A Lending Platform Prepared for Pandemic Pitfalls

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.

Fraud Attempts on the Rise Since Pandemic’s Start

As Covid-19 passes its one year anniversary in the United States, businesses are still adjusting to the pandemic’s impacts on their industry.

Banking is no exception. While banks have quickly adjusted to new initiatives like the Small Business Administration’s Paycheck Protection Program, the most notable impact to financial institutions has been the demand for online capabilities. Banks needed to adjust their offerings to ensure they didn’t lose their client base.

“ATM activity is up, drive-through banking is up 10% to 20% and deposits made through our mobile app are up 40%,” said Dale Oberkfell, president and CFO of Midwest Bank Centre last June.

The shift to digital account openings has been drastic. The chart below looks at the percent change in cumulative number of evaluations from 2019 to 2020 for a cohort of Alloy customers, limited to organizations that were clients for both years. Since the onset of the pandemic, digital account opening has increased year-over-year by at least 25%.

Although the shift to digital was necessary to meet consumer demands, online banking opens up the possibility of new types of fraud. To study the pandemic’s impact on fraudulent applications, we took a closer look at changes in consumer risk scores since the onset of the pandemic. Similar to credit scores, risk scores predict the likelihood of identity or synthetic fraud based on discrepancies in information provided, behavioral characteristics and consortium data about past fraud activity.

Comparing the pandemic months of March 2020 to December 2020 to the same period in 2019, Alloy clients saw a dramatic rise in high-risk applications. Total high-risk applications increased by 137%, driven both by overall growth in digital application volume and a comparatively riskier population of applicants.

There are several ways for you to protect your organization against this growing threat. One way is to use multiple data sources to create a more holistic understanding of your applicants and identify risky behaviors. It also ensures that you are not falling victim to compromised data from any one source. It’s a universal best practice; Alloy customers use, on average, at least 4 data sources.

Another way for you to protect your institution is by using an identity decisioning platform to understand and report on trends in your customer’s application data. Many data providers will return the values that triggered higher fraud scores, such as email and device type. An identity decisioning platform can store that data for future reference. So, even if a risky application is approved at onboarding, you can continue to monitor it throughout its lifetime with you.

Digital banking adoption and usage is expected to only increase in the future. Banks need to ensure that their processes for online capabilities are continuously improving. If your organization is spending too much time running manual reviews or using an in-house technology, it may be time for an upgrade. Click here to see how an identity decisioning platform can improve your process and help you on-board more legitimate customers.

A New Look at Problem Loan Management

Regardless of how you describe 2020, change was the common theme.

Not only did the coronavirus pandemic and economic contaction in 2020 change the way the banking industy identifies problem loans, it changed the way it approaches them. As 2020 unfolded, CLA continued to encourage institutions to evaluate policies and procedures, given that most were written for normal operating environments. A problem loan is a credit that cannot be repaid according to the terms of the initial agreement, or in an otherwise acceptable manner. In a time when payment deferrals and modifications are numerous and widespread, and government-assisted credit is necessary, how does problem loans identification change?

Risk Identification
The first step in problem loan management (PLM) is an effective risk identification program, which includes proper monitoring and continually applying appropriate risk ratings. Management teams can use internal reviews performed periodically or annually to assist with early risk detection.

Monitoring
Frequent monitoring of the portfolio remains one of the critical pillars of PLM. This requires collecting updated financials and information to monitor the wherewithal of the borrower, guarantor and related entities on a standalone and combined basis. Increased monitoring is warranted, especially for vulnerable industries.

Resources
Who leads your bank’s PLM program? Many lenders have not been exposed to a PLM process, or have not been in the industry long enough to experience an economic downturn. The art of PLM involves objective parties, including a group independent of the loan officer, to manage the loans effectively.

Evaluation of performance
Financials for 2020 will include unusual items, and completing year-over-year comparisons will require eliminating “extraordinary” items. For example, removing funds received through the Small Business Administration’s Paycheck Protection Program will be essential to ascertain and review the performance of core operations. Banks will need to consider how a borrower’s core performance would have met the requirements of the original loan terms without modifications. It is pertinent to remove these items and evaluate how the borrower is functioning at its core.

Action plans
The routine nature of completing a quarterly problem loan action report deserves a new look. Banks of all sizes must address problem loans and develop plans to mitigate exposure. Action plans are a way for management to track and document each borrower’s circumstances and next steps to reduce credit risk exposure.

Problem Loan Action Plan Considerations

  • Borrower identification and history — Identify the obligor(s) (direct and indirect), ownership composition, type of business, underlying debt(s), and operational changes over the past few years or as a result of COVID-19.
  • Communication — If the borrower remains communicative, address commitments made, if any, and all legal correspondence.
  • Financial analysis — Update financial information with a look at historical trend on standalone and global basis and impact of COVID-19.
  • Repayment history — Review payment status, including any late payments or 30/60/90-day history. Discuss modifications.
  • Collateral valuation and analysis — Evaluate need for updated values given changes in market, property type, or other pertinent factors.
  • Risk rating — Consider current and recommended risk rating changes, if any.
  • Impairment analysis — Clearly document the analysis or testing for impairment to support quarterly Allowance for Loan and Lease Losses analysis.
  • Progress update — Address actionable items from the last review. Is workout plan effective?
  • Next steps — Detail steps the borrower and institution will take to improve the status of the loan. Establish clear and quantifiable objectives and timeframes for both parties and document results as the plan progresses.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.

CLA exists to create opportunities for our clients, our people, and our communities through our industry-focused wealth advisory, outsourcing, audit, tax, and consulting services. Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.

Strengthening Stress Tests After Covid-19

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.

Bank Director has published several recent articles and videos about stress testing, including an Online Training Series unit on stress testing. You may also consider reading “Recalibrating Bank Stress Tests to a New Reality.”

Digital Transformation From a Branch Perspective

If you ask five bankers to define what constitutes a successful digital transformation, you will receive five different answers. However, organizations can employ a few measures to help them succeed, including establishing priorities, assessing capabilities and creating a digital road map.

Meeting current challenges
Many financial institutions were in no rush to transform prior to March 2020. However, the Covid-19 pandemic accelerated the implementation of digital-first models. It also put pressure on organizations to battle-test alternative business models supporting remote operations and service delivery. Most notably, banks had to activate remote working models while simultaneously figuring out how to service and support face-to-face customers.

Now in 2021, the initial challenges posed by the pandemic have mostly been addressed. At the same time, bankers acknowledge that branch traffic levels might never recover to pre-pandemic levels.

Establishing priorities
First, organizations should establish priorities. The average mid-size, full-service retail office has annual operating expenses exceeding $350,000 a year — real money that could be repurposed to build a competitive digital service. Unleashing this capital and using it more effectively is key to initiating an effective digital transformation.

One initial objective should be to rank branch locations in terms of profitability and other performance metrics to identify the bottom 20%. In most cases, that percentage represents the locations that have been habitual low performers, or that might be in declining markets or suboptimal locations. It’s important to determine if these locations are leased, and if so, if there is a clear path to exit the lease. These details affect the timeline required to exit and any write-offs or write-downs related to each location.

Digital channels do not work in a vacuum. Experience tells us that community bankers do not like to lay off staff who live and work in these markets, and organizations should consider redeployment of these employees. Reassigned branch personnel can support new customers and existing users as they navigate organization websites and online product applications.

Once organizations understand the exit strategy and cost impact for low-performing locations, they can create plans that outline the timing and potential resources that could be freed up from physical branches and funneled into the digital channel.

Assessing capabilities
After determining the digital transformation budget, organizations should make an honest assessment of their existing capabilities and identify gaps or weaknesses. One goal should be to fix what is broken or not optimal, then prioritize the spend and deployment timeline for true enhancements.

Selecting digital enhancements involves many options, dependencies and complexities, which can slow down decision-making about digital transformation initiatives. Fixing obvious problems first and then investigating enhancements will take time, so organizations don’t need to close low-performing branches immediately.

Executives need to fully understand the features of potential enhancements, what is lacking from current capabilities, what is additive to current capabilities, enhancement release timelines and costs associated with each improvement. They also should consider the roll-out of these features and the impact on existing and future customers.

Creating a digital road map
Creating a digital road map can enable banks to set expectations about when changes to digital services will occur. Doing so requires honest introspection about where the organization is positioned on the digital transformation continuum.

For example, banks might think they have effective online account opening processes, but they should ask: Is it truly an automated, end-to-end process that works at all times under all conditions? Or do deposit operations personnel need to manually move data or paper along to make sure accounts can get set up? Organizations should fully understand where and how their existing customers might be affected, and where and how new customers will be serviced as they open accounts online.

While creating their digital road maps, banks also should take a look at the digital features they’ve already deployed. Are they useful and easy to adopt? Do they drive the user toward desired actions? Do the customers really use the available digital features? Are there benefits to users? If the answers to any of these questions is “no,” organizations should consider removing problematic features or improving processes.

Teeing up for success
Keeping tabs on customer usage trends and optimizing the customer experience should be top priorities in a digital transformation. Banks that make necessary changes can help improve the entire digital experience. To learn more about digital transformation from a branch perspective, view this video.

 

How Digital Channels Can Complement Physical Branches

With the rise of digital services and changing customer habits during Covid-19, the future of brick-and-mortar banking may seem in doubt.

Looking ahead, physical bank branches remain crucial for any community bank’s outreach and distribution strategy, but their use and purpose will continue to evolve. Digital acceleration is an opportunity for community banks to reshape the in-person banking environment. Incorporating the digital channel allows banks to offer more comprehensive, customer-focused experiences that complement their brick-and-mortar branches.

Physical Banks Remain a Valuable Asset
Digital banking is a critical way for community banks to provide excellent service. Integrating best-in-class online services allows financial institutions of all sizes to compete against larger banks that may be slower to innovate. Digital branch tools can bring greater accessibility and convenience for customers, a larger customer base and enhanced automation opportunities.

While many customers are excited by digital tools, not every demographic will adapt right away. Customers of all ages may lack confidence in their own abilities and prefer to talk to someone in person. These visits can be a prime opportunity for staff to educate customers on how to engage with their digital platforms.

In-person banking is an opportunity for banks to offer above-and-beyond customer service, especially for more complex services that are difficult to replicate digitally. An in-person conversation can make all the difference when it comes to major financial decisions, such as taking out a mortgage or other loans. Customers may start out with remote tools, then visit a branch for more in-depth planning.

How One Community Bank Is Evolving
Flushing Bank in Uniondale, New York, is using digital account opening software to accelerate growth. The $8 billion bank’s mobile and online banking capabilities went live in March 2020 — the timing of which allowed the bank to more easily serve customers remotely. Digital deposit account openings comprised 19% of Flushing’s customer growth between April and June.

Implementing digital account opening expanded Flushing Bank’s geographic footprint. The online account opening software allowed the existing branches to become more efficient and have a wider reach within the surrounding community, servicing more customers without building new branches.

At the same time, in-person branches and staff remain irreplaceable for Flushing Bank. The bank is leveraging digital tools as more than just an online solution: New technology includes appointment booking, improved phone services and enhance ATM video capabilities, creating a digital experience that is safe, convenient and delightful.

Transforming Brick-and-Mortar Banking for the Future
Digital tools allow more transactions to occur remotely, which may lessen in-person branch traffic while expanding the institution’s geographic reach. Banks can focus on the transactions that do occur in person, and ensure that digital tools improve customer service in branches.

A report from Celent and Reflexis surveying banks on their current strategies noted how more institutions could use digital tools for maximum effect. Just as digital channels offer comprehensive data analysis capabilities, banks can more effectively track each customer’s in-person journey as well. One starting point is to determine why customers visit physical locations — in one case, a bank learned many customers come in looking for a notary and will quickly leave if one is not available.

The report suggests that digital tools can automate their staff’s workflow, ultimately contributing to an improved customer experience. For instance, only a third of surveyed banks offer digital appointment booking, a service that can create a more efficient experience for both customers and staff. Or, banks could onboard customers with account opening software on tablets at physical branches. These tablets are often easier for customers to understand, lower the burden on staff, and help prevent fraud with thorough identity validation.

Community banks have an opportunity during this transitional time to develop a digital strategy that complements their physical branches. A comprehensive plan includes best-in-class digital tools for remote transactions while bringing new digital capabilities to brick-and-mortar locations to ensure the highest-quality customer service.

Positive Outlook for Bank M&A as the Pandemic Subsides

Will there be an acceleration of bank merger and acquisition activity in 2021 and beyond?

The short answer is yes.

As the Covid-19 pandemic recedes, we expect bank M&A activity to rebound, both in terms of branch and whole-bank acquisitions. Banks and their advisors have evolved since the pandemic’s onset forced office closures and the implementation of a new remote working environment. In the past year, institutions and their boards of directors improved technology and online banking capabilities in response to customer needs and expectations. They also gained substantial experience providing banking products and services in a remote environment. This familiarity with technology and remote operations should cause acquirors and sellers alike to reconsider where they stand in the M&A market in 2021 and beyond.

We see a number of factors supporting an improved M&A market in 2021. First, many acquirors and potential deals were sidelined in the spring of 2020, as the pandemic’s uncertainty setting in and the markets were in turmoil. We expect a number of these deals to be rekindled in mid- to late-2021, if they haven’t already resurfaced. We also expect a robust set of acquirors to return to the market looking to add deposits, retail and commercial customers, lending teams, and additional capabilities.

Second, there remains a growing number of small banks struggling to compete that would likely consider potential merger partners with similar cultures and in similar geographic markets. Similarly, risk management and compliance costs continue to challenge bank managers amid tough competition from community banks, credit unions and other non-bank financial institutions. Some small banks have also struggled to provide the digital offerings that have become commonplace since the pandemic began. These challenges are sure to have smaller banks considering merger partners or new investors.

Third, larger banks are looking to grow deposits and market share as they look to compete with more regional players that have the necessary compliance infrastructure and digital offerings. We expect these more regional players to use acquisition partners as a way to grow core deposits and increase efficiencies. Acquiring new deposits and customers also affords these regional banks the ability to cross-sell other products that smaller banks may not have been able to offer the same customers before — increasing revenue in a sustained low-interest rate environment.

Finally, the low-interest rate environment has opened the capital markets to banks of all sizes looking to raise subordinated debt, which may support community bank M&A. Many subordinated debt offerings are priced in the 4% to 5% range, and often are oversubscribed within just a few days. Banks have found these offerings to be an attractive tool to pay off debt with higher interest rates, fund investments in digital infrastructure, provide liquidity to shareholders through buyback programs and seek branch or whole-bank acquisition targets.

We are already seeing activity pick up in bank M&A, and expect that as the economy — and life itself — begins to normalize in 2021, more transactions to be announced. The prospects for an active merger market in 2020 were cut off before spring arrived. This year, as we approach spring once again, the M&A market is not likely to return to pre-pandemic levels, but the outlook is certainly much more optimistic for bank M&A.

2021 Risk Survey Results: High Anxiety

An outsized crisis requires bold action. The banking industry responded in kind when the economy spiraled as a result of the Covid-19 pandemic.

Financial institutions across the country assisted small businesses by issuing Paycheck Protection Program loans. Banks also almost universally modified loans to help borrowers weather the storm, according to Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP. At the peak of the downturn, 43% of the directors, CEOs, chief risk officers and other senior executives responding to the survey say their bank modified more than 10% of the loans in their portfolio.

Conducted on the heels of a tumultuous 2020 — with the pandemic, social strife and political change continuing into January — the survey reveals high levels of anxiety across the risk spectrum. In particular, respondents indicate greater unease regarding cybersecurity (92%) and credit (89%), as well as strategic (62%) and operational (52%) risks.

Almost half of respondents indicate that some or most of the loan modifications extended into the fourth quarter 2020, and two-thirds reveal concerns about concentrations in their loan portfolio, with most pointing to commercial real estate (43%) and/or the hospitality industry (31%).

Forty-three percent indicate that their bank tightened underwriting standards during the downturn. Looking ahead, many are unsure whether they’ll ease their standards to lend to business customers in 2021 and 2022. The challenges to bankers have been deep during the past year.

As the CEO of a small, southeastern community bank put it: “What doesn’t kill you makes you stronger.”

Despite this uncertainty, bankers express some optimism. More than three-quarters believe that supporting their communities during the pandemic has positively affected their bank’s reputation. Eighty-seven percent expect fewer than 10% of their bank’s business customers to fail. And 84% will improve their bank’s business continuity plan due to what they’ve experienced.

Key Findings

More Robust Stress Testing
More than 80% say their bank conducts an annual stress test. Of these, 60% have expanded the quantity and/or depth of economic scenarios examined in response to the Covid-19 pandemic.

Cybersecurity Gaps
Sixty-three percent say their institution increased its oversight of cybersecurity and data privacy in 2020. Most say the bank needs to improve its cybersecurity program by training staff (68%) and implementing technology to better detect or deter threats and intrusions (65%).

Pandemic Plans Adjusted
Respondents identify several areas where they’ll enhance their business continuity plan as a result of the pandemic. The majority point to formalizing remote work procedures and policies (77%), educating and training employees (56%) and/or providing the right tools to staff (55%). Roughly half say that fewer than a quarter of employees will work remotely when the pandemic abates; 25% say that no employees will work remotely.

Banking Marijuana
Forty-one percent of respondents represent a bank headquartered where marijuana use is at least partly legal. Overall, one-third are unsure if their bank would be willing to serve marijuana businesses. Just 7% serve these businesses; 34% have discussed banking this industry but don’t work with these companies yet.

Climate Change Still Not a Hot Topic
Just 14% say their board discusses the risks posed by climate change at least annually; this is up slightly from 11% in last year’s survey. Fewer than 10% say an executive reports to the board about the risks and opportunities that climate change presents to the institution.

To view the full results of the survey, click here.

Pandemic-Induced Innovation Charts Path Toward New Normal

As the financial institutions industry embarks on 2021, our reflections capture a world disrupted by the Covid-19 pandemic. Economic uncertainty continues to impact strategic and growth plans for an inestimable period of time. Banks are closely monitoring loan payment trends and deposit account fluctuations as customers continue to struggle with stable employment and small businesses fight to survive.

The Covid-19 crisis occurred at a time of strength for most financial institutions. Unlike the 2008 Great Recession, banks have been able to rely on strong capital positions, which was crucial when it became no longer possible to continue operating business as usual.

Essentially overnight, consumer behavior shifted away from most face-to-face interactions, prompting an increase in online and contactless activity. Banks had to quickly adapt and explore innovation in order to meet both customer and employee needs. Outdated manual processes, continuity vulnerabilities and antiquated methods of communication immediately became apparent, with institutions pivoting to operate effectively. The pandemic became an accelerant and forced banks to embrace innovation to avoid business interruption, while prioritizing information security and employee and customer safety. Necessity is the mother of invention, and the Covid-19 pandemic created necessity — with an emphasis on urgency.

Top Five Covid-19 Challenges That Prompted Innovation

  1. To reduce the potential virus spread, executives found alternative means of meeting and interacting with employees and customers. Virtual meetings were the solution for many banks.
  2. While many institutions allowed for some remote work, this was not permitted for most employees prior to the pandemic. In some cases, chief technology officers had to quickly implement secure VPN access, evaluate hardware availability, order laptops and expand upon remote working policies and procedures.
  3. Digital transformation immediately moved from “wouldn’t it be great if we did this?” to “to be competitive and survive we must accomplish this immediately.” No. 1 on the transformation list was enhancing the customer experience. To remain competitive, transformation was no longer optional but absolutely required. Digital channels have been trending as customers’ preferred way to bank in the last few years, but this became the primary channel for customer engagement out of necessity. This shift prompted banks to reevaluate and enhance digital channel offerings along with supporting technologies.
  4. Round one of the Paycheck Protection Program was a difficult, labor-intensive process for participating institutions. The need for an efficient PPP application process prompted lenders of all sizes to embrace automation and fintech partnerships, resulting in a smoother process during round two.
  5. C-suite executives and bankers across the organization found themselves in a position where it was difficult to access information quickly and easily in order to make timely decisions to improve the customer experience and manage the bank. For many institutions, especially community financial institutions, this continues to be a challenge.

The need for accurate and efficiently delivered information and data across the organization has never been so great. It is still quite common for financial institutions to manage information in data silos, making it impossible to create the contextual customer intelligence necessary to compete in the post-pandemic environment. Financial institutions have the most intimate data about their customers. This data is of little value until it is transformed into meaningful information that can be easily digested, interpreted, and acted upon.

Banks that recognize that their data is a valuable asset are actively seeking out intelligent analytics tools to create contextual customer intelligence that can be strategically deployed across the organization and leveraged for consistent multichannel experiences to generate sales, increase customer and employee loyalty and reduce operating expenses. Financial institutions must have the ability to gather, aggregate and analyze their complex data assets quickly and accurately to remain competitive, meet regulatory reporting expectations and to achieve market success. The ability to analyze this data and act decisively is the path to not only being a better financial institution but prospering in uncertain times. Leveraging high-value data is imperative to thriving and increasing an institution’s competitive advantage.

A Look at the Great Loan Modification Experiment

After almost a year, Congress’ decision to suspend loan modifications rules was an unprecedented, unorthodox and, ultimately, effective way to aid banks and borrowers.

The banking industry is going on four quarters of suspended requirements for coronavirus loan modifications. Suspending the reporting rules around loan modifications was a creative way for regulators and lawmakers to encourage banks in the spring of 2020 to work with borrowers facing coronavirus-related hardships. The result is that the industry, and economy, had more time to reassess the rapidly uncertain environment before needing to process troubled credits.

“Standing here today, having completed most of my year in audit and having a pretty good idea of how things are panning out — I would call it a raging success,” says Mandi Simpson, a partner in Crowe’s audit group. She adds that the decision to pause loan payments may have helped avoid a number of business closures and foreclosures, which will help the economy stabilize and recover long-term.

Ordinarily, these modifications, like no payments or interest-only payments for a period of time before restarting payments and catching up, would have been categorized as troubled debt restructurings, or TDRs, under U.S. generally accepted accounting principles.

TDRs occur after a bank offers a concession on a credit that it wouldn’t otherwise make to a borrower experiencing financial difficulties or hardship. The CARES Act suspended the determination that a loan modified because of the coronavirus would count as a TDR, “including impairment for accounting purposes.” Banks could now offer deferments and modifications to borrowers impacted by the coronavirus without needing to record them as TDRs.

The suspension came as part of the Coronavirus Aid, Relief, and Economic Security Act of 2020, or CARES Act, and was extended in the stimulus bill passed before the end of the year. The move was supported by the U.S. Securities and Exchange Commission, the Financial Accounting Standards Board and bank regulators, who had encouraged banks to work with borrowers prior to the suspension. It is scheduled to be in effect through until Jan. 1, 2022, or 60 days after the termination of the national emergency, whichever is earlier.

“The regulatory community gets a high-five for that, in my opinion,” says Christopher Marinac, director of research at Janney Montgomery Scott. “Think about the accounting change in TDRs as another form of stimulus … For the companies and the clients that received deferrals – this pandemic is not their fault. … There was a recognition that this gave people a way to buy time. The one variable you can’t quantify in a crisis is time.”

The widespread forbearance allowed borrowers to adapt their businesses, get a handle on their finances or apply for Paycheck Protection Program funding from the Small Business Administration. It also gave banks a chance to reassess their borrowers’ evolving risk and offer new loan terms, if needed.

Reported Bank Deferral Data for 2020

Quarter Loans in deferral, median Low range High range Number of banks reporting
Q1’2020 11.1% 0.3% 38% 224
Q2’2020 15.3% 1.2% 46.4% 234
Q3’2020 3% 0% 21.5% 240
Q4’2020 1.4% 0% 14.5% 238

Source: Reports authored by Brad Milsaps, managing director at Piper Sandler & Co.

A number of institutions took advantage of the suspension to offer borrowers relief. Simpson remembers that many banks freely offered short-term forbearance in the second quarter, and panicked borrowers accepted. When those forbearance periods expired in the third quarter, borrowers had a better sense of their financial condition — aided by the PPP — and banks were better prepared to work with customers under continued pressure.

By the end of the second quarter, most banks “expressed optimism” about the direction of deferrals and reported “minimal” second requests, mostly related to restaurant and hotel borrowers, wrote Brad Milsaps, managing director at Piper Sandler & Co.

He expected deferrals to become “less of a focus going forward,” as those loans’ performance normalized or banks felt confident in marking them as nonaccruals. To that end, the median ratio of criticized loans to total loans, excluding Paycheck Protection Program loans, increased to 3.6% at the end of the third quarter, from 2.9% in the second quarter.

“Deferrals were an impactful tool utilized at the beginning of the pandemic, but have fallen to a very minimal level given the impact of PPP, the CARES Act, and improvement in the economy,” he wrote in a February 2021 report. “Although deferral data continues to be disclosed by most banks, the investment community has mostly moved on from deferrals as an area of primary focus.”

But the suspension of TDR guidance is not a green light for banks to wholly ignore changing credit risk. If anything, the year of deferrals gave banks a better sense of which customers faced outsized challenges to their businesses and whether they could reasonably and soundly continue supporting the relationship. Marinac points out that many banks have risk-rated loans that received modifications, set aside reserves for potential losses and migrated those that continued to have stress over time.

And as documented in Milsaps’ reports, a number of banks decided to share their modification activity with the broader public, with many including geography, industry and sometimes even the type of modification offered. These disclosures weren’t required by regulators but demonstrated the credit strength at many banks and reassured investors that banks had a handle on their credit risk.

The suspension of TDR reporting requirements through the end of 2021 gives the industry and stakeholders like FASB, the accounting board FASB, to consider the usefulness of the existing TDR guidance.

The reporting involved with TDRs involves an individual discounted cash flow analysis, which makes the accounting complicated and tedious. TDRs also can carry negative connotations that are impossible to shake: A modified TDR, even if it’s performing, is always recorded as a TDR. Simpson points out that the loan modification disclosures banks made in lieu of reporting TDRs was, in many cases, more useful and insightful than if the banks had just treated all modified loans as TDRs. And while mass loan modifications may have been a lot of work for banks in the midst of the pandemic’s most uncertain days, it would have been exponentially more complicated to do mass restructuring recordings and discount cash flow analyses over those four quarters.

“If you aren’t going to do TDR reporting at the time when — in theory — it would be the most valuable, doesn’t that call into question whether TDR identification is really that useful after all?” Simpson asks. “The standard-setters are doing some outreach and taking a second look with exactly that in mind.”