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.
One word seems to encapsulate concerns about banker attitudes’ toward risk in 2022: complacency.
As the economy slowly — and haltingly — normalizes from the impact of the coronavirus pandemic, bankers must ensure they hew to risk management fundamentals as they navigate the next part of the business cycle. Boards and executives must remain vigilant against embedded and emerging credit risks, and carefully consider how they will respond to slow loan growth, according to prepared remarks from presenters at Bank Director’s Bank Audit & Risk Committees Conference, which opens this week at the Swissotel Chicago. Regulators, too, want executives and directors to shift out of crisis mode back to the essentials of risk management. In other words, complacency might be the biggest danger facing bank boards and executives going into 2022.
The combination of government stimulus and bailouts, coupled with the regulatory respite during the worst of the pandemic, is “a formula for complacency” as the industry enters the next phase of the business cycle, says David Ruffin, principal at IntelliCredit, a division of QwickRate that helps financial institutions with credit risk management and loan review. Credit losses remained stable throughout the pandemic, but bankers must stay vigilant, as that could change.
“There is an inevitability that more shakeouts occur,” Ruffin says. A number of service and hospitality industries are still struggling with labor shortages and inconsistent demand. The retail sector is grappling with the accelerated shift to online purchasing and it is too soon to say how office and commercial real estate will perform long term. It’s paramount that bankers use rigorous assessments of loan performance and borrower viability to stay abreast of any changes.
Bankers that remain complacent may encounter heightened scrutiny from regulators. Guarding against complacency was the first bullet point and a new item on the Office of the Comptroller of the Currency’s supervisory operating plan for fiscal year 2022, which was released in mid-October. Examiners are instructed to focus on “strategic and operational planning” for bank safety and soundness, especially as it concerns capital, the allowance, net interest margins and earnings.
“Examiners should ensure banks remain vigilant when considering growth and new profit opportunities and will assess management’s and the board’s understanding of the impact of new activities on the bank’s financial performance, strategic planning process, and risk profile,” the OCC wrote.
“Frankly, I’m delighted that the regulators are using the term ‘complacency,’” Ruffin says. “That’s exactly where I think some of the traps are being set: Being too complacent.”
Gary Bronstein, a partner at the law firm Kilpatrick Townsend & Stockton, also connected the risk of banker complacency to credit — but in underwriting new loans. Banks are under immense pressure to grow loans, as the Paycheck Protection Program winds down and margins suffer under a mountain of deposits. Tepid demand has led to competition, which could lead bankers to lower credit underwriting standards or take other risks, he says.
“It may not be apparent today — it may be later that it becomes more apparent — but those kinds of risks ought to be carefully looked at by the board, as part of their oversight process,” he says.
For their part, OCC examiners will be evaluating how banks are managing credit risk in light of “changes in market condition, termination of pandemic-related forbearance, uncertainties in the economy, and the lasting impacts of the Covid-19 pandemic,” along with underwriting for signs of easing structure or terms.
The good news for banks is that loan loss allowances remain high compared to historical levels and that could mitigate the impact of increasing charge-offs, points out David Heneke, principal at the audit, tax and consulting firm CliftonLarsonAllen. Banks could even grow into their allowances if they find quality borrowers. And just because they didn’t book massive losses during the earliest days of the pandemic doesn’t mean there aren’t lessons for banks to learn, he adds. Financial institutions will want to carefully consider their ongoing concentration risk in certain industries, explore data analytics capabilities to glean greater insights about customer profitability and bank performance and continue investing in digital capabilities to reflect customers’ changed transaction habits.
Many community bankers and their boards are entering the post-pandemic world blindfolded. The pandemic had an uneven impact on industries within their geographic footprints, and there is no historical precedent for how recovery will take shape. Government intervention propped up many small businesses, disguising their paths forward.
Federal Reserve monetary policies have hindered the pro forma clarity that bank management and boards require to create and evaluate strategic plans. Yet these plans are more vital than ever, especially as M&A activity increases.
“The pandemic and challenging economic conditions could contribute to renewed consolidation and merger activity in the near term, particularly for banks already facing significant earnings pressure from low interest rates and a potential increase in credit losses,” the Federal Deposit Insurance Corp. warned in its 2021 risk review.
Bank management and boards must be able to understand shareholder value in the expected bearish economy, along with the financial markets that will accompany increased M&A activity. They need to understand how much their bank is worth at any time, and what market trends and economic scenarios will affect that valuation.
As the Office of the Comptroller of the Currency noted in its November 2020 Director’s Book, “information requirements should evolve as the bank grows in size and complexity and as the bank’s environment or strategic goals change.”
Clearly, the economic environment has changed. Legacy financial statements that rely on loan categories instead of industries will not serve bank management or boards of directors well in assessing risks and opportunities. Forecasting loan growth and credit quality will depend on industry behavior.
This is an extraordinary opportunity for bank management to exploit the knowledge of their directors and get them truly involved in the strategic direction of their banks. Most community bank directors are not bankers, but local industry leaders. Their expertise can be vital to directly and accurately link historical and pro forma information to industry segments.
Innovation is essential when it comes to providing boards with the critical information they need to fulfill their fiduciary duties. Bank CEOs must reinvent their strategic planning processes, finding ways to give their boards an ever-changing snapshot of the bank, its earnings potential, its risks and its opportunities. If bank management teams do not change how they view strategic planning, and what kind of data to provide the board, directors will remain in the dark and miss unique opportunities for growth that the bank’s competitors will seize.
The OCC recommends that boards consider these types of questions as part of their oversight of strategic planning:
Where are we now? Where do we want to be, and how do we get there? And how do we measure our progress along the way?
Is our plan consistent with the bank’s risk appetite, capital plan and liquidity requirements? The OCC advises banks to use stress testing to “adjust strategies, and appropriately plan for and maintain adequate capital levels.” Done right, stress testing can show banks the real-word risk as certain industries contract due to pandemic shifts and Fed actions.
Has management performed a “retrospective review” of M&A deals to see if they actually performed as predicted? A recent McKinsey & Co. review found that 70% of recentbank acquisitions failed to create value for the buyer.
Linking loan-level data to industry performance within a bank’s footprint allows banks to increase their forecasting capability, especially if they incorporate national and regional growth scenarios. This can provide a blueprint of how, when and where to grow — answering the key questions that regulators expect in a strategic plan. Such information is also vital to ensure that any merger or acquisition is successful.
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.
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.”
Digital banking is evolving in the wake of guidance from the Office of the Comptroller of the Currency as it concerns digital assets and their underpinning technology.
The regulator issued an interpretative letter last July authorizing OCC-regulated national banks to hold digital assets and another one in early 2021 allowing such banks to use blockchain and stablecoin infrastructures. Consumers and commercial entities continue to demand offerings and services for digital assets, and the pandemic has accelerated this push.
This rise of digital assets will have far-reaching implications for the entire banking sector for years to come. It’s crucial for executive teams at traditional banks to understand how best to capitalize on these changes, where the risks lie and how to prepare for the future of banking. For banks weighing how and when to start offering digital asset services, here are four key things leadership teams should do:
Prepare to stake a claim. The evolution of money toward digital assets is affecting bank and fintech organizations globally. Companies should proactively think through adjustments now that will enable them to keep up with this rapid pace of change. At the start of this century, when mobile banking apps first began appearing and banks started offering remote deposit captures for checks, organizations that were slow to adopt these technologies wound up being left behind. The OCC guidance explicitly authorizing the use of digital assets should alleviate any doubts around whether such currencies will be a major disruption.
Assess technology investments. A crucial determinant in how successful a bank will be in deploying digital asset-related services is how well-equipped and properly aligned its technology platforms, vendors, policies and procedures are. One of the primary concerns for traditional banks will be assessing their existing core banking platform; many leading vendors do not have blockchain and digital asset capabilities available at this time. This type of readiness is key if bank management hopes to avoid significant technology debt into the next decade. Additionally, banks will need to assess whether it makes sense to partner, buy or build the necessary technology components to transact, custody, settle and potentially issue digital assets.
Prepare for growing demand. As digital assets become more mainstream, there will be significant growth in institutional adoption and growth in consumer demand, especially from millennials and Generation Z customers. The OCC’s recent interpretative letters and the rapid growth of digital assets even just in the last year only emphasize that the adoption of such assets will be the next phase of evolution for banks. That also involves added responsibilities and regulatory compliance that executives need to start understanding now.
Mind the regulator. The era of digital assets is new, and as such, there is heightened scrutiny around related services and offerings. Executives will need to assess existing “know your customer” compliance obligations and update accordingly. Banks also need to understand necessary capital expenditures related to deploying digital asset services. Regulators will be especially interested in not just what’s under the hood, but how banks are managing these new parts and pieces.
What’s next? Banks that are contemplating or already in the process of deploying digital asset services will need to understand the regulatory requirements in this space and make upgrades to their core banking platforms to make sure those systems can interface with blockchain and other distributed web (sometimes called Web 3.0) technologies. To learn more about how your executive team can prepare, register now for BankDirector’s May 11 webcast — sponsored by RSM — on the future of bitcoin and digital assets.
Banks below $50 billion in assets aren’t required to conduct an annual stress test, following regulatory relief passed by Congress in May 2018. But most banks still conduct one or more annual tests, according to Bank Director’s 2021 Risk Survey.
A stress test determines whether a bank would have adequate capital or liquidity to survive an adverse event, based on historical or hypothetical scenarios. Financial institutions found value in the practice through the Covid-19 pandemic and related economic events, which created significant uncertainty around credit — particularly around commercial real estate loans and loans made to the hospitality sector, which includes hotels and restaurants.
“It gives you a peace of mind that we are prepared for some pretty big disasters,” says Craig Dwight, chair and CEO at $5.9 billion Horizon Bancorp, based in Michigan City, Indiana. Horizon disclosed its stress test results in third quarter 2020 to reassure its investors, as well as regulators, customers and its communities, about the safety and soundness of the bank. “We were well-capitalized, even under two-times the worst-case scenario,” he says. “[T]hat was an important message to deliver.”
Horizon Bancorp has been stress testing for years now. The two-times worst case scenario he mentions refers to loss history data from the Office of the Comptroller of the Currency; the bank examines the worst losses in that data, and then doubles those losses in a separate analysis. Horizon also looks at its own loan loss history.
The bank includes other data sets, as well. Dwight’s a big fan of the national and Midwest leading indicators provided by the Federal Reserve Bank of Chicago; each of those include roughly 18 indicators. “It takes into consideration unemployment, bankruptcy trends, the money supply and the velocity of money,” he says.
It’s a credit to the widespread adoption of stress testing in the years following the financial crisis of 2008-09. “All the infrastructure’s in place, so [bank management teams] can turn on their thinking fairly quickly, and [they] aren’t disconnected [from] what’s happening in the world,” says Steve Turner, managing director at Empyrean Solutions, a technology provider focused on financial risk management.
However, Covid-19 revealed the deficiencies of an exercise that relies on historical data and economic models that didn’t have the unexpected — like a global pandemic — in mind. In response, 60% of survey respondents whose bank conducts an annual stress test say they’ve expanded the quantity and/or depth of economic scenarios examined in this analysis.
“We have tested pandemics, but we really haven’t tested a shutdown of the economy,” says Dwight. “This pandemic was unforeseen by us.”
Getting Granular The specific pain points felt by the pandemic — which injured some industries and left others thriving — had banks getting more granular about their loan portfolios. This should continue, says Craig Sanders, a partner at Moss Adams LLP. Moss Adams sponsored Bank Director’s 2021 Risk Survey.
Sanders and Turner offer several suggestions of how to strengthen stress testing in the wake of the pandemic. “[D]issect the portfolio … and understand where the risks are based on lending type or lending category,” says Sanders. “It’s going to require the banks to partner a little more closely with their clients and understand their business, and be an advisor to them and apply some data analytics to the client’s business model.” How will shifting behaviors affect the viability of the business? How does the business need to adjust in response?
He recommends an annual analysis of the entire portfolio, but then stratifying it based on the level of risk. High risk areas should be examined more frequently. “You’re focusing that time, energy and capital on the higher-risk areas of the bank,” says Sanders.
The survey finds two-thirds of respondents concerned about overconcentrations in their bank’s loan portfolio, and 43% of respondents worried specifically about commercial real estate loan concentrations. This represents a sharp — but expected — increase from the prior year, which found 78% expressing no concerns about portfolio concentrations.
We’re still not out of the woods yet. Many companies are now discussing what their workplace looks like in the new environment, which could have them reducing office spaces to accommodate remote workers. If a bank’s client has a loan on an office space, which they then rent to other businesses, will they be able to fill the building with new tenants?
If this leads to defaults in 2021-22, then banks need to understand the value of any loan collateral, says Sanders. “Is the collateral still worth what we think it was worth when we wrote the loan?”
It’s hard to predict the future, but Sanders says executives and boards need to evaluate and discuss other long-term effects of the pandemic on the loan portfolio. Today’s underlying issues may rise to the surface in the next couple of years.
Knowing What Will Break Your Bank Stress testing doesn’t tend to focus on low-probability events — like the pandemic, which (we hope) will prove to be a once-in-a-lifetime occurrence. Turners says bank leaders need to bring a broader, more strategic focus to events that could “break” their bank. That could have been the pandemic, without the passage of government support like the CARES Act.
It’s a practice called reverse stress testing.
“Reverse stress testing helps to explore so-called ‘break the bank’ situations, allowing a banking organization to set aside the issue of estimating the likelihood of severe events and to focus more on what kinds of events could threaten the viability of the banking organization,” according to guidance issued by the Federal Reserve, Federal Deposit Insurance Corp. and OCC in 2012. The practice “helps a banking organization evaluate the combined effect of several types of extreme events and circumstances that might threaten the survival of the banking organization, even if in isolation each of the effects might be manageable.”
Statistical models that rely on historical norms are less useful in an unforeseen event, says Turner. “[I]f someone told you in February of 2020 that you should be running a stress test where the entire economy shuts down, you’d say, ‘Nah!’” he says. “What are the events, what are the scenarios that could happen that will break me? And that way I don’t have to rely on my statistical models to explore that space.”
Testing for black swan events that are rare but can have devastating consequences adds another layer to a bank’s stress testing approach, says Turner. These discussions deal in hypotheticals, but they should be data driven. And they shouldn’t replace statistical modeling around the impact of more statistically normal events on the balance sheet. “It’s not, ‘what do we replace,’” says Turner, “but, ‘what do we add?’”
With stress testing, less isn’t more. “My advice is to run multiple scenarios, not just one stress test. For me, it’s gotta be the worst-case stress test,” says Dwight. And stress testing can’t simply check a box. “Can you sleep at night with that worst case scenario, or do you have a plan?”
Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP, 188 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $50 billion in assets. The survey was conducted in January 2021, and focuses on the key risks facing the industry today and how banks will emerge from the pandemic environment.
Can a bank socially distance itself from its primary federal regulator?
In the midst of the Covid-19 pandemic, the answer is apparently yes.
The Office of the Comptroller of the Currency, which oversees nationally chartered banks and thrifts, has been impacted by the virus’ shutdown in much the same way as the institutions it oversees.
In an interview with Bank Director, Acting Comptroller of the Currency Brian Brooks — who replaced former Comptroller Joseph Otting after his resignation on May 29 — says the pandemic has forced the agency to adapt its preferred method of operation to the restrictions of social distancing.
“One thing that I worry about from a supervision perspective is, historically, bank examiners go on-site,” Brooks says. “Not because it’s convenient, but because being able to be in a room with bankers and sit face to face with people … is a critical tool in identifying fraud and identifying trends that might not make it onto a management report, or might not be raised in a formal presentation. And the longer banks are in a work-from-home environment, the harder it is for us to do that human aspect of bank supervision.”
Brooks says while there are legitimate health reasons why much of the banking industry has operated with a distributed workforce for the last several months, he’s anxious to reintroduce the element of personal contact into bank supervision. “I know that may not happen next month or even this quarter, but we need to start charting that course back, because this method of supervision can’t go on forever,” he says.
The OCC is reopening its facilities on June 21 and is encouraging people who do not have underlying health conditions and would feel comfortable doing so to return to their offices. “That’s our way of showing leadership to the industry of how one can start charting this course back to normalcy,” Brooks explains. “But having said that, we’ve moved to significantly enhanced cleaning schedules. We’re obviously providing face masks and gloves to people who are in mail-handling or public facing positions. We’re changing seating arrangements to maximize the availability of social distancing. And of course, we’re continuing to allow anyone who wants to, to work remotely while making the office … more normalized for everybody else.”
Brooks believes that recent data on the virus suggests that the health risk for most people is manageable. “What the data seem to be showing is that hospitalization rates and fatality rates for people of working age, who don’t have particular risk conditions, seem to be within historic norms,” he says. “Which is not to say that this is not a dangerous disease, but it does appear to be that … people who are under a certain age and who don’t have certain conditions are not at special risk relative to other types of viruses that we’ve seen before.”
And when OCC examiners do return to on-site visits to their banks, they will follow whatever safety protocols the bank has in place.
The Covid-19 pandemic has dealt a crushing blow to the U.S. economy — which entered a recession in February — and the OCC wants national banks to take a hard look at their asset quality. It’s not an easy assessment to make. Banks have granted repayment deferrals of 90 days or greater to many of their borrowers at the same time as the federal government suspended troubled debt restructuring guidance and pumped money into the economy through the Paycheck Protection Program. A clear asset risk profile has yet to emerge for many institutions.
“Some of the traditional metrics that we’ve used to determine asset quality … could be masked by a lot of the relief efforts,” says Maryann Kennedy, senior deputy comptroller for large-bank supervision at the OCC. “Many of our institutions are going back and retooling many of their stress testing models in response to the breadth, depth and velocity of the number of programs that they’re instituting there.”
Just because OCC examiners don’t have personal contact with their banks doesn’t mean they haven’t been talking to them through the pandemic. Some of those conversations are an effort to triage which banks may need the greatest attention from regulators.
“There is a real time risk-based assessment of what’s happening with our national banks and federal savings associations, so we can try to understand how we move forward and where we focus our attention. [It’s] is very challenging, similar to the challenge [banks have] trying to understand their asset quality and the situation with their loan portfolios,” says Kennedy.
The OCC is essentially trying to assess the pandemic’s economic impact on national banks and thrifts while those institutions make their own credit risk assessments.
“A real-time conversation that’s going on right now, particularly in that in our larger banks, is ‘What is your stress forecasting looking like for provision expense in the second quarter, as well as what could be those potential impacts to earnings, particularly as it relates to any earnings expectations that might be out there?’” Kennedy says. “Those are challenging conversations going on right now … as our bank managements sort of work through the struggle [with] some of those specifics. It’s not a real predictive economy right now.”
For the last few weeks, bank regulators have been gearing up
their responses and preparations as the U.S. financial industry and broader
economy confront the impact of the coronavirus pandemic.
On March 13, President Donald Trump declared a national state of emergency that freed billions in aid as cities and sectors grappled with the pandemic. The announcement capped off a tumultuous week of market freefalls and rallies, the cancelation of major sporting events, closed college campus and the start of millions of Americans voluntary and involuntary quarantining and national social distancing. It remains to be seen how long the outbreak will last and when it will peak, as well as the potential economic fallout on businesses and consumers.
Already, the Federal Open Market Committee has lowered the federal funds rate twice; the most recent was a surprise 100-basis point decline on March 15, to the range of 0 to 25 basis points. The Fed last lowered interest rates to near zero back in late 2008. The move is intended to support economic activity and labor market conditions, and the benchmark rate will stay low until the Fed is confident the economy has weathered recent events.
Additionally, the Fed announced it would increase its
holdings of both Treasury securities by at least $500 billion and agency
mortgage-backed securities by at least $200 billion.
Bank executives and directors must now contend with near-zero rates as they work with borrowers to contain the economic implications of the coronavirus.
“The adverse economic effects of a pandemic could be significant, both nationally and internationally,” the Federal Financial Institutions Examination Council wrote in recently updated guidance on how banks can minimize the adverse effects of a pandemic. “Due to their crucial financial and economic role, financial institutions should have plans in place that describe how they will manage through a pandemic event.”
The ongoing events serve as a belated reminder that pandemic
preparedness should be considered as part of board’s periodic review of
business continuity planning, according to a March 6
interagency release. These plans should address how a bank anticipates
delivering products and services “in a wide range of scenarios and with minimal
The FFIEC’s guidance says pandemic preparation in a bank’s business continuity plan should include a preventive program, a documented strategy that is scaled to the stages of an outbreak, a comprehensive framework outlining how it will continue critical operations and a testing and oversight program. The plan should be appropriate for the bank’s size, complexity and business activities.
A group of agencies including prudential bank regulators are
encouraging financial institutions to work constructively with customers in
communities impacted by the new coronavirus, according a statement
released on March 9. They also pledge to provide “appropriate regulatory
assistance to affected institutions,” adding that prudent accommodations that
follow “safe and sound lending practices should not be subject to examiner
The regulators also acknowledged that banks may face
staffing and other challenges associated with operations. The statement says
regulators will expedite requests to provide “more convenient availability of
services in affected communities” where appropriate, and work with impacted
financial institutions for scheduling exams or inspections.
The Federal Deposit Insurance Corp and the Office of Comptroller of the Currency highlighted more specific ways banks can work with customers in a set of releases dated March 13. Some of the suggested potential accommodations, made in a safe and sound manner and consistent with bank laws, include:
waiving ATM, overdraft, early time deposit
withdrawal and late credit card or loan fees
increasing ATM daily cash withdrawal limits
reducing restrictions on cashing out-of-state
and non-customer checks
increasing card limits for creditworthy
payment accommodations that could include deferring
or skipping payments or extending the payment due date to avoid delinquencies
and negative reporting if a disruption is related to COVID-19.
The OCC points
out that lending accommodations for existing or new customers can help
borrowers facing pressured cash flows, improve their ability to service debt
and ultimate help the bank collect on the loans. It adds that banks should
individually evaluate whether a loan modification would constitute a troubled
The regulator also acknowledged that some banks with customers impacted by issues related to the coronavirus may experience an increase in delinquent or nonperforming loans, and says it will consider “the unusual circumstances” these banks face when reviewing their financial condition and weighing the supervisory response.
specifically encouraged banks to work with borrowers in industries that
are “particularly vulnerable to the volatility” stemming from COVID-19
disruption, as well as the small business and independent contractors reliant
on those industries.
institution’s prudent efforts to modify the terms on existing loans for
affected customers will not be subject to examiner criticism,” the FDIC wrote
in its release.
Some of the largest and most dramatic regulatory
accommodation related to the new coronavirus has come from the Federal Reserve,
given its role in the funding market and its role overseeing large bank holding
The Fed announced
on March 12 that it would inject $1.5 trillion into the U.S. market for
repurchase agreements over the course of two days. The increased purchases,
which serve as short-term loans for banks, were not meant to directly stimulate
the economy. Instead, they were done to “address the unusual disruption” in
Treasury financing markets from the coronavirus and help ensure it would
continue functioning properly.
The Fed also announced several more changes to accommodate banks on March 15. It is now allowing depository institutions to borrow from the discount window for as long as 90 days and is encouraging banks to use its intraday credit. It is explicitly encouraging banks to use their capital and liquidity buffers to lend to customers impacted by the coronavirus and lowered the reserve requirement ratio to 0%, effective at the start of the next reserve maintenance period on March 26.
For more information from the regulators, check out their websites
Although it is difficult to predict whether Congress or the federal
banking agencies would be willing to address in a meaningful way any banking
issues in an election year, the following are some of the areas to watch for in
Community Reinvestment Act. The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. issued a proposed rule in December 2019 to revise and modernize the Community Reinvestment Act. The rule would change what qualifies for CRA credit, what areas count for CRA purposes, how to measure CRA activity and how to report CRA data. While the analysis of the practical impact on stakeholders is ongoing and could require consideration of facts and circumstances of individual institutions, the proposed rule may warrant particular attention from two groups of stakeholders as it becomes finalized: small banks and de novo applicants.
First, for national and state nonmember banks under $500 million, the
proposed rule offers the option of staying with the current CRA regime or
opting into the new one. The Federal Reserve Board did not join the OCC and the
FDIC in the proposed rule, so CRA changes would not affect state member banks
as proposed. As small banks weigh the costs and benefits of opting in, the
calculus may be further complicated by political factors beyond the four
corners of the rule itself.
Second, a number of changes in the proposed rule could impact deposit
insurance applicants seeking de novo bank or ILC charters, including those related
to assessment areas and strategic plans.
Brokered Deposits. The FDIC issued a proposed rule in December 2019 to revise brokered deposits regulations. While the proposed rule does not represent a wholesale revamp of the regulatory framework for brokered deposits — which would likely require statutory changes — some of the changes could expand the primary purpose exception in the definition of deposit broker and establish an administrative process for obtaining FDIC determination that the primary purpose exception applies in a particular case. Also, the new administrative process could offer clarity to banks that are unsure about whether to classify certain deposits as brokered.
LIBOR Transition. The London Interbank Offered Rate, a reference rate used throughout the financial system that proved vulnerable to manipulation, may no longer be available after 2021. The U.K.’s Financial Conduct Authority announced in 2017 its intention to no longer compel panel banks to contribute to the determination of LIBOR beyond 2021. In the U.S., the Financial Stability Oversight Council has flagged LIBOR as an issue in its annual Congressional report every year since 2012. Its members stepped up their rhetoric in 2019 to pressure the financial services industry to prepare for transition away from LIBOR to a new reference rate, one of which is the Secured Overnight Financing Rate, or SOFR, that was selected by the Alternative Reference Rates Committee.
For banks in 2020, it is likely that federal bank examiners, whose agency heads are all members of the FSOC, will increasingly incorporate LIBOR preparedness into exams if they have not done so already. In addition, regulators in New York are requiring submission of LIBOR transition plans by March 23, 2020.
The scope of work to effectuate a smooth transition could be significant, depending on the size and complexity of an institution. It ranges from an accurate inventory of all contracts that reference LIBOR to devising a plan and adopting fallback language for different types of obligations (such as bilateral loans, syndicated loans, floating rate notes, derivatives and retail products), not to mention developing strategies to mitigate litigation risk. Despite some concerns about the suitability of SOFR as a LIBOR replacement, including a possible need for a credit spread adjustment as well as developing a term SOFR, which is in progress, LIBOR transition will be an area of regulatory focus in 2020.