securities and Exchange Commission and Commodity Futures Trading Commission. “There’s a lot that’s going to come out there that is going to reshape the market in general, and that may further define or even open up additional avenues for banks to be involved if they want to be,” she adds.

Opportunities in crypto and a related technology called blockchain could include retail investment products, international payments capabilities or trade settlement, or payments solutions for corporate clients that leverage blockchain technology — such as those offered by Signature Bank, Customers Bancorp and Silvergate.

The risks — and opportunities — will vary by use case. “We’re being presented with entirely new risks that haven’t existed in the past,” says John Epperson, a principal at Crowe LLP.

Banks could be seen as a source of safety and trust for investors who remain interested in cryptocurrency. Larry Pruss, managing director of digital assets advisory services at Strategic Resource Management, believes banks could win back business from the crypto exchanges. “You don’t have to compete on functionality. You don’t have to compete on bells and whistles. [You] can compete on trust.”

James Wester, director, cryptocurrency at Javelin Strategy & Research, believes that with the right technology partners, banks can approach cryptocurrency from a position of strength. “We understand this stuff better,” he explains. “We understand how to present a financial product to our consumers in a safer, better, more transparent way.”

Wetherington recommends that banks consider cryptocurrency as part of a broader wealth offering. He’s visited bank boardrooms that have looked at how PayPal Holdings and other payments providers offer users a way to buy, sell or hold digital assets, and whether they should mimic that. And they’ve ultimately chosen not to mirror these services due to the reputational risk. “You can’t offer buy, hold and sell of a single asset class that is materially riskier than any number of more traditional asset classes,” he says. “If you’re going to offer the ability to buy, hold and sell a cryptographic monetary asset, you should also be making available the opportunity to buy, hold and sell any other type of asset.”

But all banks could consider how to educate their customers, many of whom are likely trading cryptocurrencies even if it’s not happening in the bank. “Help those customers with things like tax implications … or understanding how crypto may or may not fit into things that their retail customers are interested in. That’s one of the things that financial institutions could do right now that would be good for their customers,” says Wester. “There’s a real need for education on the part of consumers about [this] financial services product.”

Banking During a Time of Uncertainty

The following feature appeared in the fourth quarter 2022 edition of Bank Director magazine. It and other stories are available to magazine subscribers and members of Bank Director’s Bank Services Membership Program. Learn more about subscribing here.

For John Asbury, CEO at Atlantic Union Bankshares Corp., a $19.7 billion bank headquartered in Richmond, Virginia, concerns about the direction of the U.S. economy have a familiar feel to them. It was just two years ago that Asbury and the rest of the banking industry were staring into the abyss of an economic catastrophe caused by the Covid-19 pandemic.

The U.S. economy shrank 31.2% in the second quarter of 2020 when the country was put into lockdown mode to fight the pandemic. And while the economy made a dramatic recovery, growing 38% the following quarter, it was a time of great uncertainty for the nation’s banks as they dealt with an unprecedented set of economic and operational challenges.

For bankers like Asbury, it’s déjà vu in 2022.

“Once again we find ourselves in a period of great uncertainty — which is a familiar place to be,” says Asbury. This time the economic challenges come from a sharp rise in inflation, which came in at 8.5% in July — well above the Federal Reserve’s target rate of just 2%. The Fed clearly misread this sudden increase in inflation, thinking it was driven primarily by supply chain disruptions coming out of the pandemic, and now is trying to catch up with a fast-moving train.

Year to date through September, the Fed’s rate setting body — the Federal Open Market Committee — raised the federal funds rate five times, including three successive rate increases of 75 basis points each, bringing the upper limit of the target rate to 3.25%. It’s been a long time since the Fed raised interest rates by such a substantial margin in so short a time. The FOMC was scheduled to meet again in November and December, and Federal Reserve officials indicated in September that rates could reach 4.4% by year-end.

During the early days of the pandemic, the Federal Reserve also pumped money into the economy through a policy tool called quantitative easing, where it bought long-term securities from its member banks. Earlier this year, the Fed began to reverse that policy to reduce liquidity in the economy, which should help boost interest rates.

The result has been a dual economic outlook, with the immediate future looking more promising than it has in years — but with the longer-term prospects clouded by the threat of inflation and the Federal Reserve’s determination to bring it to heel. Rising interest rates are generally a boon to most banks, but there is a threshold point at which higher rates can lead to a prolonged economic downturn — which is not good for banks or most other companies.

“It remains to be seen what [the Fed] will do when push comes to shove but at least for now, it looks like they’re more concerned about reining in inflation than any of the effects — like a slowdown — that such actions could cause,” says R. Scott Siefers, managing director and senior research analyst at the investment bank Piper Sandler & Co.

The challenge for banks is plotting a course through such a confusing landscape. Do they push for loan growth at the beginning of an economic slowdown of unknown depth and duration, or adopt a more conservative posture toward credit? Should they compete for deposits as funding costs inevitably go up, or be content to let some of their excess funding run off? And lurking in the background is the risk that the Federal Reserve ends up tipping the economy into a deep recession as it seeks to choke off inflation.

By a traditional definition, the U.S. economy has already entered a shallow recession. The country’s gross domestic product, which is the monetary value of all goods and services produced in a specific time period, was -1.4% in the first quarter and -0.9% in the second quarter. Recessions are generally thought of as two quarters of economic contraction, but a variety of factors and data are part of that consideration. The Business Cycle Dating Committee, which is part of the National Bureau of Economic Research, is the group that declares when the U.S. is in recession and has yet to declare this current cycle one.

By other measures, however, the economy is doing surprisingly well. The country’s unemployment rate in August was just 3.7% — down from a peak of 13.2% in May 2020 — and the economy added over 500,000 new jobs in July and another 315,000 in August. In another piece of good news, August’s inflation rate was 8.3%, down from 8.5% in July and 9.1% in June, offering a glimmer of hope that the Fed’s rate hikes are beginning to work.

And in many respects, the experience of bankers on the ground is also at odds with the economic data. “What I’ve found myself saying as I speak to our clients and to our teams is that I feel better than I do when I simply read the financial press,” says Asbury. “Despite all the uncertainty, we’re actually in a pretty good place at the moment. Asset quality remains very benign. We see no end in sight to that, which is one of the more astonishing aspects of the whole pandemic, continuing even to now. Liquidity is still very good. We would have expected to see more deposit runoff than we have. It’s really all about business and consumer sentiment, which seems to be going up and down … The reality is that we’re in a pretty good spot.”

Ira Robbins, chairman and CEO at Valley National Bancorp, a $54.4 billion regional bank headquartered in Wayne, New Jersey, offers a similar assessment. In addition to New Jersey, the bank also does business in New York, Alabama and Florida. And a bank’s experience during an economic downturn may depend on its geographic location, because not all regions of the country are affected equally. “I’m sitting in Florida today, and it doesn’t feel like a recession here at all,” says Robbins in a recent interview. The economy might fit the traditional definition of a mild recession, but that doesn’t seem to bother him very much.

“I really don’t think it’s all that relevant to be honest with you,” he says. “When I look at the behavior of our consumers and commercial customers, we would say we’re not in a recession based on activity, based on spending habits, based on the desire to still have capital investments. When it comes to commercial endeavors, the economy still feels very, very strong.”

Valley National is a large residential lender, and Robbins says that the rise in interest rates has chilled the mortgage refinancing market and made it more difficult for first-time home buyers looking for an entry-level home. “But general activity in the purchase market is still very strong,” he says. “The Florida market is still on fire for us. Prices really haven’t abated yet. And the demand is still very strong in the market from a residential perspective.” Commercial real estate activity, including multi-family housing, is also booming in Florida thanks to the continued influx of people from out of state, according to Robbins. “We still have many of our borrowers — developers — looking to this footprint to grow,” he says. “And the rise in interest rates really hasn’t impacted their desire to be in this market.”

Valley National is also seeing a lot of multi-family development in the Jersey City, New Jersey market, where the bank is an active lender. “We have an environment where the supply hasn’t kept up with demand for a long time,” Robbins says. “Irrespective of what’s going on in the interest rate environment, there’s still a lot of people demanding newer product that just isn’t available to them today.”

If Asbury and Robbins see the current economic situation from a glass-half-full perspective, Tim Spence, CEO at $207 billion Fifth Third Bancorp in Cincinnati, Ohio, sees it as half empty. Spence has chosen to position the bank more conservatively given the economy’s uncertain outlook going into 2023. “We’ve elected to be more cautious as it relates to the outlook than many others have been,” he says. That caution has manifested itself in tougher expense control, “paring around the margins in terms of the lending activity” and using swaps to protect the bank’s net interest margin should the Fed end up cutting interest rates in the future, Spence explains.

While the U.S. economy may be slowing down, there are other factors that should buoy the industry’s profitability through the remainder of 2022. Most banks benefit from a rising rate environment because they can reprice their commercial loans faster than market competition forces them to reprice their deposits.

Deposit costs have yet to increase upward even as interest rates have shot up dramatically, and there is still a lot of liquidity in the country’s banking system. Siefers points to Fed data that deposits grew 0.6% in the first half of the year and remarks in an email exchange that he’s “been surprised at how resilient the deposit balances were. The conventional wisdom is that commercial balances have been looking for other homes, while consumer [deposits] have [gone] higher. Net/net, very little movement in total balances.”

One of the dichotomies in the economy is the industry’s strong loan growth despite the evidence of a slowdown. Citing Federal Reserve data, Siefers points out that loans excluding Paycheck Protection Program loans grew 5.5% in the first half of the year. While it might seem counter-intuitive that loans would grow while the economy is cooling off, Tom Michaud, CEO of investment bank Keefe, Bruyette & Woods, says that many commercial borrowers have been returning to the loan market after staying out during the early days of the pandemic. “The government took much of the role of lending out of the industry’s hands with the Paycheck Protection Program and other support elements,” he says. “And then after Covid started, most middle market corporations didn’t see any reason to increase borrowing a lot until they had a better feeling about the economy.”

The industry’s asset quality has also remained at historically low levels and along with the Fed’s interest rate hikes, has created what Siefers calls a “Goldilocks environment” with rising margins, strong loan growth and benign credit trends.

This will likely lead to higher profitability in the latter half of the year. “You’re going to see a significant expansion in bank net interest margins in the third and fourth quarters — the likes of which we’ve probably not seen in a couple of decades, because you’re going to have the cumulative impact of the May, June and July rate hikes flowing into the third and fourth quarters,” says Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities.

The dichotomy between low deposit costs and higher rates won’t last forever, of course. David Fanger, a senior vice president at Moody’s Investors Service, says that deposit rates typically move very little during the first 100 basis points in rate hikes when the Federal Reserve begins to tighten its monetary policy. And even when they do begin to move upward, it’s never on a one-to-one basis. “Even at the end of the [last] rate hike cycle, deposit rates increased only 30% of the increase in [the federal funds rate],” says Fanger. Once deposit rates do begin to rise — certainly in 2023 if not later this year as the Fed continues its tight monetary policy — that will probably cut into the expanding net interest margin that most banks are currently enjoying, although Fanger does not expect the industry’s margin to contract unless loan growth drops significantly.

What probably will change, however, is a decline in the industry’s liquidity level as banks decide not to compete for excess funds that seek out higher rates than they are willing to pay. Through a combination of federal stimulus legislation like the CARES Act, passed in March 2020 during the Trump administration, and the American Rescue Plan Act, passed in March 2021 during the Biden administration, along with $800 billion in PPP loans that banks originated and the Fed’s quantitative easing policy, trillions of dollars were pumped into the economy during the pandemic. Much of this money ended up on banks’ balance sheets at historically low interest rates. (The federal funds rate in May 2020 was 0.05%.) As rates rise, some of the money will start looking for a higher return.

“I don’t think banks are going to manage their companies just for the absolute level of deposits,” says Michaud. “I believe they’re going to manage their deposits as the market becomes more competitive for deposits relative to the size of their loan portfolio or what they believe is the size of their core bank. Some banks even started doing that in the second quarter. They were happy to let deposits run out of the bank, and they were more willing to focus on their core deposits.”

While it’s possible that the inflation rate peaked in June, Michaud doesn’t expect the central bank to begin lowering the fed funds rate anytime soon. “I think, if anything, the Fed is going to wait to see the outcome from their policy actions to ensure that inflation has gone back down to the level that they wish to see,” he says.

Asbury is of the same mind. “There have been lots of studies that suggest that if the Fed backs off too quickly, that will be a bad thing,” he says. “So, I don’t think rates are coming down anytime too soon.”

In fact, in late summer, there was a disconnect between the fed funds futures market and information coming out of the Federal Reserve. Activity in the futures market implied that the Fed would cut rates next year, even though messaging coming out of the central bank strongly suggested otherwise. The Fed’s summary of economic projections, which includes its dot plot chart that reflects each Fed official’s estimate of where the fed funds rate will be at the end of each calendar year three years into the future, suggests that the median rate will be 4.4% at the end of this year and 4.6% at the end of 2023.

And in a speech at the Federal Reserve Bank of Kansas City’s annual policy symposium in Jackson Hole, Wyoming, in late August, Federal Reserve Chairman Jerome Powell warned that “[r]educing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth and softer labor conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

Translation: If it takes a recession to bring the inflation rate back down to 2%, so be it.

Inflation has several direct effects on bank profitability. Like most other industry sectors, banks have seen their employment costs rise in a tight job market. “We’ve had to make adjustments, and we continue to look at what needs to be done to remain competitive for front line, client-facing teammates,” says Asbury. “The war for talent is raging.” Valley National also gave raises that went into effect in June, 5% to those making less than $65,000 a year, and 3.5% for those earning between $65,000 and $75,000 a year. “Those are permanent raises,” says Robbins. “It’s going to cost us almost $5 million a year in increased salary expense. So, we have to do a much better job on the revenue side to make sure we’re generating enough to support those expenses.”

The sharp rise in interest rates has also led to an increase in bond yields, which has impacted those banks that over the last two years used their excess deposits to invest in lower yielding securities. This has resulted in unrealized losses in their accumulated other comphrensive income — or AOCI — line. While these losses are not charged against a bank’s net income or its regulatory capital if the securities are being held for investment rather than trading purposes, they still impact its tangible common equity capital ratios “and industry observers watch that,” says Michaud.

But the biggest impact of inflation is how it drives the Federal Reserve’s monetary policy. Rising interest rates help fatten the industry’s net interest margin, but they also hike the debt service costs for corporate borrowers as their loans reprice higher. And some of those companies may end up defaulting on their loans in a longer, deeper recession.

As bankers look at the uncertainty hanging over the economy going into 2023, it’s important to give increased attention to customer communication and credit risk analysis. “Banks that have underwriting processes that have survived through multiple economic cycles and that are extremely client-centric will do better,” predicts Poonawala at Bank of America Securities.

“This is an appropriate time to step up communication with the client base, and we are doing that,” says Asbury. “You also have to run sensitivity analyses in terms of the impact of higher borrowing costs. We do this in the normal course of underwriting. Even when rates were at absolute historic lows, we still made credit decisions [by] running scenarios of higher rates and their capacity to service debt and repay in a higher rate environment. That’s just good banking.”

For his part, Robbins sees no need to pull Valley National back from its core commercial borrowers, even with the economy cooling off. “Seventy percent of our commercial origination comes from recurring customers,” he says. “Many of them have been through interest rate environments that have historically been much higher. Their ability to operate in this type of environment isn’t something that really concerns us.” Interest rates would have to go much higher before many of the bank’s core borrowers, particularly in an asset class like multi-family housing, where the demand for new product is high, would pull back from the market, Robbins says.

The larger risk occurs when banks stray beyond their comfort zone in search of yield or volume.

“Because we’ve been in a declining net interest margin environment, banks have been stretching to get into new geographies or asset classes they don’t have any real experience with,” Robbins says. And in an economic downturn, “banks that have done that but haven’t done it in the proper way are going to have real challenges,” he adds.

The difference in perspective may be more nuanced than truly material, but Spence at Fifth Third takes a more cautious view of the future beyond 2022. “From our point of view, it is a challenging environment to understand because the Fed has never had to move at the pace it has,” he says. “We’re coming off 15 years of zero or near-zero interest rates, and an environment where central banks were the largest bond buyers in the world. Now all of a sudden, they’re bond sellers.” Factor in the continued supply chain challenges that were initially driven by the pandemic but are now being accentuated by the war in Ukraine, along with a tight labor market, and it’s a very uncertain time.

Spence outlines three steps that Fifth Third has taken to address this uncertainty. First, the bank is spending even more time thinking about concentration risk. “Are we lending to sectors of the economy … that are going to be more resilient in any environment?” he says. On the consumer side, that has meant more emphasis on super prime customers and homeowners, and less on subprime borrowers even though they pay higher rates. And on the commercial side, that translates into greater focus on commercial and industrial loans to provide inventory financing, equipment purchases and working capital, and less emphasis on commercial real estate and leveraged lending.

Second, Fifth Third has used various hedging strategies to protect its balance sheet for a time when the Fed eventually loosens its monetary policy and begins to lower rates. Spence says the bank has added $10 billion in fixed-rate swaps to build a floor under its net interest margin for the next 10 years.

And finally, the bank is prepared for a scenario in which the Fed has to drive interest rates much higher to finally curb inflation. “In that case, nothing is more important than the quality of your deposit book,” says Spence, who believes that Fifth Third has a strong core deposit franchise.

Spence worries much less about the consequences of being too conservative than being too reckless. “In a business like ours that’s susceptible to economic cycles, the single most important thing that you can do is ask yourself what happens if I’m wrong,” he says. “From my point of view, if we are wrong, then we gave up a couple of points of loan growth in a given year that we can just get back later.”

How High Inflation, High Rates Will Impact Banking

In the latest episode of The Slant Podcast, former Comptroller of the Currency Gene Ludwig believes the combination of high inflation and rising interest rates present unique risks to the banking industry. Ludwig expects that higher interest rates will lead to more expensive borrowing for many businesses while also increasing their operating costs. This could ultimately result in “real credit risk problems that we haven’t seen for some time.”

While the banking industry is well capitalized and asset quality levels are still high, Ludwig says the combination of high inflation and rising interest rates will be a challenge for younger bankers who have never experienced an environment like this before.

Ludwig knows a lot about banking, but his journey after leaving the Comptroller of the Currency’s office has been an interesting one. After completing his five-year term as comptroller in 1998, Ludwig could have returned to his old law firm of Covington & Burling LLP and resumed his legal practice. Looking back on it, he says he was motivated by two things. One was to put “food on the table” for his family because he left the comptroller’s office “with negative net worth – [and] it was negative by a lot.”

His other motivation was to find ways of fixing people’s problems from a broader perspective than the law sometimes allows. “I love the practice of law,’’ he says. “It’s intellectually satisfying.” But from his perspective, the law is just one way to solve a problem. Ludwig says he was looking for a way to “solve problems more broadly and bring in lawyers when they’re needed.” This led to a prolonged burst of entrepreneurial activity in which Ludwig established several firms in the financial services space. His best known venture is probably the Promontory Financial Group, a regulatory consulting firm that he eventually sold to IBM.

Ludwig’s most recent initiative is the Ludwig Institute for Shared Economic Prosperity, which he started in 2019. Ludwig believes the American dream has vanished for many median- and low-income families, and the institute has developed a new metric which makes a more accurate assessment of how inflation is hurting those families than traditional measurements such as the Consumer Price Index — which he says drastically understates the impact.

Ludwig hopes the Institute’s work gives policymakers in Washington, D.C., a clearer sense of how desperate the situation is for millions of American families and leads to positive action.

This episode, and all past episodes of The Slant Podcast, are available on Bank DirectorSpotify and Apple Music.

CRA Modernization Goes Back to the Drawing Board

Bankers value certainty and consistency when it comes to regulation, but the Community Reinvestment Act currently offers neither.

In May 2020, the Office of the Comptroller of the Currency issued a controversial revision of the decades-old law. The rewrite stirred up a hornet’s nest of controversy not just because of the changes themselves — some of which were long overdue and well received — but because the agency acted on its own after it was unable to reach an agreement with the Federal Reserve and the Federal Deposit Insurance Corp. The OCC’s decision was also significant because national banks account for approximately 70% of all CRA activity, according to the agency.

“I think not having all the regulators on the same page creates a lot of confusion in the industry,” says Michael Marshall, director of regulatory and legal affairs at the Independent Community Bankers of America.

The CRA, which was enacted in 1977 and applies to all federally insured banks and thrifts, was intended to require financial institutions to help meet the credit needs of the communities where they also raised their deposits. However, under the banking industry’s trifurcated federal regulatory system, compliance is monitored by three different agencies – the OCC for national banks, the Fed for state-chartered banks that are members of the Federal Reserve System, and the FDIC for state-chartered, nonmember banks.

Normally, the feds want one rule that applies to all banks regardless of their regulator. The FDIC initially joined the OCC in the CRA overhaul, but FDIC Chair Jelena McWilliams announced in May 2020 that the agency was not ready to finalize the revisions, intimating that she felt banks were too busy dealing with the impact of the pandemic on their borrowers to implement the new rule. The Fed, for its part, had already bowed out of a joint rulemaking process over a disagreement with the approach taken by the other two agencies. In September 2020, the Fed announced its own Advance Notice of Proposed Rulemaking (ANPR) to modernize the CRA and invited public comment on how to accomplish that.

The OCC’s decision to go it alone means there are now two CRA laws in effect — the agency’s revision rule for banks with a national charter and the previous rule for everyone else. Unfortunately, the confusion surrounding the CRA doesn’t end there.

The OCC’s revision was promulgated under former Comptroller of the Currency Joseph Otting, who was appointed by former President Donald Trump. Otting unexpectedly resigned as comptroller shortly after the agency’s CRA rule changes went into effect in May of last year, even though he was only halfway through his five-year term. The agency is now being run by Acting Comptroller Michael Hsu, a former Fed official who was appointed by the Biden Administration.

In July, the OCC announced that it would rescind the CRA revision developed under Otting — even though some parts of the new framework are already in effect, and national banks had already begun to comply with them. In the OCC’s announcement, Hsu said the “disproportionate impacts of the pandemic on low and moderate income communities,” along with comments that had already been provided to the Federal Reserve under its ANPR process and the OCC’s own experience implementing the 2020 revision, convinced him of the need to start over.

While the OCC deserves credit for taking action to modernize the CRA through adoption of the 2020 rule, upon review I believe it was a false start,” Hsu said in a statement. “This is why we will propose rescinding it and facilitating an orderly transition to a new rule.” Hsu also indicated the OCC would work closely with the Fed and FDIC in a joint rulemaking process, which would in effect piggyback off the Fed’s separate rulemaking process that began last September.

One of the biggest complaints about the CRA is that it was written in an era when deposit-gathering activities were almost exclusively branch-based. The industry’s digital transformation in recent years enables institutions — including large banks with national or multi-regional footprints as well as newer, digital-only banks — to raise deposits from anywhere in the country.

“When we thought of banks [in 1977], we thought of big buildings and pillars,” says John Geiringer, a partner and the regulatory section leader in the financial institutions group at Barack Ferrazzano Kirschbaum & Nagelberg. “Now, between our phones and smart watches, each of us is effectively a walking bank branch.”

Geiringer says the regulators are well aware that digital transformation puts traditional, branch-based banks at a disadvantage when it comes to CRA compliance. “I think there is the recognition in the regulatory community that to the extent that fintechs are encroaching upon the business of banking, they should be held to comparable standards,” he says. “There should be one level playing field.”

There was also a degree of ambiguity in the original law about what kinds of activities qualified for CRA consideration, and there could be variations between different examiners and agencies. One welcomed aspect of the OCC’s revised rule is a non-exhaustive, illustrative list of example activities that would qualify for credit. “Before, you had to call somebody,” says Geiringer, who referred to this as “the secret law of CRA.” With its revision, the OCC under Otting tried to provide more clarity around the issue of qualifying activities.

The OCC rule also imposed new data collection requirements that the ICBA’s Marshall says are of concern to smaller banks. But overall, the OCC’s CRA rewrite seemed to be an honest attempt to modernize a law that badly needed it.

So, what happens now?

I think the interagency process is going to continue moving forward, but in a slightly different direction in light of the fact that we now have the Biden Administration in power,” Geiringer says. “We have seen issuances from both the Biden Administration and others calling for more of an inclination toward the unbanked and the underbanked, and similarly … low- and moderate-income areas.”

A permanent comptroller, once one has been installed at the OCC, could pursue a progressive agenda that goes beyond just modernization. Another scenario that could potential impact any CRA reform initiative is the fate of Fed Chair Jerome Powell, whose term ends in February 2022. Powell is a middle-of-the-road Republican who might be expected to have a moderating influence on CRA reform. Should Powell be replaced by a Democrat who leans more to the left on economic policy matters, that could steer CRA reform in a more progressive direction.

Equally unclear is how long a joint rulemaking process — if indeed the three federal agencies commit to that — will take. A unified revision probably won’t be issued until 2022 at the earliest. In the meantime, the industry is left with no clear sense of what that new rule might look like.

New Rule Settles a Vexing Problem for Bank Exams

One of the most contentious aspects of post-financial crisis bank examinations under the administration of President Barack Obama just got resolved.

A new set of rules implemented this year confirm a rather simple and straightforward idea: Supervisory guidance and bank regulations are different. It attempts to address concerns from banking trade groups that the regulators sometimes used supervisory guidance in place of a formal rule in examination feedback — in short, that supervisory guidance effectively substituted as a rule — and has implications for how supervisory guidance should be used going forward.

“I think there was a growing concern that [regulators] were using the soft guidance as a means of enforcing hard requirements,” says Charles Horn, a regulatory and transaction attorney at Morgan Lewis. He cites the supervisory guidance around leveraged lending as one example of guidance that created concern and confusion for the banking industry.

The Rule
The rules, which build on a 2018 interagency statement, were passed by the individual bank regulatory agencies — the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Consumer Financial Protection Bureau and the Federal Reserve — at different times but feature similar language. They specify that supervisory guidance does not establish rules that have the force and effect of law, in contrast to rules that undergo the rulemaking process that includes notice and comment periods, according to notice from the law firm Covington. A regulator’s examination staff cannot use supervisory guidance as the basis for issuing the dreaded report known as a “Matter Requiring Attention” or for any other enforcement action or report of noncompliance.

Both the Fed’s and OCC’s rules state that its examiners will not base supervisory criticisms or enforcement actions on a “violation” of or “non-compliance with” supervisory guidance, and will limit the use of thresholds or other “bright-lines” included in supervisory guidance expectations.

Unlike a law or regulation, supervisory guidance does not have the force and effect of law,” stated the OCC in January 2021 and the Federal Reserve in March of the same year. “Rather, guidance outlines expectations and priorities, or articulates views regarding appropriate practices for a specific subject.”

There are several reasons why regulators issue supervisory guidance. Guidance can educate and inform the agency’s examiners, and could be shared with banks so that both groups are on the same page. Regulators may also issue guidance on issues that are too timely or trivial to merit rulemaking. Sometimes, banks ask regulators to provide guidance or insights on an issue. It can come in many shapes and forms: bank bulletins, frequently asked questions and circulars, among others. Most pieces of supervisory guidance are not issued with a notice and comment period.

“It’s remarkable how much guidance the agencies have issued over the years,” says Greg Baer, president and CEO of the Bank Policy Institute, a research organization whose membership includes some of the biggest banks in the country. The BPI was one of the groups that formally petitioned the agencies to turn the 2018 interagency statement into a rule.

Unlike rules, supervisory guidance wasn’t supposed to be binding. But if a bank examiner treated it as binding, it could pressure bank executives to adopt the same approach. Bank trade groups became concerned that examiners could cite situations where the bank was not following supervisory guidance as the reason for issuing an MRA. MRAs fall below the seriousness of enforcement actions like consent orders, but examiners still expect banks to respond to and address them. Failure to address an MRA can generate subsequent MRAs or contribute to more formal administrative actions.

Of course, a rule on the paper could be different than a rule that is applied and enforced during an exam. It may be too soon to know if the rule has made an impact on exams. The impetus for the new rules began under the administration of President Donald Trump, although many of the rules were finalized at the start of President Joe Biden’s administration. The change in administrations and continued regulatory adjustments made in response to the coronavirus pandemic means that the agencies could still be in an adjustment period. It may take some time for the edict to trickle down from the agency heads to the front-line examiners. Bank executives and boards may also need time to learn about the rule and how it might apply to feedback they’ve received from examiners.

Bank examinations are famously secret. And while bankers and directors may have more leeway to ask for clarification on examination feedbacks or even appeal the findings of the report, especially if feedback cites supervisory guidance, they may not feel comfortable doing so to maintain good relationships with their regulators and examiners. Horn, for his part, expects banks to be cautious about challenging examination actions even with this new rule.

“Banks do value good relationships with the regulators, and there are a number of banks that don’t want to take the risk of pushing back against regulatory criticism unless they think it’s important,” he says. “Personally I think [the rule] can be helpful, but we don’t know how helpful it will be until we can see how this plays out over the coming months and, frankly, the coming years.”

Best Practices to Achieve True Financial Inclusivity

According to the Federal Reserve’s report on the economic well-being of U.S. households in 2019, 6% of American adults were “unbanked” and 16% of U.S. adults make up the “underbanked” segment.

Source: Federal Reserve

With evolving technological advancements and broader access to digital innovations, financial institutions are better equipped to close the gap on financial inclusivity and reach the underserved consumers. But to do so successfully, banks first need to address a few dimensions.

Information asymmetry
Lack of credit bureau information on the so-called “credit invisible” or “thin file” portions of unbanked/underbanked credit application has been a key challenge to accurately assessing credit risk. Banks can successfully address this information asymmetry with Fair Credit Reporting Act compliant augmented data sources, such as telecom, utility or alternative financing data. Moreover, leveraging the deposits and spend behavior can help institutions understand the needs of the underbanked and unbanked better.

Pairing augmented data with artificial intelligence and machine learning algorithms can further enhance a bank’s ability to identify low risk, underserved consumers. Algorithms powered by machine learning can identify non-linear patterns, otherwise invisible to decision makers, and enhance their ability to screen applications for creditworthiness. Banks could increase loan approvals easily by 15% to 40% without taking on more risk, enhancing lives and reinforcing their commitment towards the financial inclusion.

Financial Inclusion Scope and Regulation
Like the Community Reinvestment Act, acts of law encourage banks to “help meet the credit needs of the communities in which they operate, including low- and moderate-income (LMI) neighborhoods, consistent with safe and sound banking operations.” While legislations like the CRA provide adequate guidance and framework on providing access to credit to the underserved communities, there is still much to be covered in mandating practices around deposit products.

Banks themselves have a role to play in redefining and broadening the lens through which the customer relationship is viewed. A comprehensive approach to financial inclusion cannot rest alone on the credit or lending relationships. Banks must both assess the overall banking, checking and savings needs of the underbanked and unbanked and provide for simple products catering to those needs.

Simplified Products/Processes
“Keep it simple” has generally been a mantra for success in promoting financial inclusion. A simple checking or savings account with effective check cashing facilities and a clear overdraft fee structure would attract “unbanked” who may have avoided formal banking systems due to their complexities and product configurations. Similarly, customized lending solutions with simplified term/loan requirements for customers promotes the formal credit environment.

Technology advancements in processing speed and availability of digital platforms have paved the way for banks to offer these products at a cost structure and speed that benefits everybody.

The benefits of offering more financially inclusive products cannot be overstated. Surveys indicate that consumers who have banking accounts are more likely to save money and are more financially disciplined.

From a bank’s perspective, a commitment to supporting financial inclusivity supports the entire banking ecosystem. It supports future growth through account acquisition — both from the addition of new customers into the banking system and also among millennial and Gen Z consumers with a demonstrated preference for providers that share their commitment to social responsibility initiatives.

When it comes to successfully executing financial inclusion outreach, community banks are ideally positioned to meet the need — much more so than their larger competitors. While large institutions may take a broader strategy to address financial inclusion, community banks can personalize their offerings to be more relevant to underserved consumers within their own local markets.

The concept of financial inclusion has evolved in recent years. With the technological advancements in the use of alternative data and machine learning algorithms, banks are now positioned to market to and acquire new customers in a way that supports long-term profitability without adding undue risk.

Low Interest Rates Threaten Banks — But Not the Way You Think

The coronavirus pandemic laid bare the struggles of average Americans — middle class and lower-income individuals and families. But these struggles are an ongoing trend that Karen Petrou, managing partner of the consulting firm Federal Financial Analytics, tracks back to monetary policy set by the Federal Reserve since the financial crisis of 2008-09.

In short, she says, the Fed bears some of the blame for the widening wealth gap, which sees the rich getting richer, the poor getting poorer and the middle class slowly disappearing. And that’s an existential threat to most financial institutions.

“The bread and butter of community banks — urban, rural, suburban — is the middle class and the upper-middle class, as well as the health of the communities [banks] serve,” Petrou explains to me in a recent interview. Even for banks focused on more affluent populations, the health of their communities derives from everyone living and working in it. “When you have a customer base that is really living hand to mouth,” she says, “that’s not a growth scenario for stable communities, or of course, [a bank’s] customer base.”

A lot of digital ink has been spilled on inequality, but Petrou’s analysis — which you’ll find in her book, “Engine of Inequality: The Fed and the Future of Wealth in America,” is unique. She explores how misguided Fed policy fuels inequality, why it matters, and how she’d recraft monetary policy and regulation. And she believes the future is bleak for banks and their communities if changes don’t occur.

Her ideas have the attention of industry leaders like Richard Hunt, CEO of the Consumer Bankers Association. “She’s not what I’d consider an activist or someone who has an agenda,” he says. “She is purely facts-driven.”

Central to the inequality challenge is the ongoing low-rate environment. We often talk about the Fed’s dual mandates — promoting maximum employment and price stability — but Petrou points out in her book that setting moderate rates also falls under its purview.

Low rates have pressured banks’ net interest margins for over a decade, but they’ve squeezed the average American household, too. Petrou writes that these ultra-low rates have failed to stimulate growth. They’ve also “made most Americans even worse off because trillions of dollars in savings were sacrificed in favor of ever higher stock markets.”

The Fed’s preoccupation with markets over households, she says, benefits the most affluent.

Low interest rates, as we all know, lower the returns one earns on safer investments, like money market accounts or certificates of deposit. That drives investors to the stock market, driving up valuations. Excepting a brief blip early in the pandemic, the S&P 500, Dow Jones Industrial Average and Nasdaq have all performed well over the past year, despite high unemployment and economic closures.

However, stock ownership is concentrated in the hands of a few. As of the fourth quarter 2020, the top 1% hold 53% of corporate equity and mutual fund shares, according to the Federal Reserve; the bottom 90% own 11% of those shares. Most of us would be better off, Petrou concludes, earning a safe, living return off the money we manage to sock away.

More than 60% of middle-class wealth is tied up in their homes; pension funds account for another 17%. Those have been underfunded, “but even underfunded pensions have a hope of paying claims when interest rates are enough above the rate of inflation to ensure a meaningful return on investment,” she writes.

And while homes account for a huge portion of middle-class wealth, home ownership has actually declined over the past two decades among adults below the age of 65, according to a Harvard University study. The supply of lower-cost homes has dwindled, and banks are reticent to make small mortgage loans, which are costly to underwrite. And for those who already own a home, prices still haven’t reached the levels seen before the financial crisis — in real dollars, they’re not worth what they once were.

And homes aren’t a liquid asset. Middle class Americans used to hold more than 20% of their assets in deposit accounts, but that’s declined dramatically. All told, low interest rates severely punish savers, who actually lose money when one adjusts for inflation.

Average real wages haven’t budged in decades — but the costs for everything else have risen, from medical expenses to childcare to education and housing. So, what’s paying for all that if savings yield little and incomes are stagnant? Debt. And a lot of it, at least for the middle class, whose debt-to-income ratio has grown to a whopping 120% — almost double what it was in 1983. For the top 1%, it’s more than halved, to 35% of income.

Middle class households were in survival mode before the pandemic hit, explains Petrou.

“All of the Fed’s monetary-policy thinking is premised on the view that ultra-low rates spur economic growth, but most low-cost debt isn’t available to lower-income households, and most middle-income households are already over their head in debt,” she writes. “Monetary policy has failed in part because the Fed failed to understand America as it bought, saved and borrowed.”

Debt can be wonderful; it can build businesses and make buying a home possible for many. But that dream is disappearing. Coupled with the regulatory regime, low interest rates have changed traditional banking, explains Petrou. Financial institutions are forced to chase fee income, found in wealth management and similar products and services. And lending to more affluent customers makes better business sense.

Petrou wants the Fed to gradually raise rates to “ensure a positive real return.” Combined with other factors, rising rates would “make saving for the future not just virtuous, but successful,” she writes, “giving families with growing wages in a more productive economy a better chance for wealth accumulation, intergenerational mobility, and a secure retirement.”

It won’t fix everything, but it will help middle and lower-income families save for their homes, save for college and even pay down some of that debt.

Petrou is clear — in her book and in my interview with her — that the Fed isn’t ill-intentioned. But the agency is ill informed, she believes, relying on aggregate data that doesn’t reflect a full picture of the economy.

“The economy we’re in is not the one in which most of us grew up,” she says, referring to the baby boomers who form the majority of bank boards and C-suites. The top 10% hold a much greater share of wealth, and that share is growing. The things that many boomers took for granted, she says, are increasingly unattainable, or require an unsustainable debt burden.

College tuition offers a measurable example of how much things have changed. Adjusted for 2018-19 dollars, baby boomers paid an average $7,719 a year to attend a four-year public college, according to the U.S. Department of Education. Generation Z is now entering college paying roughly 2.5 times that amount — contributing to the growing volume of student loans.

“Assuming that [the economy] works equitably because there’s a large middle class means that banks will make strategic errors, misunderstanding their customers and communities,” Petrou tells me. “And that the Fed will make terrific financial policy mistakes.”

A Banker’s Perspective on LIBOR Transition to SOFR

The scandal associated with manipulation of the London Interbank Offered Rate (LIBOR) during the 2008 financial crisis caused a great deal of concern among banking and accounting regulators. In 2014, the Financial Stability Oversight Council recommended that U.S. regulators identify an alternative benchmark rate to LIBOR.  This recommendation was given an effective timeline in 2017 when the UK Financial Conduct Authority, as the regulator of LIBOR, announced the intent to discontinue the rate by year-end 2021. The Federal Reserve and the Alternative Reference Rates Committee (AARC) have since recommended the Secured Overnight Funding Rate (SOFR) as the recommended replacement rate for LIBOR.  Additionally, the AARC recommends that all LIBOR loan agreements cease using any LIBOR index rates by Sept. 30, 2021.

The transition to SOFR presents two distinct challenges for U.S. banks: term structure and fallback language.

Term structure: SOFR is an overnight rate, and not directly appropriate for term lending with monthly or quarterly resets. As such, several possibilities for using SOFR for term lending have emerged, with the main recommendation being Daily Simple SOFR plus a spread adjustment.  This spread adjustment is currently 12 basis points for 1-month LIBOR and 26 basis points for 3-month LIBOR, reflecting the difference between SOFR as a secured rate and LIBOR as an unsecured rate.  More importantly, Daily Simple SOFR is an arrears calculation, which is not particularly client-friendly for a standard commercial bank loan. Nevertheless, the AARC recommends that Daily Simple SOFR be used to replace LIBOR until a true term SOFR rate emerges.

SOFR vs 1-month LIBOR

Source: Federal Reserve Bank of New York

Banks are continuing to discuss options that would be easier for clients to understand on smaller bilateral loans, including prime or a historical average SOFR set at the beginning of an interest period (Figure 1). While not necessarily in-line with the cost-of-funds approximation of Daily Simple SOFR in arrears, the ability to set a rate at the beginning of an accrual period may be more appealing for client-friendly relationship banking.  Overall, the market still needs to settle on the best SOFR rate solutions for bilateral bank loans, and banks need to have a plan for using overnight SOFR until a true term SOFR rate is available.

Figure 1: Calculation Options for monthly payment

Fallback language: Most existing loan documentation is not expected to support SOFR without amendment. The AARC recommends adding “fallback language” to existing loan documents, with a very specific “hardwired” approach to using SOFR. This language defines a “waterfall” of options, depending upon what SOFR rates are available. However, many banks have also been working through a more general fallback language, to allow greater flexibility for different types of SOFR calculations as well as the use of other replacement rates. Whatever language is used, however, commercial banks are likely to have hundreds of thousands of floating-rate LIBOR loans that will need to be amended with new fallback language within the next 10 months.

In light of these issues, banks need to examine three key areas that will be affected by LIBOR replacement: documentation, systems and analytics.

Documentation: All existing LIBOR-based loans will need to be reviewed and potentially amended with appropriate fallback language before September 2021.  Amendments will require consent and signature from clients, opening the opportunity for negotiation of existing terms. Banks should have appropriate legal and banker teams working the review and amendment negotiation process with clients. And plenty of time should be allocated for these amendments to be executed and booked ahead of the fourth-quarter 2021 discontinuation of LIBOR.

Systems: All loan and trading systems that index to LIBOR will need to be re-coded to support SOFR. Most major loan system vendors have already created updates to support multiple SOFR calculations, which banks will need to install and test before re-booking amended LIBOR loans. Interfaces and downstream systems may also be impacted. Overall, a full enterprise examination of systems is required as loan systems are re-coded for the SOFR rate.

Analytics: All models — including those used for funds transfer pricing, risk adjusted return on capital and asset-liability management — will need to be rebuilt and pushed into production to support a new SOFR base rate.  Aligning the new floating rate index of SOFR with the models used internally to price funds and risk is essential to ensure that lending is evaluated appropriately.

The move from LIBOR to SOFR is now less than a year away. Bankers have generally embraced an approach to using SOFR; however, there is a great deal of work to be done on documentation, systems and models to be ready for the conversion in 2021.

Loan Modification Rules Suspended in Race to Minimize Pandemic Losses

The suspension of accounting rules on modified loans is another dramatic measure that regulators and lawmakers have taken in the struggle to limit pandemic-related loan defaults.

The question of how — and increasingly, whether — to account for, report and reserve for modified loans has taken on increasing urgency for banks working to address borrowers’ unexpected hardship following the COVID-19 outbreak.

Regulators homed in on the treatment for troubled debt restructurings, or TDRs, in late March, as cities and states issued stay-at-home orders and the closure of nonessential businesses sparked mass layoffs. The intense focus on the accounting for these credits comes as a tsunami of once-performing loans made to borrowers and businesses across the country are suddenly at risk of souring.

“The statements from regulators and the CARES Act are trying to reduce the conversations that we have about TDRs by helping institutions minimize the amount of TDR challenges that they’re dealing with,” says Mandi Simpson, a partner in Crowe’s audit group.

TDRs materialize when a bank offers a concession on a credit that it wouldn’t have otherwise made to a borrower experiencing financial difficulties or hardship. Both of those prongs must exist for a loan to be classified as a TDR. Banks apply an individual discounted cash flow analysis to modified credits, which makes the accounting complicated and tedious, Simpson says.

“You can imagine, that could be pretty voluminous and cumbersome” as borrowers en mass apply for modifications or forbearance, she says.

Late last month, federal bank regulators provided guidance on TDRs to encourage banks to work with borrowers facing coronavirus-related hardship. Still, Congress intervened, broadening both the relief and the scope of eligible loans.

The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, which went into effect on March 27, suspended the requirements under U.S. generally accepted accounting principles for coronavirus loan modifications that would have otherwise been categorized as TDRs. It also suspended the determination that a loan that has been modified because of the coronavirus would count as a TDR, “including impairment for accounting purposes.” This applies to any loan that receives a modification that was not more than 30 days past due as of Dec. 31, 2019.

The law encourages banks to record the volume of modified loans. It also specified that bank regulators can collect data about these loans for supervisory purposes.

Bank regulators issued their revised interagency statement on April 7 to align with Congress’ rule. Bankers should maintain appropriate allowances and reserves for all loan modifications. It adds that examiners will exercise judgment when reviewing modifications and “will not automatically adversely risk rate credits that are affected by COVID-19.”

Importantly, the U.S. Securities and Exchange Commission’s chief accountant issued an opinion accepting the CARES Act treatment of TDRs as GAAP on April 3. The statement reconciled U.S. accounting policy and federal law, and spared auditors from issuing modified opinions for institutions that adopt the TDR relief.

But the accounting relief could create longer-term issues for banks, says Graham Steele, staff director of the Corporations and Society Initiative at Stanford Graduate School of Business. He previously served as minority chief counsel for the Senate Committee on Banking, Housing and Urban Affairs and was a member of the staff of the Federal Reserve Bank of San Francisco.

He understands the imperative to provide forbearance and flexibility, but he says the modifications and concessions could lead to diminished cash flows that could erode a bank’s future lending capacity. He points out that it’s also unclear what would happen to balance sheets once the national emergency ends, and how fast those modifications would be reclassified.

“This seems like an ‘extend and pretend’ policy to me,” he says. “Congress and regulators have offered forbearance, but they’re changing mathematical and numerical conventions that you can’t just assume away.”

Simpson says that as part of the tracking of modified loans, institutions may want to consider those credits’ risk ratings and how their probability of default compares to performing loans. She is encouraging her clients to consider making appropriate and reasonable disclosures to share with investors, such as the amount and types of modifications. The disclosures could also give bank executives a chance to highlight how they’re working with borrowers and have a handle on their borrower’s problems and financial stress.

“I think proactively helping borrowers early on is a good move. I know banks are challenged to keep up with the information, just I am, and the timing is challenging,” Simpson says. “They’re needing to make very impactful decisions on their business, and you’d like to be able to do that with a little bit more proactivity than reactivity. Unfortunately, that’s just not the place that we find ourselves in these days.”

Coronavirus Strategies, Considerations for Banks

Over the past two weeks, we have received numerous inquiries from financial institutions on what actions should be taken or considered to address the COVID-19, or the new coronavirus, pandemic. While the current situation is evolving each day, we have engaged in numerous discussions with banks on various strategies and considerations that are being reviewed or implemented during this uncertain time.

Business Continuity Plan

Every financial institution should have implemented pandemic planning contingencies contained in its business continuity plan. In response to the burgeoning public health crisis, the Federal Financial Institutions Examination Council issued revised guidance on March 6 on how to address pandemic planning in a bank’s business continuity plans. The revision updates previous guidance issued in response to the avian flu pandemic of 2007.

Although there are no substantive updates contained in the revised Pandemic Planning Guidance, the FFIEC’s update reiterates and emphasizes the importance of maintaining a pandemic response plan that includes strategies to minimize disruptions and recover from a pandemic wave. The updated guidance states that banks should consider minimizing staff contact, encouraging employees to telecommute and redirecting customers from branch to electronic banking services. We anticipate that regulators will review an institution’s utilization of its business continuity plan at upcoming safety and soundness examinations.

Branch Operations

Based on our discussions, we believe that many banks have taken or plan to take actions related to their branch operations. Below is a summary of various actions that a bank may wish to take regarding its branch operations.

Branches Remain Open, with Caveats. A number of banks have elected to close branch lobbies and direct customers to utilize drive-up facilities, walk-up teller lines and ATM machines where possible. In addition, they are also directing customers to their online platforms. Some banks are requesting customers who require physical or in-person assistance, such as access to a safe deposit box, to schedule an appointment with bank employees.

Branch Closures. To the extent a bank may be readying a branch closure strategy, below are federal and state requirements that must be satisfied.

Federal Requirements. On March 13, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Federal Reserve Board issued corresponding guidance addressing COVID-19’s impact on customers and bank operations indicating that they expect bank branch closures, or changes to branch hours. In such an event, they recommend that a bank (i) notify the applicable federal banking regulator as soon as practicable of the closure/change in bank hours, (ii) comply with any notice or filing requirements with applicable state banking regulators and (iii) place a customer notice on the front entrance of the impacted branch describing the reason for the closure and/or change in hours.

State Law Requirements. Closing lobbies and redirecting customers to drive-ups does not generally require a bank to obtain the approval of state banking authorities, but some state banking authorities have requested that banks provide notice of such changes. For example, Illinois-chartered banks seeking to fully close a branch or change branch hours must provide prior notice to the Illinois Department of Financial and Professional Regulation, Division of Banking, and obtain an official proclamation from the IDB under the Illinois Banking Emergencies Act (205 ILCS 610). In addition, the bank must post notice of the temporary closing or change in branch hours and the authorization for such change on the main entrance doors of the applicable branch.

ATM/Cash-On-Hand Strategies. In a push to increase customer traffic to ATMs and minimize direct customer contact, some banks have increased or plan to increase ATM daily allowable cash withdrawal limits. The size of the increase depends on the individual circumstances of the institution. Banks may experience greater cash withdrawal requests from depositors and may wish to keep higher levels of cash in its branch offices.

Regular and Periodic Cleaning of Branches. Each bank we spoke with also indicated that they have implemented enhanced periodic cleaning of their branches and offices. Some banks have indicated that “deep” cleanings are being completed on a weekly basis.

Employee Considerations

Flexible Work-from-Home Arrangements. We have also discussed the potential for implementing flexible work-from-home or telecommuting arrangements for specific business line employees with institutions. Whether or not this is a viable option for a specific institution is dependent upon a number of specific circumstances: whether the bank’s information technology systems can support an increased number of employees utilizing the bank’s server remotely, ensuring that each employee who remotely accesses the bank’s systems can do so in a confidential manner that protects that bank’s data and whether there are geographic and business-line specific considerations that prevent working remotely, among others. Nonetheless, a bank should plan to test their IT systems and update policies prior to implementing such arrangements.

Utilization of Split-Staff and Split-Location Strategies. In addition, we’ve discussed split-staff and split-location strategies;  a number of banks indicated that they are currently utilizing a split-staff strategy. Under a split-staff strategy, an institution staggers its employees on any given day. For instance, half of the institution’s employees come in on Monday, Wednesday and Friday, and the other half of the employees come in on Tuesday, Thursday and Saturday. The aim is that limiting employee interaction with customers on any given day allows a bank to maintain operations on a much more limited basis if only one group of employees is potentially exposed to COVID-19.

In addition, some institutions also indicated that they plan to utilize a split-location strategy, distributing staff across various branches and offices. If one location is potentially exposed to COVID-19, a bank’s operations can continue through its other locations.

Employee Training. Banks have also implemented staff training on how to properly interact with customers during this troubling time. Following guidance from the World Health Organization and Centers for Disease Control and Prevention, banks have implemented new procedures meant to limit physical contact (like prohibiting handshakes) and eliminating or reducing scheduled meetings.

Liquidity and Capital Considerations

During times of uncertainty and financial market volatility, like the financial crisis, banks have often found it difficult to enhance liquidity and raise additional capital when they may need it the most. Based on our discussions, we recommend that financial institutions review their current and near-term liquidity/capital strategies. Below are a few items to consider.

Subordinated Debt and Equity Issuances. Banks may need to weather a prolonged economic slowdown. Bankers agree that reviewing the firm’s capital strategies in uncertain times is a critical consideration to address any potential need to enhance immediate or near-term liquidity or to shore up capital. Other banks may also wish to review various alternatives available to issue debt for additional liquidity, to potentially refinance outstanding debt arrangements at lower rates, or to provide additional capital.

Lines of Credit. As lenders, banks are aware that their borrowers may be considering a draw down on existing lines of credit. Banks may also wish to consider potentially drawing down on their existing lines of credit (such as Federal Home Loan Bank advances or holding company lines of credit) as an effective tool to increase the holding company’s or bank’s liquidity. Before either drawing down any existing line of credit or utilizing the proceeds for any purpose other than increasing cash-on-hand, a bank should carefully review the covenants in the underlying loan agreements.

Securities Portfolio. Reviewing current strategies pertaining to an institution’s securities portfolio is also a consideration for banks. Many banks have built-in gains in their portfolio. Consequently, institutions are reviewing their portfolios to determine whether to realize existing gains to boost liquidity in the short-term or maintain its current strategy to assist earnings in the longer-term.

Stock Repurchase Programs. Many publicly traded banks have suspended their stock repurchase programs as part of a capital conservation strategy. While no bank has announced plans to cut dividends, now is the time to review contingency plans and consider when such action may be warranted.

Federal Reserve Discount Window. Bankers should also discuss potentially using the Federal Reserve’s short-term emergency loans dispensed through the discount window if necessary. While many institutions consider using the discount window as a last resort and could indicate dire financial straits, senior bank management should revisit their policies and procedures to ensure their institution can access the discount window should circumstances require it.

Importantly, on March 17, the Federal Reserve and eight of the largest financial institutions in the U.S. worked together to provide these large financial institutions access to the discount window. Largely symbolic, the actions are being viewed by banks as an effort to remove the stigma of accessing the discount window. Whether these coordinated efforts will be a success remains to be seen.

Stress Testing of Loans. We anticipate that many institutions will consider the need to begin stress testing their portfolios, and some already are. For some, stress testing may be centered on specific industries and sectors of the loan portfolio that may have been more substantially impacted by COVID-19 (such as hospitality/restaurants, travel, entertainment and companies with supply chains dependent upon China or Europe). For others, the entire loan portfolio may be tested, under the assumption it could be subject to pandemic-related stress.

Review Insurance Policies. Another consideration we’ve discussed with banks is the need to review in-place insurance policies for business disruption coverage to determine if they would cover matters resulting from the COVID-19 pandemic.

Assist Impacted Customers. Consistent with the recent guidance issued by the Fed, FDIC and OCC, banks are considering offering a variety of relief options related to specific product/service lines to customers. Some banks may waive late fees on loan payments or credit cards and others may waive ATM- and deposit-related fees. We expect these relief options will be limited to specific product and service lines, and to a certain period of time.

On March 19, the FDIC issued a set of Frequently Asked Questions for banks impacted by the coronavirus. The FAQs provide insight into how the FDIC, and potentially other federal banking regulators, will view payment accommodations, reporting of delinquent loans, document retention and reporting requirements, troubled debt restructurings, nonaccrual loans and the allowance for loan and lease losses. Banks should review the FAQs in connection with providing any financial assistance to impacted customers.

The items noted above should not be considered definitive or exclusive. A financial institution should carefully consider the above items, among others, and determine how to tailor any proposed changes to its operations in light of the very fluid circumstances surrounding the current COVID-19 pandemic.

Click here to review the March 13 OCC Bulletin 2020-15 (Pandemic Planning: Working With Customers Affected by Coronavirus and Regulatory Assistance).

Click here to review the March 13 FDIC FIL-17-2020 (Regulatory Relief: Working with Customers Affected by the Coronavirus).

Click here to review the March 13 FRB SR 20-4/CA 20-3 (Supervisory Practices Regarding Financial Institutions Affected by Coronavirus).