Managing Credit Risk Without Overburdening Resources

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Deposit Costs Creep Up Following Rate Increases

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The rapidly rising interest rate environment is beginning to impact the funding dynamics at banks as deposit competition increases and they pay up for time deposits.

While rising rates are generally good for lending, the unrelenting climb in interest rates hasn’t been uniformly positive for banks. Since the pandemic, many banks have had historic deposit growth and liquidity. The aggressive and continuous rising interest rate environment could change that. 

There was a 1.1% drop in total deposits at all Federal Deposit Insurance Corp.-chartered banks in the third quarter, according to a November report from analysts at Janney Montgomery Scott. Excluding time deposits like certificates of deposits, or CDs, core deposits dropped 2%. But over that time, 40% of banks reported positive deposit growth in excess of 1%. That could mean that as core deposits leave banks, they are growing time deposits. 

The median cost of deposits for banks in the Kroll Bond Rating Agency universe more than doubled in the third quarter to 37 basis points. 

“No longer content with letting the hot money exit, this sharp increase in deposit costs is the product of a strategy of rate increases designed to stem outflows of less sticky or rate sensitive deposits,” wrote KBRA in a Nov. 15 report.  

One reason for this deposit shift is consumers and businesses are leveraging technology to move their funds into higher rate accounts. Core deposit outflows in future quarters could be unpredictable for institutions: they might happen at a faster pace or higher volume than a bank is prepared for, or a few large, important deposit relationships may leave. This could deplete available cash on hand that an institution would use for ongoing operations or to fund new loan opportunities. 

“The last time we went through a significantly rising rate environment, in the 1970s, money market funds did not exist. People were captive to the bank,” says Nate Tobik, CEO of CompleteBankData and author of “The Bank Investor’s Handbook.” “Now we’re [repeating] the ‘70s, except there are alternatives.”

One option banks had in the past to raise short-term liquidity — selling securities marked as available for sale (AFS) — may be off the table for the time being. The bank space carried a total unrealized loss, mostly tied to bonds, of more than $450 billion in the second quarter, according to the FDIC. This loss is recorded outside of net income, in a call report line item called accumulated other comprehensive income. Selling AFS securities right now would mean the bank needs to record the loss. 

“Over the past couple weeks, we have had multiple discussions with community bankers that have been very focused on deposit generation,” wrote attorney Jeffrey Gerrish, of Gerrish Smith Tuck, in a late October client newsletter. “Unfortunately, many of these community banks have a securities portfolio that is so far under water they really don’t see the ability to sell any securities to generate cash because they cannot afford to take the loss. This is a very common scenario and will result in a pretty healthy competition for deposits over the next 12 to 24 months.”

In response, banks will need to consider other options to raise alternative funds fast. Noncore funding can include brokered CDs, wholesale funding or advances from the Federal Home Loan Banks system. Tobik says CDs appeal to banks because they are relatively easy to raise and are “time deterministic” — the funding is locked for the duration of the certificate. 

All of those products come at a higher rate that could erode the bank’s profit margin. 

Another ratio to watch at this time is the liquidity ratio, wrote Janney analysts in a Nov. 21 report. The liquidity ratio, which compares liquid assets to total liabilities, is used by examiners as a more “holistic” alternative to ratios like loans-to-deposits. The median liquidity ratio for all publicly traded banks at the end of the third quarter was 20%, with most banks falling in a distribution curve ranging from 10% to 25%.

The 20% median is still 4% higher than the median ratio in the fourth quarter of 2019. The effective federal funds rate got as high as 2.4% in summer 2019, compared to 3.08% in October. Janney did find that banks between $1 billion and $10 billion had “relatively lower levels” of liquidity compared to their smaller and bigger peers.

But for now, they see little to worry about, but a lot to keep their eyes on. “Our analysis shows that while liquidity has tightened slightly by several measures since a [fourth quarter 2021] peak, banks still maintain much higher levels of liquidity than prior to the pandemic and have plenty of capacity to take on additional wholesale funding as needed to supplement their core funding bases,” they wrote.

Going forward, banks will need to balance the tension between managing their liquidity profile and keeping their cost of funds low. What is the line between excess liquidity and adequate liquidity? How many deposit relationships need to leave any given bank before it starts a liquidity crunch? What is cost of paying more for existing deposits, versus the potential cost of bringing in wholesale or brokered deposits? 

The answers will be different for every bank, but every bank needs to have these answers.

How Banks Can Speed Up Month-End Close

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In accounting, time is of the essence.

Faster financial reporting means executives have more immediate insight into their business, allowing them to act quicker. Unfortunately for many businesses, an understaffed or overburdened back-office accounting team means the month-end close can drag on for days or weeks. Here are four effective strategies that help banks save time on month-end activities.

1. Staying Organized is the First Step to Making Sure Your Close Stays on Track
Think of your files as a library does. While you don’t necessarily need to have a Dewey Decimal System in place, try to keep some semblance of order. Group documentation and reconciliations in a way that makes sense for your team. It’s important every person who touches the close knows where to find any information they might need and puts it back in its place when they’re done.

Having a system of organization is also helpful for auditors. Digitizing your files can help enormously with staying organized: It’s much easier to search a cloud than physical documents, with the added benefit of needing less storage space.

2. Standardization is a Surefire Way to Close Faster
Some accounting teams don’t follow a close checklist every month; these situations make it more likely to accidentally miss a step. It’s much easier to finance and accounting teams to complete a close when they have a checklist with clearly defined steps, duties and the order in which they must be done.

Balance sheet reconciliations and any additional analysis also benefits from standardization. Allowing each member of the team to compile these files using their own specific processes can yield too much variety, leading to potential confusion down the line and the need to redo work. Implementing standard forms eliminates any guesswork in how your team should approach reconciliations and places accountability where it should be.

3. Keep Communication Clear and Timely
Timely and clear communication is essential when it comes to the smooth running of any process; the month-end close is no exception. With the back-and-forth nature between the reviewer and preparer, it’s paramount that teams can keep track of the status of each task. Notes can get lost if you’re still using binders and spreadsheets. Digitizing can alleviate some of this. It’s crucial that teams understand management’s expectations, and management needs to be aware of the team’s bandwidth. Open communication about any holdups allows the team to accomplish a more seamless month-end close.

4. Automate Areas That Can be Automated
The No. 1 way banks can save time during month-end by automating the areas that can be automated. Repetitive tasks should be done by a computer so high-value work, like analysis, can be done by employees. While the cost of such automation can be an initial barrier, research shows automation software pays for itself in a matter of months. Businesses that invest in technology to increase the efficiency of the month-end close create the conditions for a happier team that enjoys more challenging and fulfilling work.

Though month-end close with a lack of resources can be a daunting process, there are ways banks can to improve efficiency in the activities and keep everything on a shorter timeline. Think of this list of tips as a jumping off point for streamlining your institution’s close. Each business has unique needs; the best way to improve your close is by evaluating any weaknesses and creating a road map to fix them. Next time the close comes around, take note of any speed bumps. There are many different solutions out there: all it takes is a bit of research and a willingness to try something new.

Student Loans Come Due

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Just as the Federal Reserve raises rates and inflation hits a 40-year high, Americans with federal student loan debt will start making payments on the debt after a two-year pause. On Aug. 31, the Department of Education will require 41 million people with student loans to begin paying again. 

According to the Federal Reserve, about one in five Americans have federal student loan debt and they saved $5 billion per month from the forbearance. It’s safe to say that a lot of people are going to struggle to restart those payments again and some of them work for banks.

The good news is that there are new employee programs that can help. One CARES Act provision allowed companies to pay up to $5,250 toward an employee’s student loans without a negative tax hit for the employee. Ally Financial, Fidelity Investments, SoFi Technologies, and First Republic Bank are a few of the many financial companies offering this benefit to employees. First Republic launched its program in 2016, after its purchase of the fintech Gradifi, which helps employers repay their employees’ loans. These programs typically pay between $100 and $200 a month on an employee’s loans, and usually have a cap.

The 2020 Bank Director Compensation Survey shows that 29% of financial institutions offered student loan repayment assistance to some or all employees. Many of those programs discontinued when the student forgiveness program started. In the anticipation of government forbearance coming to a close, now is a good time to think about restarting your program or even developing one. 

Americans now hold $1.59 trillion in student loan debt, according to the Federal Reserve. How did we get here? College got more expensive— much more expensive. 

Earlier this summer, the Federal Reserve and Aspen Institute had a joint summit to discuss household debt and its chilling effect on wealth building. The average cost of college tuition and fees at public 4-year institutions has risen 179.2% over the last 20 years for an average annual increase of 9.0%, according to EducationData.org.

At the same time, wages have not shown much inflation-adjusted growth. ProPublica found in 2018 that the real average wage of workers, after accounting for inflation, has about the same purchasing power it did 40 years ago. And inflation in 2022 has far outpaced wage increases. Some economists speculate that any pandemic-era wage increases are effectively nullified by this rapid inflation.

Not all borrowers are equally impacted. Sixteen percent of graduates will have a debt-to-income ratio of over 20% from their student loans alone, according to the website lendedu.com, while another 28% will have a DTI of over 15%. The 44% of graduates with that level of debt exiting school will face a steep climb to meaningful wealth building. The students that didn’t graduate will have an even harder climb.

Those graduates who struggle with their student loans will be less likely to buy a home or more likely to delay home ownership. They will be less likely to take on business debt or save for retirement. Housing prices have risen in tandem with education prices. The “starter home” of generations past has become unattainable to many millennial and Gen Z debt holders.

More than half of borrowers owe $20,000 or less. Seven percent of people with federal debt owe more than $100,000, according to The Washington Post. Economists at the Federal Reserve say borrowers with the least amount of debt often have difficulty repaying their loans, especially if they didn’t finish their degree. Conversely, people with the highest loan balances are often current on their payments. It’s likely that people with higher loan debt generally have higher education levels and incomes.

The Aspen Institute published a book known as “The Future of Building Wealth: Brief Essays on the Best Ideas to Build Wealth — for Everyone,” in conjunction with the Federal Reserve Bank of St. Louis. It illuminates long-term solutions for financial planning, focusing on policies and programs that could be applied at a national scale. 

In the absence of these national solutions, some employers are taking the matter into their own hands with company policies designed to help employees with student debt. Those banks are making a difference for their own employees and are part of the solution. 

Inflation, Interest Rates and ‘Inevitable’ Recession Complicate Risks

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What is the bigger risk to banks: inflation, or the steps the Federal Reserve is taking to bring it to heel?

Community banks are buffeted by an increasingly complicated operating environment, said speakers at Bank Director’s 2022 Bank Audit and Risk Committees Conference in Chicago, held June 13 to 15. In rather fortuitous timing, the conference occurred in advance of the Federal Reserve’s Federal Open Market Committee’s June meeting, where expectations were high for another potential increase in the federal funds rate. 

On one hand, inflation remains high. On the other hand, rapidly increasing interest rates aimed at interrupting inflation are also increasing risk for banks — and could eventually put the economy into a tailspin. Accordingly, interest rates and the potential for a recession were the biggest issues that could impact banks over the next 12 to 18 months, according to a pop up poll of some 250 people attending the event.  

Brandon Koeser, a financial services senior analyst at audit and consulting firm RSM US, said that inflation is the “premier risk” to the economic outlook right now. He called the consumer price index trend line “astonishing” — and its upward path may still have some momentum, given persistently high energy prices. Just days prior, on June 10, the Bureau of Labor Statistics announced that the CPI increased 1% in May, to 8.6% over the last 12 months. 

Koeser also pointed out that inflation is morphing, broadening from goods into services. That “rotation” creates a stickiness in the market that will be harder for the Federal Reserve to fight, increasing the odds that inflation persists.

It is “paramount” that the economy regain some semblance of price stability, Koeser said. In response, central bankers are increasing the pace, and potential size, of federal fund rate increases. But jacking up rates to lower prices without causing a recession is a blunt approach akin to “trying to thread a needle wearing boxing gloves,” he said.

While higher interest rates are generally good for banks, an inflationary environment could dampen loan growth while intensifying interest rate and credit risk, according to the Federal Deposit Insurance Corp.’s 2022 Risk Review. Inflation could lead consumers to cut back on spending, leading to lower business sales, and it could make it harder for borrowers to afford their payments.

At the same time, banks awash in pandemic liquidity added longer-term assets in 2021 in an attempt to capture some yield. Assets with maturities that were longer than three years made up 39% of assets at banks in 2021, compared with 36% in 2019, according to the FDIC. Community banks were even more vulnerable. Longer-term assets made up 52% of total assets at community banks at the end of 2021.

Managing this interest rate risk could be a challenge for banks that lack institutional knowledge of this unique environment. Kyle Manny, a partner at audit and consulting firm Plante Moran, pointed out that many banks are staffed with individuals who weren’t working in the industry in the 1980s or prior. He shared an anecdote of a seasoned banker who admitted he was “caught flat footed” by taking too much risk on the yield curve in the securities portfolio, and was now paying the price after the fair value of those assets fell. 

And high enough rates may ultimately send the economy into a recession. In Koeser’s poll of the audience, about 34% of audience members believe a recession will occur within the next six months; another 36% saw one as likely occurring in the next six to 12 months. Koeser said he doesn’t think it’s “impossible” for the central bank to avert a recession with a soft landing — but the margin for error is getting so small that a downturn may be “inevitable.”

Banks have limited options in the face of such macroeconomic trends, but they can still manage their own credit risk. David Ruffin, principal at credit risk analytics firm IntelliCredit, a division of Qwickrate, said that credit metrics today are the most “pristine” he had seen in his nearly 50 years in the industry. Still, the impact of the coronavirus pandemic and inflation could hide emerging credit risk on community bank portfolios. Kamal Mustafa, chairman of the strategic advisory firm Invictus Group, advised bankers to dig into their loan categories, industry by industry, to analyze how different borrowers will be impacted by these countervailing forces. Not all businesses in a specific industry will be impacted equally, he said.

So while banks can’t control the environment, they can at least understand their own loan books. 

The Topic That’s Missing From Strategic Discussions

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As of Oct. 8, 2021, the U.S. experienced 18 weather-related disasters with damages exceeding the $1 billion mark, according to the National Oceanic and Atmospheric Administration (NOAA). These included four hurricanes and tropical storms on the Gulf Coast — the costliest disaster, Hurricane Ida, totaled $64.5 billion, destroying homes and knocking out power in Louisiana before traveling north to cause further damage via flash flooding in New Jersey and New York. Out West, the financial damage caused by wildfires, heat waves and droughts has yet to be tallied but promises to be significant. More than 6.4 million acres burned, homes, vegetation and lives were destroyed, and a hydroelectric power plant outside Sacramento even shut down due to low water levels.

These incidents weren’t unique to 2021. In fact, the frequency of costly natural disasters — exceeding $1 billion, adjusted for inflation — have been ticking up since at least the 1980s.

 

Scientists at the NOAA and elsewhere point to climate change and increased development in vulnerable areas such as coastlines as the cause of these more frequent, costlier disasters, but bank boards aren’t talking about the true risks they pose to their institutions. Bank Director’s 2021 Risk Survey, conducted in January, found just 14% of directors and senior executives reporting that their board discusses the risks associated with climate change at least annually. An informal audience poll at Bank Director’s Bank Audit & Risk Committees Conference in late October confirmed little movement on these discussions, despite attention from industry stakeholders, including regulators and investors that recognize the risks and opportunities presented by climate change.

These include acting Comptroller of the Currency Michael Hsu, who on Nov. 3 announced his agency’s intent to “develop high-level climate risk management supervisory expectations for large banks” above $50 billion in assets along with guidance by the end of the year. He followed that announcement with a speech a few days later that detailed five questions every bank board should ask about climate change. While his comments — and the upcoming guidance — focus on larger institutions, smaller bank boards would benefit from these discussions.

Hsu’s first two questions for boards center on the bank’s loan portfolio: “What is our overall exposure to climate change?” and “Which counterparties, sectors or locales warrant our heightened attention and focus?” Hsu prompts banks to dig into physical risks: the impacts of more frequent severe weather events on the bank’s markets and, by extension, the institution itself. He also asks banks to look at transition risks: reduced demand and changing preferences for products and services in response to climate change. For example, auto manufacturers including General Motors Co. and Ford Motor Co. announced in November that they plan to achieve zero emissions by 2040; those shifts promise broad impacts to the supply chain as well as gas stations across the country due to reduced demand for fuel.

Consider your bank’s geographic footprint and client base: What areas are more susceptible to frequent extreme weather events, including hurricanes, floods, wildfires and droughts? How many of your customers depend on carbon intensive industries, and will their business models be harmed with the shift to clean energy? These are the broad strategic areas where Hsu hopes boards focus their attention.

But the changes required in transitioning to a clean economy will also result in new business models, new products and services, and the founding and growth of companies across the country. It’s the other side to the climate change coin that prompts another question from Hsu: “What can we do to position ourselves to seize opportunities from climate change?”

Some large investors agree. In Larry Fink’s 2021 letter to CEOs, the head of BlackRock reaffirmed the value the investment firm places on climate change, noting the opportunities along with the risks. “[W]e believe the climate transition presents a historic investment opportunity,” he wrote in January. “There is no company whose business model won’t be profoundly affected by the transition to a net zero economy – one that emits no more carbon dioxide than it removes from the atmosphere by 2050. … As the transition accelerates, companies with a well-articulated long-term strategy, and a clear plan to address the transition to net zero, will distinguish themselves with their stakeholders.”

Some banks are positioning themselves to be early movers in this space. These include $187 billion Citizens Financial Group, which launched a pilot green deposit program in July 2021 that ties interest-bearing commercial deposits to a sustainable-focused lending portfolio. The challenger bank Aspiration launched a credit card in November that plants two trees with every purchase. And $87 million Climate First Bank opened its doors over the summer, offering residential and commercial solar loans, and financing environmentally-friendly condo upgrades. Climate First is founder and CEO Kenneth LaRoe’s second bank focused on the environment, and he sees a wide range of opportunities. “I call myself a rabid environmentalist — but I’m a rabid capitalist, too,” he told Bank Director magazine earlier this year.

 

Select Green Initiatives Announced in 2021

Source: Bank press releases and other public information

Climate First Bank (St. Petersburg, Florida)
Specialized lending to finance sustainable condo retrofits and residential/commercial solar loans; contributes 1% of revenues to environmental causes.

Citizens Financial Group (Providence, Rhode Island)
Launched pilot green deposit program in July 2021, totaling $85 million as of Sept. 30, 2021.

Aspiration (Marina Del Rey, California)
Fintech introduced Aspiration Zero Credit Card, earning cash back rewards and planting two trees with every purchase.

JPMorgan Chase & Co. (New York)
Designated “Green Economy” team to support $1 trillion, 10 year green financing goal.

Bank of America Corp. (Charlottesville, North Carolina)
Increased sustainable finance target from $300 million to $1.5 trillion by 2030.

Fifth Third Bancorp (Cincinnati, Ohio)
Issued $500 million green bond to fund green building, renewable energy, energy efficiency and clean transportation projects.

 

Boards that don’t address climate change as a risk in the boardroom will likely overlook strategic opportunities. “Banks that are poorly prepared to identify climate risks will be at a competitive disadvantage to their better-prepared peers in seizing those opportunities when they arise,” Hsu said.

Hsu offered two additional questions for bank boards in his speech. “How exposed are we to a carbon tax?”references the price the U.S. government could place on greenhouse gas emissions; however, he also stated that the passage of such a tax in the near future is unlikely. The other, “How vulnerable are our data centers and other critical services to extreme weather?” certainly warrants attention from the board and executive team as part of any bank’s business continuity and disaster recovery planning.

Most management teams won’t be able to answer broader, strategic questions on climate initially, Hsu said, but that shouldn’t keep boards from asking them. “Honest responses should prompt additional questions, rich dialogue, discussions about next steps and management team commitments for action at future board meetings,” Hsu stated. “By this time next year, management teams hopefully should be able to answer these questions with greater accuracy and confidence.”

Tips to Navigate Top Risk Factors for Banks in 2021

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Risk is always a prominent factor for banks. Their ability to strategically navigate change proved to be crucial in a year of unprecedented challenges caused by the Covid-19 pandemic.

Moss Adams partnered with Bank Director to conduct the 2021 Risk Survey that explored key risks facing the industry — and forecast how banks will emerge from the pandemic. Below is a summary of top insights from the survey, as well as considerations that bank leadership should keep front of mind as they go into the second half of the year.

Rising Credit Risk Concerns

Unsurprisingly, concerns around credit risk increased in 2020.

Two-thirds of bank respondents worry about concentrations in their loan portfolio, particularly around industries significantly strained during the pandemic, including commercial real estate and hospitality. Almost all respondents modified loans in second and third quarters of 2020 to aid their customers during the initial wave; some of these modifications extended into the fourth quarter.

Evaluation Metrics and Portfolio Concerns

Two separate metrics are now in play for regulators’ evaluations. As a result, it’s important to remember that just because your bank’s loan portfolio doesn’t receive a favorable rating doesn’t mean your bank or management won’t be evaluated favorably.

Regulators might downgrade a portfolio rating as some credits went into deferrals due to business shutdowns and borrowers being unable to make payments. However, bank management could receive a strong rating because of actions they took to keep the bank running and support customers.

While modifications reflect current realities, they don’t diminish the fact that portfolios are degrading from a stability standpoint. Forty-three percent of respondents tightened underwriting standards during the pandemic, while roughly half are unsure if they’ll adjust standards in 2021 and 2022.

Banks that have good governance will loosen their underwriting standards and will be strategic about to whom they lend money. In addition, they will assess which loans they’ll permit to be in delinquent status without taking action, and which they’ll defer.

Increases in Stress Testing

While annual stress tests are common for banks, 60% of respondents expanded the quantity or depth of economic scenarios in response to the pandemic. This is despite regulators’ previous increase of the asset cap threshold for required testing.

Most institutions focus not just on interest rate stress testing — they test the whole portfolio. This is driving more stress testing on the viability of collateral for loans and liquidity. Institutions know they’ll face increased allowance provisions and write-offs, so they’re stress testing the capital resiliency of their organization and see how they would shoulder that burden.

Looking forward, banks may want to focus on concentrated risks within the portfolio. They may also want to apply different, more specific stress testing criteria to various segments such as multifamily real estate, hospitality and mortgages, knowing certain areas may pose greater risk.

Improved Plans for Continuity and Disaster Recovery

The pandemic placed a renewed focus on continuity and disaster recovery. While most organizations had a pandemic provision in their plans following guidance from the Federal Financial Institutions Examination Council (FFIEC), they had been considered only hypothetical exercises. When an actual pandemic hit, many organizations had to react quickly, focus and learn how to adapt during the experience. Most banks will enhance their business continuity plans as a result of the pandemic: 84% of respondents say they’ve made or plan to make changes to their plans.

Key improvement areas include plans to:

  • Formalize remote work procedures.
  • Educate and train employees.
  • Provide the right tools to staff.
  • Ensure the bank’s IT infrastructure can adapt in a crisis.

Cybersecurity and Remote Work Setups

Three-quarters of respondents plan for at least some employees to work remotely after the pandemic abates. This makes cybersecurity a significant concern that boards need to further explore and implement additional precautions around.

Previously, with employees working in one space, there was only one entry point of attack for cybercriminals. Suddenly, with employees working from potentially hundreds of different locations, hundreds of entry points could exist.

Factoring in employees’ mental states is also a crucial vulnerability. It’s easier for cybercriminals to take advantage of or deceive employees that are navigating the difficulties of working from home and the general stresses of the pandemic. Increased staff training, as well as technology improvements, can help better detect and deter cyberthreats and intrusions.

Looking Forward

Though many respondents noted the resilience of the industry, it’s important to not get complacent. Banks certainly weathered the hard times, but the biggest impacts of the past year likely won’t be fully visible until the pandemic subsides.

Once that occurs, some businesses will reopen but may need more capital. Others may still close permanently, leaving banks to determine which loans won’t get repaid, engage bankruptcy courts, take cents on the dollars for the loan and charge write-offs.

So while this past year has been a major learning experience, the lesson likely won’t be concluded until early 2022.

 

Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC.

A Lending Platform Prepared for Pandemic Pitfalls

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Managing a loan portfolio requires meticulous review, careful documentation and multiple levels of signoff.

That can often mean tedious duplication and other labor-intensive tasks that tie up credit administration staffers. So, when Michael Bucher, chief credit officer at Lawton, Oklahoma-based Liberty National Bank, came across a demonstration of Teslar Software’s portfolio management system, he couldn’t believe it. The system effortlessly combined the most labor-intensive and duplicative processes of loan management, stored documents, tracked exceptions and generated reports that allowed loan and credit officers to chart trends across borrowers. The $738 million bank signed a contract at the end of 2019 and began implementation in February 2020.

That was fortuitous timing.

Teslar Software’s partnership with institutions like Liberty National, along with its efforts to assist banks and borrowers with applications for the Small Business Administration’s Paycheck Protection Program, earned it the top spot in the lending category in Bank Director’s 2021 Best of FinXTech Awards. Finalists included Numerated — a business loan platform that was another outperformer during the PPP rollout — and SavvyMoney, which helps banks and credit unions offer pre-qualified loans through their digital channels. You can read more about Bank Director’s awards methodology and judging panel here.

Prior to implementing Teslar Software, Liberty National used a standalone platform to track every time a loan didn’t meet the bank’s requirements. It was an adequate way to keep track of loan exceptions when the bank was smaller, but it left him wondering if it would serve the bank’s needs as it continued to grow. The old platform didn’t communicate with the bank’s Fiserv Premier core, which meant that when the bank booked a new loan, a staffer would need to manually input that information into the system. The bank employed one person full-time to keep the loan tracking system up-to-date, reconcile it with the core and upload any newly cleared exceptions on various loans.

Bucher says it was immediately apparent that Teslar Software offered efficiency gains. Its system can integrate with several major cores and is refreshed daily. It collects documentation that different areas within the bank, like commercial loan officers and credit administration staff, can access, allows the bank to set loan exceptions, clears them and finalizes the documentation so it can be imaged and stored in the correct location. Staffers that devoted an entire day to cumbersome reconciliation tasks now spend a few hours reviewing documentation.

Bucher was also impressed by the fintech’s approach to implementation and post-launch partnership. The bank is close enough to Teslar Software’s headquarters in Springdale, Arkansas, that founder and CEO Joe Ehrhardt participated in the bank’s implementation kickoff. Teslar Software’s team is comprised of former bankers who leveraged that familiarity in designing the user’s experience. Between February and June of 2020, the earliest months of the coronavirus pandemic, Teslar Software built the loan performance reports that Liberty National needed, and made sure the core and platform communicated correctly. Weekly calls ensured that implementation was on track and the reports populated the correct data.

Teslar Software’s platform went live at Liberty National in June — missing the bulk of the bank’s first-round PPP loan issuance. But Teslar Software partnered with Jill Castilla, CEO of Citizens Bank of Edmond, and tech entrepreneur and NBA Dallas Mavericks owner Mark Cuban to power a separate website called PPP.bank, a free, secure resource for multiple banks to serve PPP borrowers.

“Teslar Software came to the rescue when they provided their Paycheck Protection Program application tool to all community banks during a period of extreme uncertainty for small businesses due to the Covid-19 pandemic,” Castilla says in a statement to Bank Director. “The partnership we forged with them and Mark Cuban was a game changer for so many that were in distress.”

And Liberty National was able to use Teslar Software’s platform to create and process forgiveness applications for the 500 first-round PPP loans it made. Bucher says the forgiveness application platform is similar to the tax preparation software TurboTax — it breaks the complex application down into digestible sections and prompts borrowers to submit required documents to a secure portal. The bank needs only one employee to review these applications.

“We had such a good experience with the forgiveness side that for PPP in 2021, we partnered with them to handle the front end and the back end of PPP [application],” he says. “It’s now all centralized within Teslar so that when we move on to forgiveness, everything is going to be there. I’m expecting the next round of forgiveness to go a lot smoother than the previous round.”

Outside of PPP, Teslar Software has allowed Liberty National’s credit administration team to manage its current workload, even as staffing decreased from 10 people to six. Instead of taking a full day to review and verify loan exceptions, it takes only a few hours. Bucher says the bank is exploring an expanded relationship with the fintech to add additional workflow modules that would reduce duplication and eliminate the use of email to share documents.

Can the Industry Handle the Truth on Credit Quality?

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Maybe Jack Nicholson was right: “You can’t handle the truth!”

The actor’s famous line from the 1992 movie “A Few Good Men” echoes our concern on bank credit quality in fall 2019 and heading into early 2020.

Investors have been blessed with record lows in credit quality: The median ratio of nonperforming assets (NPA) is nearly 1%, accounting for nonperforming loans and foreclosed properties, a figure that modestly improved in the first half of 2019. Most credit indicators are rosy, with limited issues across both private and public financial institutions.

However, we are fairly certain this good news will not last and expect some normalization to occur. How should investors react when the pristine credit data reverts to a higher and more-normalized level?

The median NPA ratio between 2004 and 2019 peaked at 3.5% in 2011 and hit a record low of 60 basis points in 2004, according to credit data from the Federal Deposit Insurance Corp. on more than 1,500 institutions with more than $500 million in assets. It declined to near 1% in mid-2019. Median NPAs were 2.9% of loans over this 15-year timeframe. The reversion to the mean implies over 2.5 times worse credit quality than currently exists. Will investors be able to accept a headline that credit problems have increased 250%, even if it’s simply a return to normal NPA levels?

Common sense tells us that investors are already discounting this potential future outcome via lower stock prices and valuation multiples for banks. This is one of many reasons that public bank stocks have struggled since late August 2018 and frequently underperform their benchmarks.

It is impressive what banks have accomplished. Bank capital levels are 9.5%, 200 basis points higher than 2007 levels. Concentrations in construction and commercial real estate are vastly different, and few banks have more than 100% of total capital in any one loan category. Greater balance within loan portfolios is the standard today, often a mix of some commercial and industrial loans, modest consumer exposure, and lower CRE and construction loans.

Median C&I problem loans at banks that have at least 10% of total loans in the commercial category — more than 60% of all FDIC charters — showed similar trends to total NPAs. The median C&I problem loan levels peaked at 4% in late 2009 and again in 2010; it had retreated to 1.5%, as of fall 2019. The longer-term mean is greater due to the “hockey stick” growth of commercial nonaccrual loans during the crisis years spanning 2008 to 2011, as well as the sharp decline in C&I problem loans in 2014. Over time, we feel C&I NPAs will revert upward, to a new normal between 2% to 2.25%.

Public banks provide a plethora of risk-grade ratings on their portfolios in quarterly and annual filings, following strong encouragement from the Securities and Exchange Commission to provide better credit disclosures. The nine-point credit scale consists of “pass” (levels 1 to 4), “special mention/watch” (5), “substandard” (6), “nonperforming” (7), “doubtful” (8) and “loss” (9, the worst rating).

They define a financial institution’s criticized assets, which are loans not rated “pass,” indicating “special mention/watch” or worse, as well as classified assets, which are rated “substandard” or worse. The classified assets show the same pattern as total NPAs and C&I problem loans: low levels with very few signs of deterioration.

The median substandard/classified loan ratio at over 300 public banks was 1.14% through August 2019. That compared to 1.6% in fall 2016 and 3.4% in early 2013. We prefer looking at substandard credit data as a way to get a deeper cut at banks’ credit risk — and it too flashes positive signals at present.

The challenge we envision is that investors, bankers and reporters have been spoiled by good credit news. Reversions to the mean are a mathematical truth in statistics. We ultimately expect today’s good credit data to revert back to higher, but normalized, levels of NPAs and classified loans. A doubling of problem credit ratios would actually just be returning to the historical mean. Can investors accept that 2019’s credit quality is unsustainably low?

We believe higher credit problems will eventually emerge from an extremely low base. The key is handling the truth: An increase in NPAs and classified loans is healthy, and not a signal of pending danger and doom.

As the saying goes: “Keep Calm and Carry On.”

77 Percent of Bank Boards Approve Loans. Is That a Mistake?

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loans-5-17-19.pngBank directors face a myriad of expectations from regulators to ensure that their institutions are safe and sound. But there’s one thing directors do that regulators don’t actually ask them to do.

“There’s no requirement or even suggestion, that I’m aware of, from any regulators that says, ‘Hey, we want the board involved at the loan-approval level,’” says Patrick Hanchey, a partner at the law firm Alston & Bird. The one exception is Regulation O, which requires boards to review and approve insider loans.

Instead, the board is tasked with implementing policies and procedures for the bank, and hiring a management team to execute on that strategy, Hanchey explains.

“If all that’s done, then you’re making good loans, and there’s no issue.”

Yet, 77 percent of executives and directors say their board or a board-level loan committee plays a role in approving credits, according to Bank Director’s 2019 Risk Survey.

Boards at smaller banks are more likely to approve loans than their larger peers. This is despite the spate of loan-related lawsuits filed by the Federal Deposit Insurance Corp. against directors in the wake of the recent financial crisis.

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The board at Mayfield, Kentucky-based First Kentucky Bank approves five to seven loans a month, says Ann Hale Mills, who serves on the board. These are either large loans or loans extended to businesses or individuals who already have a large line of credit at the bank, which is the $442 million asset subsidiary of Exchange Bancshares.

Yet, the fact that directors often lack formal credit expertise leads some to question whether they should be directly involved in the process.

“Inserting themselves into that decision-making process is putting [directors] in a place that they’re not necessarily trained to be in,” says James Stevens, a partner at the law firm Troutman Sanders.

What’s more, focusing on loan approvals may take directors’ eyes off the big picture, says David Ruffin, a director at the accounting firm Dixon Hughes Goodman LLP.

“It, primarily, deflects them from the more important role of understanding and overseeing the macro performance of the credit portfolio,” he says. “[Regulators would] much rather have directors focused on the macro performance of the credit portfolio, and understanding the risk tolerances and risk appetite.”

Ruffin believes that boards should focus instead on getting the right information about the bank’s loan portfolio, including trend analyses around loan concentrations.

“That’s where a good board member should be highly sensitized and, frankly, treat that as their priority—not individual loan approvals,” says Ruffin.

It all boils down to effective risk management.

“That’s one of [the board’s] main jobs, in my mind. Is the institution taking the right risk, and is the institution taking enough risk, and then how is that risk allocated across capital lines?” says Chris Nichols, the chief strategy officer at Winter Haven, Florida-based CenterState Bank Corp. CenterState has $12.6 billion in assets, which includes a national correspondent banking division. “That’s exactly where the board should be: [Defining] ‘this is the risk we want to take’ and looking at the process to make sure they’re taking the right risk.”

Directors can still contribute their expertise without taking on the liability of approving individual loans, adds Stevens.

“[Directors] have information to contribute to loan decisions, and there’s nothing that says that they can’t attend officer loan committee meetings or share what they know about borrowers or credits that are being considered,” he says.

But Mills disagrees, as do many community bank directors. She believes the board has a vital role to play in approving loans.

First Kentucky Bank’s board examines quantitative metrics—including credit history, repayment terms and the loan-to-value ratio—and qualitative factors, such as the customer’s relationship with the bank and how changes in the local economy could impact repayment.

“We are very well informed with data, local economic insight and competitive dynamics when we approve a loan,” she says.

And community bank directors and executives are looking at the bigger picture for their community, beyond the bank’s credit portfolio.

“We are more likely to accept risk for loans we see in the best interest of the overall community … an external effect that is hard to quantify using only traditional credit metrics,” she says.

Regardless of how a particular bank approaches this process, however, the one thing most people can agree on is that the value of such bespoke expertise diminishes as a bank grows and expands into far-flung markets.

“You could argue that in a very small bank, that the directors are often seasoned business men and women who understand how to run a business, and do have an intuitive credit sense about them, and they do add value,” says Ruffin. “Where it loses its efficacy, in my opinion, is where you start adding markets that they have no understanding of or awareness of the key personalities—that’s where it starts breaking apart.”