When it Comes to Loan Quality, Who Knows?

Seven months into the Covid-19 pandemic, which has flipped the U.S. economy into a deep recession, it’s still difficult to make an accurate assessment of the banking industry’s loan quality.

When states locked down their economies and imposed shelter-in-place restrictions last spring, the impact on a wide range of companies and businesses was both immediate and profound. Federal bank regulators encouraged banks to offer troubled borrowers temporary loan forbearance deferring payments for 90 days or more.

The water was further muddied by passage of the $2.2 trillion CARES Act, which included the Paycheck Protection Program – aimed at a broad range of small business borrowers – as well as weekly $600 supplemental unemployment payments, which enabled individuals to continuing making their consumer loan repayments. The stimulus made it hard to discriminate between borrowers capable of weathering the storm on their own and those kept afloat by the federal government.

The CARES Act undoubtedly kept the recession from being even worse, but most of its benefits have expired, including the PPP and supplemental unemployment payments. Neither Congress nor President Donald Trump’s administration have been able to agree on another aid package, despite statements by Federal Reserve Chairman Jerome Powell and many economists that the economy will suffer even more damage without additional relief. And with the presidential election just two months away, it may be expecting too much for such a contentious issue to be resolved by then.

We expect charge-offs to increase rapidly as borrowers leave forbearance and government stimulus programs [end],” says Andrea Usai, associate managing director at Moody’s Investors Service and co-author of the recent report, “High Volume of Payment Deferrals Clouds a True Assessment of Credit Quality.”

Usai reasons that if there’s not a CARES Act II in the offing, banks will become more selective in granting loan forbearance to their business borrowers. Initially, banks were strongly encouraged by their regulators to offer these temporary accommodations to soften the blow to the economy. “And the impression that we have is that the lenders were quite generous in granting some short-term relief because of the very, very acute challenges that households and other borrowers were facing,” Usai says.

But without another fiscal relief package to help keep some of these businesses from failing, banks may start cutting their losses. That doesn’t necessarily mean the end of loan forbearance. “They will continue to do that, but will be a little more careful about which clients they are going to further grant this type of concessions to,” he says.

For analysts like Usai, getting a true fix on a bank’s asset quality is complicated by the differences in disclosure and forbearance activity from one institution to another.  “Disclosure varies widely, further limiting direct comparisons of practices and risk,” the report explains. “Disclosure of consumer forbearance levels was more comprehensive than that of commercial forbearance levels, but some banks reported by number of accounts and others by balance. Also, some lenders reported cumulative levels versus the current level as of the end of the quarter.”

Usai cites Ally Financial, which reported that 21% of its auto loans were in forbearance in the second quarter, compared to 12.7% for PNC Financial Services Group and 10% for Wells Fargo & Co. Usai says that Ally was very proactive in reaching out to its borrowers and offering them forbearance, which could partially explain its higher percentage.

“The difference could reflect a different credit quality of the loan book,” he says. “But also, this approach might have helped them materially increase the percentage of loans in forbearance.” Without being able to compare how aggressively the other banks offered their borrowers loan forbearance, it’s impossible to know whether you’re comparing apples to apples — or apples to oranges.

If loan charge-offs do begin to rise in the third and fourth quarters of this year, it doesn’t necessarily mean that bank profits will decline as a result. The impact to profitability occurs when a bank establishes a loss reserve. When a charge-off occurs, a debit is made against that reserve.

But a change in accounting for loss reserves has further clouded the asset quality picture for banks. Many larger institutions opted to adopt the new current expected credit losses (CECL) methodology at the beginning of the year. Under the previous approach, banks would establish a reserve after a loan had become non-performing and there was a reasonable expectation that a loss would occur. Under CECL, banks must establish a reserve when a loan is first made. This forces them to estimate ahead of time the likelihood of a loss based on a reasonable and supportable future forecast and historical data.

Unfortunately, banks that implemented CECL this year made their estimates just when the U.S. economy was experiencing its sharpest decline since the Great Depression and there was little historical data on loan performance to rely upon. “If their assumptions about the future are much more pessimistic then they were in the previous quarter, you might have additional [loan loss] provisions being taken,” Usai says.

And that could mean that bank profitability will take additional hits in coming quarters.

Five Ways PPP Accelerates Commercial Lending Digitization

The Small Business Administration’s Paycheck Protection Program challenged over 5,000 U.S. banks to serve commercial loan clients remotely with extremely quick turnaround time: three to 10 days from application to funding. Many banks turned to the internet to accept and process the tsunami of applications received, with a number of banks standing up online loan applications in just several days. In fact, PPP banks processed 25 times more loan applications in 10 days than the SBA had processed in all of 2019. In this first phase of PPP, spanning April 3 to 16, banks approved 1.6 million applications and distributed $342 billion of loan proceeds.

At banks that stood up an online platform quickly, client needs drove innovation. As institutions continue down this innovation track, there are five key technology areas demonstrated by PPP that can provide immediate value to a commercial lending business.

Document Management: Speed, Security, Decreased Risk
PPP online applications typically provided a secure document upload feature for clients to submit the required payroll documentation. This feature provided speed and security to clients, as well as organization for lenders. Digitized documents in a centrally located repository allowed appropriate bank staff easy access with automatic archival. Ultimately, such an online document management “vault” populated by the client will continue to improve bank efficiency while decreasing risk.

Electronic Signatures: Speed, Organization, Audit Trail
Without the ability to do in-person closings or wait for “wet signature” documents to be delivered, PPP applications leveraged electronic signature services like DocuSign or AdobeSign. These services provided speed and security as well as a detailed audit trail. Fairly inexpensive relative to the value provided, the electronic signature movement has hit all industries working remotely during COVID-19 and is clearly here to stay.

Covenant Tickler Management: Organization, Efficiency, Compliance
Tracking covenants for commercial loans has always been a balance between managing an existing book of business while also generating loan growth. Once banks digitize borrower information, however, it becomes much easier to create ticklers and automate tracking management. Automation can allow banker administrative time to be turned toward more client-focused activities, especially when integrated with a document management system and electronic signatures. While many banks have already pursued covenant tickler systems, PPP’s forgiveness period is pushing banks into more technology-enabled loan monitoring overall.

Straight-Through Processing: Efficiency, Accuracy, Cost Saves
Banks can gain significant efficiencies from straight-through processing, when data is captured digitally at application. Full straight-through processing is certainly not a standard in commercial lending; however, PPP showed lenders that small components of automation can provide major efficiency gains. Banks that built APIs or used “bots” to connect to SBA’s eTran system for PPP loan approval processed at a much greater volume overall. In traditional commercial lending, it is possible for data elements to flow from an online application through underwriting to final entry in the core system. Such straight-through processing is becoming easier through open banking, spelling the future in terms of efficiency and cost savings.

Process Optimization: Efficiency, Cost Saves
PPP banks monitored applications and approvals on a daily and weekly basis. Having applications in a dynamic online system allowed for good internal and external reporting on the success of the high-profile program. However, such monitoring also highlighted problems and bottlenecks in a bank’s approval process — bandwidth, staffing, external vendors and even SBA systems were all potential limiters. Technology-enabled application and underwriting allows all elements of the loan approval process to be analyzed for efficiency. Going forward, a digitized process should allow a bank to examine its operations for the most client-friendly experience that is also the most cost and risk efficient.

Finally, these five technology value propositions highlight that the client experience is paramount. PPP online applications were driven by the necessity for the client to have remote and speedy access to emergency funding. That theme should carry through to commercial banking in the next decade. Anything that drives a better client experience while still providing a safe and sound operating bank should win the day. These five key value propositions do exactly that — and should continue to drive banking in the future.

Approaching Credit Management, Risk Ratings Today

As a credit risk consulting firm that supports community and regional banks, Ardmore Banking Advisors has assembled some credit risk management best practices when it comes to how executives should look at their bank’s portfolio during the coronavirus-induced economic crisis.

It is clear that the expectation of regulators is that credit risk management programs (including identification, measurement, monitoring, control and reporting) should be enhanced and adapted to the current economic challenges. Credit risk management programs require proactive actions from the first line of defense (borrower contact by loan officers), the second line of defense (credit oversight) and the third line of defense (independent review and validation of actions and risk ratings).

Boards will have to enhance their oversight of asset quality. Regulators and CPAs will be focusing on process and control, and challenge the banks on what they have done to mitigate risk. Going concern opinions on borrowers by CPAs may become widely used, which will put pressure on banks to be conservative in risk ratings.

New regulatory guidance and best practices indicate that more forward-looking, leading indicators of credit must be employed. We expect greater emphasis on borrower contact and information on liquidity and projections. These concepts are also embodied in the new credit loss and loan loss reserve model that went into effect at larger banks in the first quarter.

Many banks have used Covid-19 as an opportunity to increase their loan loss provisions, reviewing their portfolios for weaknesses in borrowers that may never recover. This evaluation will be expected by regulators during examinations; it is a good indication of forward-thinking proactive oversight by a bank’s officers and directors.

Risk Rating Approaches in the Current Climate
When it comes to risk ratings, it is not advisable for banks to automatically downgrade entire business segments. Instead, executives should scrutinize the most vulnerable segments of the portfolio that include highly stressed industries and types of loans.

Banks do not have to downgrade modifications or extensions solely because they provided relief related to Covid-19; however, the basis for extensions or modifications should be evaluated relative to the ultimate ability of the borrower to repay their loans going forward, after the short-term disruption concludes or the deferral matures.

We have observed that regulators are focusing on second deferrals and asking whether a risk rating change or troubled debt restructuring are warranted. Banks should be reviewing information on further deferrals to determine if there could be an underlying problem indicating that payment is ultimately unlikely.

Paycheck Protection Program loans do not require a downgrade; however, banks may want an independent review of PPP loans to identify any operational or reputational risk. We also recommend that current customers who received PPP loans should be evaluated for their ability to repay other loans once the short-term disruption concludes.

Credit review, the third line of defense, is typically a backward-looking exercise, after loans are already made and funded. It is predicated primarily on an independent review of the analysis of borrowers by loan officers during the first line of defense, and credit officers in the second line of defense. For over 10 years, the industry has experienced relatively good economic times. The current environment requires a more insightful assessment of the bank’s actions and the borrower’s emerging risk profile and outlook, with less reliance on past performance.

The bank should evaluate historical and recent financial information from the borrower as a predicate for evaluating the borrower’s ability to withstand current economic challenges. Executives should review any new information reported by the bank’s officers on the current condition, extensions or modifications provided and the current status of the borrower’s operations to determine if a risk rating change is necessary.

Importance of Credit Review for Banks
Banks must look carefully at risk ratings to confirm that all lines of defense have properly reviewed the borrowers, with a realistic assessment of their ultimate ability to repay the loan after any short-term deferrals, modifications or extensions due to the Covid-19 disruption. This includes an assessment of whether the action requires formal valuation of troubled debt restructuring status. The banks can then follow the current regulatory guidance that an extension or modification does not in itself require a designation as a TDR.

We believe based on our years in banking that the bank regulators will test the bankers’ response and process in the current economic downturn. They, and the CPAs certifying annual financial statements, will expect realistic credit risk evaluations and controls as confirmed by independent and credible loan reviews. Bank boards and executive management teams will be well-served by accurate loan and borrower credit risk assessment during regulatory exams and the annual financial CPA audits for 2020.

Navigating Troubled, Murky Waters

Banks face a cloudy future as they navigate today’s unique environment, characterized by an economic downturn — caused by a health crisis rather than an asset bubble or industry malfeasance — and a prolonged low-rate environment.

“This downturn is different,” says Steve Turner, a managing director at Empyrean Solutions who has focused on balance sheet management and risk over his multi-decade career.

“All of the problems in the last downturn, you pretty much knew where you were. You could look at your balance sheet, you could look at the credit profiles,” he continues. But this time, “we have such a wide range of things that could be happening to us over the next number of months and years.”

With that in mind, Turner joined me as co-host for a virtual peer exchange on Aug. 5, where 10 chief financial officers shared their perspectives on how they’re planning for loan losses and handling the deposit glut, and the lessons they learned from the last crisis.

Asset Quality Remains Strong … For Now
So far, these CFOs aren’t seeing indicators of weakness in their markets. Yet, their experience in the industry tells them that losses are coming. How does a bank still using the incurred loss model justify a loan allowance that aligns with U.S. accounting principles and still prepares it for what history tells them is inevitable?

“The allowance, we’re struggling with that a little bit,” says Suzanne Loken, CFO at $1.3 billion S.B.C.P. Bancorp in Cross Plains, Wisconsin. “Just looking at our data, we don’t see the losses coming through.”

The bank provides talking points to lenders so they can conduct structured conversations with troubled clients, she adds.

Banks are doing their best to monitor the environment, sometimes employing a deeper analysis so they can better assess any potential damage. Joseph Chybowski, CFO at $2.8 billion Bridgewater Bancshares, shares that his team at the Bloomington, Minnesota-based bank created a tenant rental database to better identify troubled areas. “[It’s] a much more granular look on a go-forward basis of what our borrowers’ tenant bases look like,” he explains.

Focus on Deposits, Funding Costs
Arkadelphia, Arkansas-based Southern Bancorp planned to jettison its excess liquidity in 2020, as part of its strategy to improve earnings and profitability. Instead, Paycheck Protection Program loans have swelled the balance sheet of the $1.5 billion community development financial institution (CDFI). “And when these loans are forgiven, our excess liquidity is going to almost double from that perspective,” says CFO Christopher Wewers. “So, [we’re] working hard to drive down the cost of funds.”

In the discussion, the CFOs report that new PPP customers were required to open a deposit account with them to apply for the loan, fueling deposit growth. They expect to deepen these relationships, as their banks essentially kept these customers afloat when their old bank left them out to dry.

The group also confirms that they’re exercising caution around promoting particular deposit products, like certificates of deposit. And the retail team, like the lending team, should be provided talking points so they can better convey today’s reality to customers, says Emily Girsh, CFO at Reinbeck, Iowa-based Lincoln Savings Bank, a $1.4 billion subsidiary of Lincoln Bancorp. “We need to help walk [customers] through and educate them about the market.”

Lessons from the Last Crisis
While the root of the coronavirus crisis differs from the 2008-09 financial crisis, bankers did learn valuable lessons about managing through a prolonged low-rate environment.

“We learned a deposit pricing lesson,” says Michele Schuh, CFO at Anchorage, Alaska-based First National Bank Alaska, which has $4.6 billion in assets. To strengthen customer relationships in the aftermath of the previous crisis, the bank floored deposit rates. “Our assets didn’t immediately downward reprice [then], so we wanted to continue to share and provide some level of above-market yield to the customers that had money deposited in the bank.”

No one could have forecasted that a decade later, rates would remain low. “As rates have come back down … we’ve taken a little bit more practical approach to trying to decide where and how we might floor rates,” she adds.

There’s also caution around hedging. Out of the last crisis, “there were institutions for five years that were betting on rates going up, and [those] institutions lost a lot of money,” notes Kevin LeMahieu, CFO of $2.2 billion Bank First Corp., based in Manitowoc, Wisconsin. “

In the most uncertain environment in memory, how bank leaders look ahead will matter,” says Turner. “Stress testing should look at more scenarios, early warning indicators and processes should be beefed up, and sensitivity to staff and customer concerns should be heightened. Fee income opportunities and creating relationships with new customers from the PPP program will be opportunities to offset some of the lost income from net interest margin compression.”

Audit Hot Topics: Internal Controls

Bank boards and executive teams face a number of risks in these challenging times. They may need to adapt their strong internal controls in response, as Mandi Simpson and Sal Inserra — both audit partners at Crowe — explain in this short video. You can find out more about the audit and accounting issues your bank should be addressing in their recent webinar with Bank Director CEO Al Dominick, where they discuss takeaways from the adoption of the current expected credit loss model (CECL) and issues related to the pandemic and economic downturn, including the impact of the Paycheck Protection Program and concerns around credit quality.

Click HERE to view the webinar.

Four Questions for Three CEOs

The coronavirus pandemic has thrown the banking industry into an environment that is both rapidly changing and a prolonged grind.

The recession induced as a result of public and private response to Covid-19 has lowered the revenue outlook and increased credit risk for institutions across the country. Bankers must navigate an extraordinarily uncertain operating environment and make tough decisions. To that end, Bank Director created the AOBA Summer Series — a free, on-demand compilation of pragmatic information, honest conversations and real-world insight.  

The series goes live on Aug. 12. As a preview, we sat down (virtually) with three executives featured in the series — Chuck Sulerzyski, Jill Castilla and John Asbury — for a glimpse into where they see challenges, opportunities and inspiration. Sulerzyski is CEO of Peoples Bancorp in Marietta, Ohio, which has $5 billion in assets; Castilla is chairman and CEO of Citizens Bancshares, which has $317 million in assets and is based in Edmond, Oklahoma; and John Asbury is CEO of Richmond, Virginia-based Atlantic Union Bankshares Corp., which has $19.8 billion in assets. These conversations were conducted independently, and have been lightly edited for length and clarity.

BD: What is the biggest challenge you see for your bank?

JC: I think about businesses that aren’t able to recover as quickly and making sure that you have the tools available to get to the other side. These are unprecedented times and these businesses are struggling — not due to something they caused; it was something inflicted upon them. I think it’s going to be difficult moving through that.

JA: Navigating the credit risk implications of the Covid-19-induced recession. We remain confident in our overall asset quality, credit loss reserves, capital position and preparedness for this event. However, the duration of Covid-19 will largely determine just how great a challenge this will be. Time will tell.

CS: Maybe not in the next three months, but in the upcoming quarters, I think credit is going to be the biggest challenge, and helping our customers get through all of this. We feel good about our portfolio and its diversification. The places where we feel the most stress is in the hotel portfolio. Obviously, businesspeople aren’t traveling, and consumers are starting to travel a little more but way below normal levels. It’s very difficult for hotel operators to [meet] cash flow.

BD: What is the biggest opportunity for your bank?

JC: The biggest opportunity is continuing to be a leader and advocate, and restoring trust in financial services — both nationally as well as locally —  and being seen as a trusted advisor and a trusted advocate.

JA: The bank has demonstrated resilience, agility, courage and innovation in its response to Covid-19. We developed and launched an online portal and automated workflow system to take Paycheck Protection Program loan applications in five days because we remained agile and knew the stakes were high as our customers were counting on us. We were also quick to make difficult decisions to align our expense structure to the expected lower-for-longer rate environment, beginning in March, to ensure we emerge on the other side of Covid-19 positioned for success. Permanently ingraining these characteristics into our culture will result in an even better, stronger and more capable company.

CS: Peoples really crushed it on the PPP program. We were open for new customers and brought them in with the understanding they would become full-service customers. The biggest opportunity over the next three to six months is taking in these relatively new people and cross-selling them loans, deposits, insurance and investments. Already, we bought in over $40 million dollars of loans and deposits, and over $150,000 in fee income. 

BD: Where are you getting inspiration right now?

JC: So many places. I’m fortunate to be in a city that has diverse leadership. Whether it’s in our underrepresented and underserved communities, those leaders that have fought the odds for decades and are striving for their communities to reach higher levels and pull more out of me to be a better person, a better leader and a better businessperson, and provide access to capital and liquidity and things that. That’s been extraordinary. Seeing our leaders make hard decisions for the welfare of their communities or for the business community as well — that courage, whether I agree with the actions or not — seeing the willingness to take a stand and to stand up for something has been inspirational.

JA: Our teammates! They amaze me with their determination, resourcefulness, effort and caring for our customers and each other. Their efforts on PPP in particular were heroic.

CS: There’s much going on in the world. The healthcare workers, I’ve been touched by everything that they have done. One of my kids is a doctor, one is a nurse, and another is working on a Ph.D. in public health. All of what’s going on with healthcare workers and first responders has been very motivational. 

I know we’ve gone through a lot of social unrest, but I find inspiration in [Senator] John Lewis’ passing and everything that he stood for. I was eight years old when the Voting Rights Act was passed. It’s mind-numbing that folks of color didn’t have the opportunity to vote, and here we are, 50 years later, fighting similar fights and hopefully making progress.

BD: What has been the best thing you’ve read or watched since the pandemic began?

JC: Maybe because it’s on my mind, but the timeliness of the release of “Hamilton” [on the Disney+ streaming service]. I got to see it live in Oklahoma City a year ago; I had tickets and had waited forever to go see it. And then I got hit by a truck walking across my street two days before the show.

We ended up [seeing] the last performance before it left Oklahoma City. I’ve been really excited to see it coming back in my life a year later and in this time. The boldness of the vision to create a musical that uses a diverse cast and a difficult topic, the timeliness of the messaging and then making something accessible to everyone.

It’s the last thing I’ve seen that’s blown me away. But there’s been so many instances where someone has blown me away with something they’ve written online, an article I’ve read or a podcast I’ve listened to. This crisis is so bad, but again, you get to see this beauty of leadership, this boldness of action and constant inspiration of people stepping up and doing wonderful work.

JA: Despite having never worked longer or harder for such a sustained period of time, since Covid-19 hit I’ve read books extensively. The most impactful is “How to Be an Antiracist” by Ibram X. Kendi. It has given me a perspective on social injustice and systemic racism that I did not have before, as well as a better understanding of its root causes and what can be done about it.

CS: I’m a Yankees fan; Aaron Judge had two home runs [in the Aug. 2 game against the Boston Red Sox], and I liked that a great deal. I also think John Lewis’ obituary goodbye letter in The New York Times was the best thing that I’ve read. We shared that so that our employees could read it.

Designing a Pandemic-Proof Compensation Plan

The ability to pivot and adapt to a changing landscape is critical to the success of an organization.

The coronavirus pandemic has created a unique challenge for banks in particular. Government stimulus through the Paycheck Protection Program tasked banks with processing loans at an unheard-of rate, turning bankers working 20-hour days into economic first responders. Simultaneously, the altered landscape forced businesses to adopt a remote work environment, virtual meetings and increase flexibility — amplifying the need for safe and reliable technology platforms, enhanced data security measures and appropriate cyber insurance programs as standard operating procedure.

Prior to Covid-19, a major driver of change was the demographic shift in the workforce as baby boomers retire and Generation X and millennials take over management and leadership positions. Many businesses were focused on ways to attract and retain these workers by adapting their cultures and policies to offer them meaningful rewards. The pandemic will likely make this demographic shift more relevant, as the workforce continues adapting to the impending change. 

Gen X and millennial employees are more likely than previous generations to value flexibility in when and where they work. They may seek greater  alignment in their career and life, according to Gallup. The pandemic has forced businesses to either adapt — or risk the economic consequences of losing their top performers to competitors.

Many employees find they are more productive when working remotely compared to the traditional office setting, which could translate into increased employee engagement. In fact, the Gallup’s “State of the American Workplace” study finds that employees who spend 60% to  80% of their time working remotely reported the highest engagement. Engagement relates to the level of involvement and the relationship an employee has with their position and employer. Gallup finds that engaged employees are more productive because they have increased autonomy, job satisfaction and desire to make a difference. Simply put, increase engagement and performance will rise.

The demographic shift and a force-placed virtual office culture means that designing programs to attract and retain today’s workers require a well thought out combination of strategies. An inexpensive — though not necessarily simple — method of employee retention includes providing recognition when appropriate and deserved. Recognition is a critical aspect in employee engagement, regardless of demographic. Employees who feel recognized are more likely to be retained, satisfied and highly engaged. Without appropriate recognition, employee turnover could increase, which contributes to decreased morale and reduced productivity.

In addition to showing appreciation and recognizing employees who perform well, compensating them appropriately is fundamental to attracting and retaining the best. The flexibility of a non-qualified deferred compensation program allows employers to customize the design to respond to changing needs.

Though still relevant, the traditional Supplemental Executive Retirement Plan has been used to attract and retain leadership positions. It is an unsecured promise to pay a future benefit in retirement, with a vesting schedule structured to promote retention. Because Gen X and millennials may have 25 years or more until retirement, the value of a benefit starting at age 65 or later could miss the mark; they may find a more near-term, personally focused, approach to be more meaningful.

Taking into consideration what a younger employee in a leadership, management, or production position values is the guide to developing an effective plan. Does the employee have young children, student loan debt or other current expenses? Using personalized criteria, the employer can structure a deferred compensation program to customize payments timed to coincide with tuition or student loan debt repayment assistance. Importantly, the employer is in control of how these programs vest, can include forfeiture provision features and require the employee perform to earn the benefits.

These benefits are designed to be mutually beneficial. The rewards must be meaningful to the recipient while providing value to the sponsoring employer. The employer attracts and retains top talent while increasing productivity, and the employee is engaged and compensated appropriately. Banks can increase their potential success and avoid the financial consequences of turnover.

Ultimately, the pandemic could be the catalyst that brings the workplace of tomorrow to the present day. Nimbleness as we face the new reality of a virtual office, flexibility, and reliance on technology will holistically increase our ability to navigate uncertainty.

Compensating Employees in a Crisis

It’s an old conflict with new, pandemic-created urgency: How to compensate employees during a crisis.

Compensation is one of the biggest variable expenses a bank has, and many incentive compensation plans may have components or goals that are no longer realistic at this state of the business cycle. At the same time, bank employees have served as first-responders to the economic crisis created by the coronavirus pandemic, putting in long hours to modify or originate loans. Boards are figuring out how to reward employees for these efforts while keeping a lid on expenses overall, balancing the bank’s growth and safety against the short-term operating environment.

The Paycheck Protection Program from the Small Business Administration creates an interesting compensation opportunity for banks, says Flynt Gallagher, president of Compensation Advisors. Many banks had employees who pulled all-nighters while working remotely to fulfill demand for these unsolicited loans. Some institutions may choose to exercise discretion by issuing spot awards, which reward employees for a specific behavior over a limited period of time, to bankers who worked overtime to help customers. Gallagher believes these may be larger than a typical award, citing one client that is setting aside $100,000 of PPP profits to distribute to employees who pitched in.

The pandemic created challenges for Civista Bancshares’ commercial lenders and their incentive compensation program, though it presented opportunities as well. Processing PPP applications took time that the Sandusky, Ohio-based bank’s commercial team may have spent monitoring and administrating their existing portfolios or prospecting for new customers. But after the $2.6 billion bank satiated demand from current customers, it opened its doors for new customers, says Civista Bancshares CEO Dennis Shaffer. Some new customers transferred their accounts and service needs as a result, which counts toward deposit goals that retail bank staff have.

Banks with plans featuring objectives or goals that may no longer be reasonable or prudent may be able to exercise discretion under their plans’ “extraordinary events” clause, Gallagher says. The clause applies to events that materially affect profitability, like selling a branch or implementing a new operating system. Banks electing that approach, he says, will also need to quantify the impact that Covid-19 has had on their performance.

At Civista, goals tend to be set in the first quarter, and Shaffer says that changing course on an incentive plan midstream could compromise its integrity. Gallagher adds that public companies like Civista may face scrutiny from proxy advisory firms if they make changes to a current plan or exercise too much description.

But boards have some options as they evaluate their current incentive compensation plans. Some may break their compensation plans into shorter plan periods. Gallagher predicts that banks may decide to shift or roll up individual goals into team or department objectives to reward the broad efforts of groups that may have gone beyond the four corners of their job descriptions.

“I don’t think you’re going to see any general methodology adopted. It’s going to be all over the board, based on the institution,” he says.

Walden Savings Bank is comparing its compensation plan, which uses a scorecard of 12 metrics evaluated monthly, to its expected financial performance, says Stephen Burger, who has chaired the Montgomery, New York-based bank’s compensation committee for 16 years. He says there is already “no way” to achieve at least four of those metrics, reducing the incentive accrual by 25%. The board and CEO of the $603 million bank also decided to cut their pay, but so far no employees have been laid off or furloughed.

“The scorecard is just a guideline,” he says. “We do have latitude to look at other opportunities and reward or cut in certain areas.”

The bank is already trying to keep a tight lid on expenses. They stayed local for their strategic planning weekend instead of going out of town, implemented a hiring freeze, paused a branch transformation project and are mulling alternations to certain benefits or staff reductions.

“We will find a way to reward our employees,” Burger says. “At the same time, if earnings aren’t there, we’ll also do a very effective job of making sure that they recognize that it’s a unique type of year.

Gallagher cautions against banks making short-term cuts in employment or not rewarding producers. Good employees need to be retained in anticipation of better operating periods. And some banks may actually look to hire new employees right now, given that mass unemployment has flooded the marketplace with talent.

“One banker [I spoke to] said he doesn’t think he is overstaffed, he just doesn’t think he has people in the right places,” Gallagher says. “Companies that are forward-thinking will go hard on people while they’re available, even if they don’t need them. You’ll figure out how to use them to the best of their ability later. Get the talent right now.”

Opportunity Emerges from Coronavirus Crisis

The banking industry has experienced shocks and recessions before, but this one is different.

Never has the economy been shut so quickly, has unemployment risen so fast or the recovery been so uncertain. The individual health risks that consumers are willing to take to create demand for goods and services will drive the recovery. As we weigh personal health and economic health, banking communities and their customers hang in the balance.

Ongoing economic distress will vary by market but the impact will be felt nationwide. Credit quality will vary by industry; certain industries will recover more quickly, while others like hotels, restaurants, airlines and anything involving the gathering of large crowds will likely need the release of a coronavirus vaccine to fully recover. As more employees work from home, commercial office property may never be the same. While this pandemic is different from other crises, some principles from prior experience are worth consideration as bankers manage through this environment.

Balance sheet over income statement. In a crisis, returns, margins and operating efficiency — which often indicate performance and compensation in a strong economy — should take a back seat to balance sheet strength and stability. A strong allowance, good credit quality, ample liquidity and prudent asset-liability management must take priority.

Quality over quantity. Growth can wait until the storm has passed. Focus on the quality of new business. In a flat yield curve and shrinking margin environment, resist the thinking that more volume can compensate for tighter spread. Great loans to great customers are being made at lower and lower rates; if the pie’s not growing, banks will need to steal business from each other via price in a race to the bottom. Value strong relationships and ask for pricing that compensates for risk. Resist marginal business on suspect terms and keep dry powder for core investments in the community.

Capital is king. It’s a simple concept, but important in a crisis. Allocate capital to the most productive assets, hold more capital rather than less and build capital early. A mistake banks made in prior crises was underestimating their capital need and waiting too long to build or raise capital. Repurchasing shares seems tempting at current valuations, but the capital may be more valuable internally. Some banks may consider cutting or suspend common stock dividends, but are fearful of condemnation in the market. The cost of carrying too much capital right now is modest compared to the cost of not having enough — for credit losses but equally for growth opportunity during the recovery.

The market here serves as the eye of the storm. The front edge of the storm saw the closure of the economy, concern for family, friends and staff and community outreach with the Paycheck Protection Program (PPP), not once but twice. Now settles in the calm. Banks have deployed capital, the infection rate is slowing and small businesses are trying to open up. But don’t mistake this period for the storm being over. There is a back edge of the storm that may occur in the fall: the end of enhanced unemployment insurance benefits, the exhaustion (and hopefully forgiveness) of PPP funds and the expiration of forbearance. Industries that require a strong summer travel and vacation season will either recover or struggle further. And any new government stimulus will prolong the inevitable as a bandage on a larger wound. Banks may see credit losses that rival the highest levels recorded during the Great Recession. Unemployment that hits Great Depression-era levels will take years to fully recover.

But from crisis comes opportunity. Anecdotal evidence suggests that business may shift back to community banks. When markets are strong, pricing power, broad distribution and leading edge technology attract consumers to larger institutions. In periods of distress, however, customers are reminded of the strength of human relationships. Some small businesses found it difficult to access the PPP because they were a number in a queue at a larger bank or were unbanked without a relationship at all. Consumers that may have found it easy to originate their mortgage online had difficulty figuring out who was looking out for them when they couldn’t make their payment. In contrast, those that had a banking relationship and someone specific to call for help generally had a positive experience.

This devastating crisis will be a defining moment for community banks, as businesses and consumers have new appreciation for the value of the personal banking relationship. Having the strength, capital, brand and momentum to take advantage of the opportunity will depend on the prudence and risk management that these same banks navigate the pandemic-driven downturn today.

Did the PPP Create Class Action Liability for Banks?

The federal government has a history of assisting businesses when a crisis occurs, but one of its latest interventions may have created risk for bank partners providing aid.

Most recently, the CARES Act’s Paycheck Protection Program, commonly called PPP, helped businesses affected by Covid-19 by providing forgivable loans if, among other things, a company used the funds for “payroll costs, interest on mortgages, rent, and utilities” and used at least 60% of the amount forgiven on payroll. The program’s rocky rollout came during an extremely turbulent time, so it should surprise no one that disgruntled applicants and agents have filed a series of class action lawsuits with similar patterns of claims and allegations.

The first PPP class action lawsuits were filed against Bank of America Corp. and Wells Fargo & Co. in early April. In both cases — Profiles v. Bank of America Corp. and Scherer v. Wells Fargo Bank — the plaintiffs alleged the banks improperly restricted access to PPP loans to customers with a pre-existing banking relationship. Per this theory, the banks favored established, pre-existing clients in order to receive larger fees from larger loans at the expense of new customers.

Critically, in Profiles, the district court denied the plaintiffs’ motion to enjoin Bank of America from imposing eligibility restrictions. Specifically, the court held that no express or implied private right of action exists under the PPP, and that only the Small Business Administration could file a civil suit for alleged violations of the PPP. The district court determined the alleged conduct was allowed, stating “[t]he statutory language does not constrain banks such that they are prohibited from considering other information when deciding from whom to accept applications, or in what order to process applications it accepts.”

Recognizing issues with asserting claims directly under the CARES Act, another group of class action plaintiffs brought claims under state law theories in separate cases against Bank of America, JPMorgan Chase & Co, U.S. Bancorp and Wells Fargo in California federal court. These plaintiffs assert that the banks prioritized applications for large loans to generate higher fees in violation of California’s Unfair Competition and False Advertising Laws and engaged in common law fraudulent concealment. The law firms that led the California class actions have filed suits under similar theories in New York against JPMorgan.

Utilizing different theories, class plaintiffs in California argue lenders are failing to process PPP loan applications on a first-come, first-served basis, as purportedly expected by the SBA. In Outlet Tile Center v. JPMorgan Chase & Co, the plaintiffs claimed Chase solicited applications from more-favored clients, making it impossible for the others to obtain loans. Even though there is no express requirement applications be processed on a first-come, first-served basis, plaintiffs claim they gave up opportunities to get loans from institutions that took applications as they came because of their pending applications with Chase. Suits employing this theory were also filed in New York, Illinois and Texas. 

Espousing novel-market theories under the Sherman and Clayton Acts, plaintiffs in Legendary Transport v. JPMorgan Chase & Co. allege lenders conspired to only provide PPP loans to their larger clients as a way to “protect their market share and to limit competition” with respect to PPP funds. That suit also accuses JPMorgan of negligence and misrepresentation in connection with its PPP application process.

Finally, loan seekers are not the only class action plaintiffs seeking relief. Parties purporting to be agents assisting clients with applying for PPP loans are also seeking compensation. Cases in Florida and Ohio assert, despite CARES Act fee requirements, agents including accountants, attorneys, consultants and loan brokers who helped businesses prepare and submit applications are not being paid. These suits allege banks are not properly processing agent fees, intentionally failing to process loans that refer to an agent and/or directing applicants to online portals that do not allow customers to designate an agent.

All of these suits are still in their early stages, and some may be abandoned now that additional PPP funds have been made available and named plaintiffs may have received funds. Nonetheless, class action theories and new targets will evolve and emerge over time. In defending these suits, banks will likely rely upon “no private right of action” rulings, the lack of specific process requirements (as opposed to statutory guidance) and, in cases when only state law actions are pled, federal preemption. Importantly, financial institutions that evaded the first strike of class action litigation should prepare for future attacks utilizing the same or very similar theories of liability.