- How Risk Management is Evolving
- Adopting AI Solutions
- Planning for the Future
Could credit quality finally crack in the third quarter?
Banks spent the summer and fall risk-rating loans that had been impacted by the coronavirus pandemic and recession at the same time they tightened credit and financial standards for second-round deferral requests. The result could be that second-round deferrals substantially fall just as nonaccruals and criticized assets begin increasing.
Bankers must stay vigilant to navigate these two diametric forces.
“We’re in a much better spot now, versus where we were when this thing first hit,” says Corey Goldblum, a principal in Deloitte’s risk and financial advisory practice. “But we tell our clients to continue proactively monitoring risk, making sure that they’re identifying any issues, concerns and exposures, thinking about what obligors will make it through and what happens if there’s another outbreak and shutdown.”
Eight months into the pandemic, the suspension of troubled loan reporting rules and widespread forbearance has made it difficult to ascertain the true state of credit quality. Noncurrent loan and net charge-off volumes stayed “relatively low” in the second quarter, even as provisions skyrocketed, the Federal Deposit Insurance Corp. noted in its quarterly banking profile.
The third quarter may finally reveal that nonperforming assets and net charge-offs are trending higher, after two quarters of proactive reserve builds, John Rodis, director of banks and thrifts at Janney Montgomery Scott, wrote in an Oct. 6 report. He added that the industry will be closely watching for continued updates on loan modifications.
Banks should continue performing “vulnerability assessments,” both across their loan portfolios and in particular subsets that may be more vulnerable, says James Watkins, senior managing director at the Isaac-Milstein Group. Watkins served at the FDIC for nearly 40 years as the senior deputy director of supervisory examinations, overseeing the agency’s risk management examination program.
“Banks need to ensure that they are actively having those conversations with their customers,” he says. “In areas that have some vulnerability, they need to take a look at fresh forecasts.”
Both Watkins and Goldblum recommend that banks conduct granular, loan-level credit reviews with the most current information, when possible. Goldblum says this is an area where institutions can leverage analytics, data and technology to increase the efficiency and effectiveness of these reviews.
Going forward, banks should use the experiences gained from navigating the credit uncertainty in the first and second quarter to prepare for any surprise subsequent weakening in credit. They should assess whether their concentrations are manageable, their monitoring programs are strong and their loan rating systems are responsive and realistic. They also should keep a watchful eye on currently performing loans where borrower financials may be under pressure.
It is paramount that banks continue to monitor the movement of these risks — and connect them to other variables within the bank. Should a bank defer a loan or foreclose? Is persistent excess liquidity a sign of customer surplus, or a warning sign that they’re holding onto cash? Is loan demand a sign of borrower strength or stress? The pandemic-induced recession is now eight months old and yet the industry still lacks clarity into its credit risk.
“All these things could mean anything,” Watkins says. “That’s why [banks need] strong monitoring and controls, to make sure that you’re really looking behind these trends and are prepared for that. We’re in uncertain and unprecedented times, and there will be important lessons that’ll come out of this crisis.”
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.
Any bank that stress tested its loan portfolios prior to the Covid-19 pandemic probably used a worst-case scenario that wasn’t nearly as bad as the economic reality of the last five months.
Stress tests are an analysis of a bank’s loans or revenue stream against a variety of adverse computer-generated scenarios. The results help management teams and their boards of directors gauge whether the bank has adequate reserves and capital to withstand loan losses of various magnitudes. One challenge for banks today that incorporate stress tests into their risk management approach is the lack of relevant historical data. There is little modern precedent for what has befallen the U.S. economy since March, when most of the country went into lockdown to try to flatten the pandemic’s infection rate. The shutdowns tipped the U.S. economy into its steepest decline since the Great Depression.
Does stress testing still have value as a risk management tool, given that we’re navigating in uncharted economic waters?
“I would argue absolutely,” says Jay Gallagher, deputy comptroller for systemic risk identification support and specialty supervision at the Office of the Comptroller of the Currency. “It is not meant to be an exercise in perfection. It’s meant to say within the realm of possibility, these are the scenarios or variables we want to test against. Could we live with what the outcome is?”
The Dodd-Frank Act required banks with assets of $10 billion or greater to run annual stress tests, known as DFAST tests, and report the results to their primary federal regulator. The requirement threshold was raised to $100 billion in 2018, although Gallagher believes that most nationally chartered banks supervised by the OCC still do some form of stress testing.
“They see value in the exercise and not having the regulatory framework around it makes it even more nimble for them to focus on what’s really important to them as opposed to checking all the boxes from a regulatory exercise,” says Gallagher. “We still see a lot of banks that used to have to do DFAST still use a lot of the key tenets in their risk management programs.”
Amalgamated Bank, a $5.8 billion state chartered bank headquartered in New York, has been stress testing its loan portfolios on an individual and macro level for several years even though it sits well below the regulatory threshold. For the first time ever, the bank decided to bring in an outside firm to do its own analysis, including peer comparisons.
President and CEO Keith Mestrich says it is as much a business planning tool as much as it is a risk mitigation tool. It gives executives insight into its loan mix and plays an important role in decisions that Amalgamated makes about credit and capital.
“It tells you, are you going to have enough capital to withstand a storm if the worst case scenario comes true and we see these loss rates,” he says. “And if not, do you need to go out and raise additional capital or take some other measures to get some risk off the balance sheet, even if you take a pretty significant haircut on it?”
Banks that stress test have been forced to recalibrate and update their economic assumptions in the face of the economy’s sharp decline, as well as the government’s response. The unemployment rate spiked to 14.7% in April before dropping to 11.1% in June when the economy began to reopen, according to the Bureau of Labor Statistics. But the number of Covid-19 cases in the U.S. has surged past 3 million and several Western and Southern states are experiencing big increases in their infection rates, raising the possibility that unemployment might spike again if businesses are forced to close for a second time.
“I feel like the unemployment numbers are probably the most important ones, but they’re always set off by how the Covid cases go,” says Rick Childs, a partner at the consulting firm Crowe. “To the extent that we don’t get [the virus] back under control, and it takes longer to develop a vaccine and/or effective treatment options for it, I think they’ll always be in competition with each other.”
Another significant difference between the Great Recession and the current situation is the unparalleled level of fiscal support the U.S. Congress has provided to businesses, local governments and individuals through the $2 trillion CARES Act. It is unclear another round of fiscal support will be forthcoming later this year, which could also drive up the unemployment rate and lead to more business failures. These and other variables complicate the process of trying to construct a stress test model, since there aren’t clear precedents to rely on in modern economic history.
Stress testing clearly still has value despite these challenges, but Childs says it’s also important that banks stay close to their borrowers. “Knowing what’s happening with your customer base is probably going to be more important in terms of helping you make decisions,” he says.
A common misconception among many community bankers is that it isn’t necessary to evaluate (or re-evaluate for some) their use of artificial intelligence – especially in the current market climate.
In reality, these technologies absolutely need a closer look. While the Covid-19 crisis and Paycheck Protection Program difficulties put a recent spotlight on outdated financial technology, slow technology adoption is a long-standing issue that is exacerbating many concerning industry trends.
Over the last decade, community banks have faced massive disruption and consolidation — a progression that is likely to continue. It’s imperative that bank executives take a clear-eyed look at how advanced technologies such as AI can support their business objectives and make them more competitive, while gaining a better understanding of the requirements and risks at play.
Incorporating AI to Elevate Existing Business Processes
This may seem like a contrarian view, but banks do not need a specific, stand-alone AI strategy. The value of AI is its ability to improve upon existing structures and processes. Leadership teams need to be involved in the development process to identify opportunities where AI can tangibly drive business objectives, and manage expectations around the resources necessary to get the project up and running.
For example, community banks should review how AI can automate efficiencies into their existing compliance processes — particularly in the areas of anti-money laundering and Bank Secrecy Act compliance. This application of AI can free up manpower, reduces error rates and help banks make informed decisions while better serving their customers.
It’s necessary to have a strong link between a bank’s digital transformation program and AI program. When properly incorporated, AI helps community financial institutions better meet rising customer expectations and close the gap with large financial institutions that have heavily invested in their digital experiences.
Practical Steps for Incorporating AI
Once a bank decides the best path forward for implementing AI, there are a few technical and organizational steps to keep in mind:
Minimizing Technical Debt and “Dirty Data”: AI requires vast amounts of data to function. “Dirty data,” or information containing errors, is a real possibility. Additionally, developers regularly make trade-offs between speed and quality to keep projects moving, which can result in greater vulnerability to crashes. Managing these deficiencies, “or technical debt,” is crucial to the success of any AI solution. One way to minimize technical debt is to ensure that both the quantity and quality of data taken in by an AI system are carefully monitored. Organizations should also be highly intentional about the data they collect.More isn’t always better.
Minimizing technical debt and dirty data is also key to a smooth digital transformation process. Engineers can add value through new and competitive features rather than spending time and energy addressing errors — or worse, scrapping the existing infrastructure altogether.
Security & Risk Management: Security and risk management needs to be top-of-mind for community bankers any time they are looking to deploy new technologies, including leveraging AI. Most AI technologies are built by third-party vendors rather than in-house. Integrations can and likely will create vulnerabilities. To ensure security and risk management are built into your bank’s operating processes and remain of the highest priority, chief security officers should report directly to the CEO.
Managing risks that arise within AI systems is also crucial to avoid any interruptions. Effective risk management ties back to knowing exactly how and why changes affect the bank’s system. One common challenge is the accidental misuse of sensitive data or data being mistakenly revealed. Access to data should be tightly controlled by your organization.
Ongoing communication with employees is important since they are the front line when it comes to spotting potential issues. The root cause of any errors detected should be clearly tracked and understood so banks can make adjustments to the model and retrain the team as needed.
Resource Management: An O’Reilly Media survey from 2018 found that company culture was the leading impediment to AI adoption in the financial services sector. To address this, leaders should listen to and educate employees within each department as the company explores new applications. Having a robust change management program — not just for AI but for any digital transformation journey — is absolutely critical to success. Ongoing education around AI efforts will help garner support for future initiatives and empower employees to take a proactive role in the success of current projects.
At a glance, implementing AI technologies may seem daunting, but adopting a wait-and-see approach could prove detrimental — particularly for community banks. Smaller banks need to use every tool in their toolkit to survive in a consolidating market. AI poses a huge opportunity for community banks to become more innovative, competitive and prosperous.
“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question,” Bezos said in 2012. “I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two, because you can build a business strategy around the things that are stable in time.”
In few industries is this truer than banking.
Much of the conversation in banking in recent years has focused on the ever-evolving technological, regulatory and operational landscapes. The vast majority of deposit transactions at large banks nowadays are made over digital channels, we’re told, as are a growing share of loan originations. As a result, banks that don’t change could soon go the way of the dinosaurs.
This argument has merit. But it also needs to be kept in perspective. Technology is not an end in itself for banks, it’s a means to an end — the end being to help people better manage their financial lives. Doing this in a sustainable way calls for a marriage of technology with the timeless tenets of banking.
It’s with this in mind that Bank Director and nCino, a provider of cloud-based services to banks, collaborated on a new report, The Flywheel of Banking: Six Timeless Tenets of Extraordinary Banks.
The report is based on interviews of more than a dozen CEOs from top-performing financial institutions, including Brian Moynihan at Bank of America Corp., Rene Jones at M&T Bank Corp. and Greg Carmichael at Fifth Third Bancorp. It offers unique and invaluable insights on leadership, growth, risk management, culture, stakeholder prioritization and capital allocation.
The future of banking is hard to predict. There is no roadmap to reveal the way. But a mastery of these tenets will help banks charge ahead with confidence and, in Bezos’ words, build business strategies around things that are stable in time.
The Six Tenets of Extraordinary Banks
Jonathan Rowe of nCino describes the traits that set exceptional banks — and their leaders — apart from the industry.
To download the free report, simply click here now.
Have you ever been through a breakup you didn’t see coming? Judging by the stories small businesses share about their banks — and the stories that banks tell themselves about those same relationships — it seems the industry is on the verge of needing a pint of ice cream and a good cry.
It might be over between small businesses and banks.
I talk to a lot of bankers, and many tout their banks’ focus on small businesses — the restaurants, hairdressers and other staples that fuel local economies. These bankers pride themselves and their teams on knowing their clients well. If a hard rain floods the local lake, they pick up the phone to call their marina clients to make sure they’re doing OK. It’s special — but in a springtime pockmarked by pandemic, it might not be enough.
The relationships between banks and their small business customers are more strained than banks might realize, according to a January research report sponsored by Autobooks and conducted by Aite Group.
“Less than half (47%) of U.S.-based small businesses believe their primary institution understands their needs,” stated Autobooks, a Detroit-based fintech that provides small business accounting tools, in a release about the research. Aite also found that more than 60% of small businesses have turned to a nonbank provider to meet at least one financial need that their bank can’t fill.
These shortfalls have been ongoing, but changing market conditions caused by the outbreak of COVID-19 could be the final straw for underserved small businesses.
It boils down to this: Banks that haven’t invested in technology are behind the curve when it comes to helping their small business clients weather crises. At the same time, technology companies that are already providing small business customers with products they love now have clear paths to offering financial services that only banks used to be able to provide. Cash management, payments and fast loans will be crucial to the survival of small businesses; technology is going to be the key to saving them.
Nowhere is the importance of technology more crystallized than in the current debate over emergency small business loans. Banks are struggling to keep up with rising loan demand. Complicated applications, slow underwriting and a lack of payment options may convince small business customers to turn to nonbank lenders for fast funding, even if they pay a higher interest rate.
The same scenario is unfolding in the realm of government-backed loans from the Small Business Administration. Until recently, banks were the only institutions that could serve as conduits for the Economic Injury Disaster Loans that help troubled businesses in times of crisis. But big, national fintech lenders were quick to lobby for an expansion of that rule, and they got it. Congressional coronavirus relief gave the U.S. Treasury Department the authority to allow “additional lenders” to make these loans. Congress acquiesced to the change because timing is everything when it comes to small business loans in a crisis.
Half of small businesses only have enough cash on hand to operate for 27 days, and an additional 25% only have enough cash reserves to operate for 13 days without new revenue, according to an oft-cited 2016 survey from JPMorgan Chase & Co. SBA loans made through partner banks typically take several months before the cash is available to borrowers — an untenable timeline for companies with mounting expenses and no revenue. Fintech lenders say they could push emergency loans out in days, potentially saving many businesses from failure but funneling significant volume away from banks.
The loans businesses need to survive today could easily morph into larger relationships with nonbanks tomorrow, as fintechs cross old regulatory moats by securing their own charters and deposit insurance.
So far, 2020 has seen significant fintech advances into banking from Varo Money and LendingClub Corp. But the move that seems to have caused the most hand-wringing among traditional banks is Square’s approval for deposit insurance as part of its Utah industrial loan charter. The payments heavyweight has an established national brand among small businesses, and could divert large amounts of small business clients away from brick-and-mortar banks when it starts offering loans and deposit products in 2021.
Square has provided mission-critical financial services for small businesses since its inception. Many businesses trust their payment products for every transaction they make. Square may have the loyalty it needs to earn the entire banking relationship.
Technology companies like Square aren’t going to pick up the phone to check in on a marina client after the local lake floods. But they are going to provide timely, tuned-in products. In a crisis, that may matter more.
Bank directors and management teams must prepare themselves and their institution for the potential for an economic crisis due to the COVID-19 outbreak.
This preparation process is different than how they would manage credit issues in more traditional economic downturns; traditional credit risk management tools and techniques may not apply or be as effective. Directors and others in bank management may need to consider new alternatives and act quickly and deliberately if they are going to be successful during this very difficult time.
The traditional three lines of defense against quickly elevating credit risk may not work to prevent the credit impact of the new coronavirus and its consequences. The “horse is out of the barn” and no existing, normal risk management system can prevent some level of losses. This pandemic is the proverbial black swan.
The real questions now are how can banks prepare to deal with the related issues and problems?
Some institutions are likely to be better prepared, including those with:
- A strong capital base.
- Good, conservative allowance reserve levels.
- Realistic credit risk assessments and portfolio ratings prior to the pandemic.
- Are poised to take part in a potential acquisition.
- A good strategic approach that is not materially swayed by quarterly earning pressures.
- A management and board that “tells it like it is” and is realistic.
- Good relationship with regulators, CPA firms, professionals and investors.
What are a bank’s options when trying to assess and manage the pandemic’s impact?
- Deny the problem and kick the can down the road.
- Wait for the government and regulators to provide solutions or a playbook for the problems.
- Sell the bank — most likely at a big discount if at all.
- Liquidate the bank, likely only after expending capital, with assistance from the Federal Deposit Insurance Corp.
- Be proactive and put in place processes to deal with the problem and consequences.
There are some steps a bank can take to be proactive:
- Identify emerging and potential problems and the options to handle them, and then create a plan that is strategic, operational and provides the best financial result.
- Commit to doing what’s right for the bank, its employees, customers and community.
- Enhance or replace the current credit risk management system with a robust identification, measurement, monitoring, control and reporting program.
- Adopt an “all hands-on deck” to improve focus and deal with material issues in a priority order, deferring things that do not move the needle.
- Assess internal resources and consider moving qualified personnel into areas that require more focus.
- Seek outside professional assistance, if needed, such as loan workout or portfolio analysis and planning.
- Perform targeted reviews of portfolio segments that are or may become challenged because of the pandemic and potential fallout, along with others may have had weaker risk profiles before the pandemic.
- Communicate the issues such as the magnitude of the financial challenge to employees, the market, regulators, CPAs and other professionals who provide risk management services to your bank.
- Deal with problems head-on and decisively to maintain credibility and respect from various constituencies while achieving a superior result.
It is best for everyone in the bank to work together and act quickly, thoughtfully, honestly and strategically. There will, of course, be some expected and understood need in the short term for increases in allowance provisioning. If planning and actions are executed well, the long-term results will improve the bank’s performance and enhance its credibility with the market, regulators and all other professionals. Just as valuable as an outcome is that your bank’s reputation will be enhanced with your employees, who will be proud to have been part of the effort during these difficult times.
The delay in the current expected credit loss accounting model has created a window of opportunity for small banks.
The delay from the Financial Accounting Standards Board created two buckets of institutions. Most of the former “wave 1” institutions constitute the new bucket 1 group with a 2020 start. The second bucket, which now includes all former “wave 2 and 3” companies are pushed back to 2023 — giving these institutions the time required to optimize their approach to the regulation.
Industry concerns about CECL have focused on two of its six major steps: the requirement of a reasonable and supportable economic forecast and the expected credit loss calculation itself. It’s important to note that most core elements of the process are consistent with current industry best practices. However, they may take more time for banks to do it right than previously thought.
Auditors and examiners have long focused on the core of CECL’s six steps — data management and process governance, credit risk assessment, accounting, and disclosure and analytics. Financial institutions that choose to keep their pre-CECL process for these steps do so at their own peril, and risk falling behind competitors or heightened costs in a late rush to compliance. Strategically minded institutions, however, are forging ahead with these core aspects of CECL so they can fully vet all approaches, shore up any deficiencies and maintain business as usual before their effective date.
Discussions over the impact of the CECL standard continue, including the potential for changes as the impacts from CECL bucket 1 filings are analyzed. Unknown changes, coupled with a three-year deadline, could easily lead to procrastination. Acting now to build a framework designed to handle the inevitable accounting and regulatory changes will give your bank the opportunity to begin CECL compliance with confidence and create a competitive advantage over your lagging peers.
Centering CECL practices as the core of a larger management information system gives institutions a way to improve their risk assessment and mitigation strategies and grow business while balancing risk and return. More widely, institutions can align the execution across the organization, engaging both management and shareholders.
Institutions can use their CECL preparations to establish an end-to-end credit risk management framework within the organization and enjoy strategic, incremental improvements across a range of functions — improving decision making and setting the stage for future standards. This can yield benefits in several areas.
Data management and quality: Firms starting to build their data histories with credit risk factors now can improve their current Allowance for Loan and Lease Losses process to ensure the successful implementation of CECL. Financial institutions frequently underestimate the time and effort required to put the required data and data management structures in place, particularly with respect to granularity and quality. For higher quality data, start sourcing data now.
Integration of risk and financial analysis: This can strengthen the risk modeling and provisioning process, leading to an improved understanding and management of credit quality. It also results in more appropriate provisions under the standard and can give an early warning of the potential impact. Improved communication between the risk and finance functions can lead to shared terminologies, methods and approaches, thereby building governance and bridges between the functions.
Analytics and transparency: Firms can run what-if scenario analysis from a risk and finance perspective, and then slice and dice, filter or otherwise decompose the results to understand the drivers of changes in performance. This transparency can then be used to drive firms’ business scenario management processes.
Audit and governance: Firms can leverage their CECL preparations to adopt an end-to-end credit risk management architecture (enterprise class and cloud-enabled) capable not only of handling quantitative compliance to address qualitative concerns and empower institutions to better answer questions from auditors, management and regulators. This approach addresses weaknesses in current processes that have been discovered by audit and regulators.
Business scenario management: Financial institutions can leverage these steps to quantify the impact of CECL on their business before regulatory deadlines, giving them a competitive advantage as others catch up. Mapping risks to potential rewards allows firms to improve returns for the firm.
Firms can benefit from CECL best practices now, since they are equally applicable to the current incurred loss process. Implementing them allows firms to continue building on their integration of risk and finance, improving their ALLL processes as they do. At the same time, they can build a more granular and higher quality historical credit risk database for the transition to the new CECL standards, whatever the timeframe. This ensures a smoother transition to CECL and minimizes the risk of nasty surprises along the way.
A new accounting standard could make hedging with derivatives a more-viable risk management strategy for banks that had previously avoided them.
The Financial Accounting Standards Board sought to remove some barriers that previously discouraged many banks from using derivatives to hedge exposure to fluctuating interest rates. Now is an appropriate time for board members at banks of all sizes to ask their executive teams about their risk management strategies, and whether derivatives should play a larger role.
The standard — Accounting Standards Update (ASU) 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” — went into effect for publicly traded institutions in the fiscal year beginning after Dec. 15, 2018. It takes effect for privately held banks in the fiscal year beginning after Dec. 15, 2020, though early adoption is permitted.
In theory, using derivatives such as interest-rate swaps should be an effective way for banks to fine-tune portfolios and offset risks that come with having a mix of fixed rate and floating rate assets and liabilities. In practice, however, many banks chose not to hedge with derivatives because of complicated accounting and financial reporting practices required by generally accepted accounting principles.
Old hedging rules required banks to separately measure and report hedge ineffectiveness, or any amounts by which a derivative did not perfectly mirror the instrument being hedged —even if the hedge was effective overall. Separately reporting ineffectiveness was confusing for investors and often conveyed a misleading impression of a bank’s derivatives-based hedging practices.
The new standard eliminates that requirement, resulting in hedge accounting that more accurately reflects a bank’s risk management activities and provides financial statement users more worthwhile information about the effect of hedging activities.
When initially establishing a hedge, banks must document how they will evaluate its effectiveness in offsetting the changes in the fair value or cash flow of the hedged instrument. This evaluation must be performed quarterly.
In the past, when a bank chose the “shortcut” method for evaluating hedge effectiveness, it was bound to that method throughout the life of the hedge. If management later determined that the more complicated “long-haul” method would be more appropriate, they could not simply start using that method prospectively. Rather, they would also have to evaluate for a possible restatement of previous financial statements, as if hedge accounting had never been applied.
The new standard changes that. Banks now may specify a long-haul method in their documentation to be used as a fallback method if they later determine that the shortcut method is no longer appropriate.
Things also have gotten simpler for banks that choose the long-haul method at inception. Previously, banks using the long-haul method were required to perform a quantitative assessment (such as a regression analysis) every quarter for the life of a hedge. The new standard still requires a quantitative assessment at inception, but now in certain circumstances banks can perform subsequent quarterly assessments using only qualitative methods, validating that the terms and conditions of the hedged transaction and hedging derivative have not changed.
The new guidance also revises how a bank may measure the change in a hedged item’s fair value due to changes in its benchmark interest rate. Instead of calculating fair value based on all the cash flows of the instrument’s coupon, banks now can calculate the change in fair value based solely on the benchmark interest rate component, which is a more targeted and appropriate measure.
Under old hedging rules, hedging the change in fair value of an instrument (such as a fixed-rate loan) generally required the life of the hedged instrument and the life of the hedging derivative (such as an interest-rate swap) to match. The new standard removes that burden and allows for partial-term fair value hedges. For example, a bank can hedge a 10-year fixed rate loan for only two years, using a two-year interest-rate swap.
Another new opportunity known as the “last-of-layer” technique lets banks hedge the change in fair value of a pool of long-term fixed rate assets such as loans or securities — a hedge that generally was not possible in the past. Upon adoption of the standard, banks are permitted to transfer eligible held-to-maturity securities to available for sale, even if the bank eventually chooses not to hedge the securities at all.
Bank directors should familiarize themselves with the ways the new standard simplifies hedge accounting and enables new hedging techniques before engaging management to decide if it’s time to introduce or expand derivatives as risk management tools.