2020 Risk Survey Results: “Don’t Panic. Just Fly the Airplane.”

It wasn’t uncommon in the latter half of 2019 for bank executives to note the margin pressure faced by the industry, brought on by an inhospitable interest rate environment. And rates dropped even lower in early 2020, with the Federal Reserve cutting rates to zero.

“In spite of the Fed’s yo-yo interest rate, we have a responsibility to manage our assets in a manner that is in the best interest[s] of our shareholders and communities we serve. The key is not to panic, but [to] hold the course,” said John Allison, CEO of Conway, Arkansas-based Home Bancshares, in the $15 billion bank’s second quarter 2019 earnings call. “At the end of the day, your management’s trying to operate profitably in the middle of this chaos. They say when you’re piloting an airplane and there’s a major problem, like an engine going out: ‘Don’t panic. Just fly the airplane.’”

Allison’s advice to “just fly the airplane” seems an appropriate way to frame the risks facing the banking industry, which Bank Director explored again in its 2020 Risk Survey, sponsored by Moss Adams. Conducted in January, it includes the views of more than 200 independent directors, CEOs, risk officers and other senior executives of U.S. banks below $50 billion in assets.

A majority of these industry leaders say they’re more worried about interest rate risk amid a competitive environment for deposit growth — 25% report their bank lost deposit share in 2019, and 34% report gains in this area. Looking ahead to 2020, most (73%) say their bank will leverage personal relationships to attract deposits from other institutions. Less than half will leverage digital channels, a strategy that skews toward — but is not exclusive to — larger banks.

In the survey, almost 60% cite increased concerns around credit risk, consistent with the Federal Reserve’s Senior Loan Officer Opinion Survey from January, which reports dampened demand for commercial loans and expectations that credit quality will moderately deteriorate.

Interestingly, Bank Director’s 2020 Risk Survey finds respondents almost unanimously reporting that their bank’s loan standards have remained consistent over the past year. However, the majority (67%) also believe that competing banks and credit unions have eased their underwriting standards over the same time period.

 

Key Findings

  • Scaling Back on Stress Tests. The Economic Growth, Regulatory Relief and Consumer Protection Act, passed in May 2018, freed banks between $10 billion and $50 billion in assets from the Dodd-Frank Act (DFAST) stress test requirements. While last year’s survey found that 60% of respondents at these banks planned to keep their stress test practices in place, participants this year reveal they have scaled back (7%) or modified (67%) these procedures.
  • Ready for CECL. More than half of survey respondents say their bank is prepared to comply with the current expected credit loss (CECL) standards; 43% indicate they will be prepared when the standards take effect for their institution.
  • Cyber Anxiety Rising. Eighty-seven percent of respondents say their concerns about cybersecurity threats have risen over the past year. This is the top risk facing the banking industry, according to executives and directors. Further, 77% say their bank has significantly increased its oversight of cybersecurity and data privacy.
  • Board Oversight. Most boards review cybersecurity regularly — either quarterly (46%) or at every board meeting (24%). How the board handles cybersecurity governance varies: 28% handle it within a technology committee, 26% within the risk committee and 19% as a full board. Just one-third have a director with cybersecurity expertise.
  • Climate Change Overlooked. Despite rising attention from regulators, proxy advisors and shareholders, just 11% say their bank’s board discusses climate change at least annually as part of its analysis and understanding of the risks facing the organization. Just 9% say an executive reports to the board annually about the risks and opportunities presented by climate change. More than 20% of respondents say their bank has been impacted by a natural disaster in the past two years.

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

Coronavirus Strategies, Considerations for Banks

Over the past two weeks, we have received numerous inquiries from financial institutions on what actions should be taken or considered to address the COVID-19, or the new coronavirus, pandemic. While the current situation is evolving each day, we have engaged in numerous discussions with banks on various strategies and considerations that are being reviewed or implemented during this uncertain time.

Business Continuity Plan

Every financial institution should have implemented pandemic planning contingencies contained in its business continuity plan. In response to the burgeoning public health crisis, the Federal Financial Institutions Examination Council issued revised guidance on March 6 on how to address pandemic planning in a bank’s business continuity plans. The revision updates previous guidance issued in response to the avian flu pandemic of 2007.

Although there are no substantive updates contained in the revised Pandemic Planning Guidance, the FFIEC’s update reiterates and emphasizes the importance of maintaining a pandemic response plan that includes strategies to minimize disruptions and recover from a pandemic wave. The updated guidance states that banks should consider minimizing staff contact, encouraging employees to telecommute and redirecting customers from branch to electronic banking services. We anticipate that regulators will review an institution’s utilization of its business continuity plan at upcoming safety and soundness examinations.

Branch Operations

Based on our discussions, we believe that many banks have taken or plan to take actions related to their branch operations. Below is a summary of various actions that a bank may wish to take regarding its branch operations.

Branches Remain Open, with Caveats. A number of banks have elected to close branch lobbies and direct customers to utilize drive-up facilities, walk-up teller lines and ATM machines where possible. In addition, they are also directing customers to their online platforms. Some banks are requesting customers who require physical or in-person assistance, such as access to a safe deposit box, to schedule an appointment with bank employees.

Branch Closures. To the extent a bank may be readying a branch closure strategy, below are federal and state requirements that must be satisfied.

Federal Requirements. On March 13, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Federal Reserve Board issued corresponding guidance addressing COVID-19’s impact on customers and bank operations indicating that they expect bank branch closures, or changes to branch hours. In such an event, they recommend that a bank (i) notify the applicable federal banking regulator as soon as practicable of the closure/change in bank hours, (ii) comply with any notice or filing requirements with applicable state banking regulators and (iii) place a customer notice on the front entrance of the impacted branch describing the reason for the closure and/or change in hours.

State Law Requirements. Closing lobbies and redirecting customers to drive-ups does not generally require a bank to obtain the approval of state banking authorities, but some state banking authorities have requested that banks provide notice of such changes. For example, Illinois-chartered banks seeking to fully close a branch or change branch hours must provide prior notice to the Illinois Department of Financial and Professional Regulation, Division of Banking, and obtain an official proclamation from the IDB under the Illinois Banking Emergencies Act (205 ILCS 610). In addition, the bank must post notice of the temporary closing or change in branch hours and the authorization for such change on the main entrance doors of the applicable branch.

ATM/Cash-On-Hand Strategies. In a push to increase customer traffic to ATMs and minimize direct customer contact, some banks have increased or plan to increase ATM daily allowable cash withdrawal limits. The size of the increase depends on the individual circumstances of the institution. Banks may experience greater cash withdrawal requests from depositors and may wish to keep higher levels of cash in its branch offices.

Regular and Periodic Cleaning of Branches. Each bank we spoke with also indicated that they have implemented enhanced periodic cleaning of their branches and offices. Some banks have indicated that “deep” cleanings are being completed on a weekly basis.

Employee Considerations

Flexible Work-from-Home Arrangements. We have also discussed the potential for implementing flexible work-from-home or telecommuting arrangements for specific business line employees with institutions. Whether or not this is a viable option for a specific institution is dependent upon a number of specific circumstances: whether the bank’s information technology systems can support an increased number of employees utilizing the bank’s server remotely, ensuring that each employee who remotely accesses the bank’s systems can do so in a confidential manner that protects that bank’s data and whether there are geographic and business-line specific considerations that prevent working remotely, among others. Nonetheless, a bank should plan to test their IT systems and update policies prior to implementing such arrangements.

Utilization of Split-Staff and Split-Location Strategies. In addition, we’ve discussed split-staff and split-location strategies;  a number of banks indicated that they are currently utilizing a split-staff strategy. Under a split-staff strategy, an institution staggers its employees on any given day. For instance, half of the institution’s employees come in on Monday, Wednesday and Friday, and the other half of the employees come in on Tuesday, Thursday and Saturday. The aim is that limiting employee interaction with customers on any given day allows a bank to maintain operations on a much more limited basis if only one group of employees is potentially exposed to COVID-19.

In addition, some institutions also indicated that they plan to utilize a split-location strategy, distributing staff across various branches and offices. If one location is potentially exposed to COVID-19, a bank’s operations can continue through its other locations.

Employee Training. Banks have also implemented staff training on how to properly interact with customers during this troubling time. Following guidance from the World Health Organization and Centers for Disease Control and Prevention, banks have implemented new procedures meant to limit physical contact (like prohibiting handshakes) and eliminating or reducing scheduled meetings.

Liquidity and Capital Considerations

During times of uncertainty and financial market volatility, like the financial crisis, banks have often found it difficult to enhance liquidity and raise additional capital when they may need it the most. Based on our discussions, we recommend that financial institutions review their current and near-term liquidity/capital strategies. Below are a few items to consider.

Subordinated Debt and Equity Issuances. Banks may need to weather a prolonged economic slowdown. Bankers agree that reviewing the firm’s capital strategies in uncertain times is a critical consideration to address any potential need to enhance immediate or near-term liquidity or to shore up capital. Other banks may also wish to review various alternatives available to issue debt for additional liquidity, to potentially refinance outstanding debt arrangements at lower rates, or to provide additional capital.

Lines of Credit. As lenders, banks are aware that their borrowers may be considering a draw down on existing lines of credit. Banks may also wish to consider potentially drawing down on their existing lines of credit (such as Federal Home Loan Bank advances or holding company lines of credit) as an effective tool to increase the holding company’s or bank’s liquidity. Before either drawing down any existing line of credit or utilizing the proceeds for any purpose other than increasing cash-on-hand, a bank should carefully review the covenants in the underlying loan agreements.

Securities Portfolio. Reviewing current strategies pertaining to an institution’s securities portfolio is also a consideration for banks. Many banks have built-in gains in their portfolio. Consequently, institutions are reviewing their portfolios to determine whether to realize existing gains to boost liquidity in the short-term or maintain its current strategy to assist earnings in the longer-term.

Stock Repurchase Programs. Many publicly traded banks have suspended their stock repurchase programs as part of a capital conservation strategy. While no bank has announced plans to cut dividends, now is the time to review contingency plans and consider when such action may be warranted.

Federal Reserve Discount Window. Bankers should also discuss potentially using the Federal Reserve’s short-term emergency loans dispensed through the discount window if necessary. While many institutions consider using the discount window as a last resort and could indicate dire financial straits, senior bank management should revisit their policies and procedures to ensure their institution can access the discount window should circumstances require it.

Importantly, on March 17, the Federal Reserve and eight of the largest financial institutions in the U.S. worked together to provide these large financial institutions access to the discount window. Largely symbolic, the actions are being viewed by banks as an effort to remove the stigma of accessing the discount window. Whether these coordinated efforts will be a success remains to be seen.

Stress Testing of Loans. We anticipate that many institutions will consider the need to begin stress testing their portfolios, and some already are. For some, stress testing may be centered on specific industries and sectors of the loan portfolio that may have been more substantially impacted by COVID-19 (such as hospitality/restaurants, travel, entertainment and companies with supply chains dependent upon China or Europe). For others, the entire loan portfolio may be tested, under the assumption it could be subject to pandemic-related stress.

Review Insurance Policies. Another consideration we’ve discussed with banks is the need to review in-place insurance policies for business disruption coverage to determine if they would cover matters resulting from the COVID-19 pandemic.

Assist Impacted Customers. Consistent with the recent guidance issued by the Fed, FDIC and OCC, banks are considering offering a variety of relief options related to specific product/service lines to customers. Some banks may waive late fees on loan payments or credit cards and others may waive ATM- and deposit-related fees. We expect these relief options will be limited to specific product and service lines, and to a certain period of time.

On March 19, the FDIC issued a set of Frequently Asked Questions for banks impacted by the coronavirus. The FAQs provide insight into how the FDIC, and potentially other federal banking regulators, will view payment accommodations, reporting of delinquent loans, document retention and reporting requirements, troubled debt restructurings, nonaccrual loans and the allowance for loan and lease losses. Banks should review the FAQs in connection with providing any financial assistance to impacted customers.

The items noted above should not be considered definitive or exclusive. A financial institution should carefully consider the above items, among others, and determine how to tailor any proposed changes to its operations in light of the very fluid circumstances surrounding the current COVID-19 pandemic.

Click here to review the March 13 OCC Bulletin 2020-15 (Pandemic Planning: Working With Customers Affected by Coronavirus and Regulatory Assistance).

Click here to review the March 13 FDIC FIL-17-2020 (Regulatory Relief: Working with Customers Affected by the Coronavirus).

Click here to review the March 13 FRB SR 20-4/CA 20-3 (Supervisory Practices Regarding Financial Institutions Affected by Coronavirus).

Exclusive: How This Growing Community Bank Focuses on Risk


risk-5-16-19.pngManaging risk and satisfying examiners can be difficult for any bank. It’s particularly hard for community banks that want to manage their limited resources wisely.

One bank that balances these challenges well is Bryn Mawr Bank Corp., a $4.6 billion asset based in Bryn Mawr, Pennsylvania, on the outskirts of Philadelphia.

Bank Director Vice President of Research Emily McCormick recently interviewed Chief Risk Officer Patrick Killeen about the bank’s approach to risk for a feature story in our second quarter 2019 issue. That story, titled “Banks Regain Sovereignty Over Risk Practices,” dives into the results of Bank Director’s 2019 Risk Survey. (You can read that story here.)

In the transcript of the interview—available exclusively to members of our Bank Services program—Killeen goes into detail about how his bank approaches stress testing, cybersecurity and credit risk, and explains how the executive team and board have strengthened the organization for future growth.

He discusses:

  • The top risks facing his community bank
  • Hiring the right talent to balance risk and growth
  • Balancing board and management responsibilities in lending
  • Conducting stress tests as a community bank
  • Managing cyber risk
  • Responding to Bank Secrecy Act and anti-money laundering guidance

The interview has been edited for brevity, clarity and flow.

download.png Download transcript for the full exclusive interview

2019 Risk Survey: Cybersecurity Oversight


risk-3-25-19.pngBank leaders are more worried than ever about cybersecurity: Eighty-three percent of the chief risk officers, chief executives, independent directors and other senior executives of U.S. banks responding to Bank Director’s 2019 Risk Survey say their concerns about cybersecurity have increased over the past year. Executives and directors have listed cybersecurity as their top risk concern in five prior versions of this survey, so finding that they’re more—rather than less—worried could be indicative of the industry’s struggles to wrap their hands around the issue.

The survey, sponsored by Moss Adams, was conducted in January 2019. It reveals the views of 180 bank leaders, representing banks ranging from $250 million to $50 billion in assets, about today’s risk landscape, including risk governance, the impact of regulatory relief on risk practices, the potential effect of rising interest rates and the use of technology to enhance compliance.

The survey also examines how banks oversee cybersecurity risk.

More banks are hiring chief information security officers: The percentage indicating their bank employs a CISO ticked up by seven points from last year’s survey and by 17 points from 2017. This year, Bank Director delved deeper to uncover whether the CISO holds additional responsibilities at the bank (49 percent) or focuses exclusively on cybersecurity (30 percent)—a practice more common at banks above $10 billion in assets.

How bank boards adapt their governance structures to effectively oversee cybersecurity remains a mixed bag. Cybersecurity may be addressed within the risk committee (27 percent), the technology committee (25 percent) or the audit committee (19 percent). Eight percent of respondents report their board has a board-level cybersecurity committee. Twenty percent address cybersecurity as a full board rather than delegating it to a committee.

A little more than one-third indicate one director is a cybersecurity expert, suggesting a skill gap some boards may seek to address.

Additional Findings

  • Three-quarters of respondents reveal enhanced concerns around interest rate risk.
  • Fifty-eight percent expect to lose deposits if the Federal Reserve raises interest rates by more than one hundred basis points (1 percentage point) over the next 18 months. Thirty-one percent lost deposit share in 2018 as a result of rate competition.
  • The regulatory relief package, passed in 2018, freed banks between $10 billion and $50 billion in assets from stress test requirements. Yet, 60 percent of respondents in this asset class reveal they are keeping the Dodd-Frank Act (DFAST) stress test practices in place.
  • For smaller banks, more than three-quarters of those surveyed say they conduct an annual stress test.
  • When asked how their bank’s capital position would be affected in a severe economic downturn, more than half foresee a moderate impact on capital, with the bank’s capital ratio dropping to a range of 7 to 9.9 percent. Thirty-four percent believe their capital position would remain strong.
  • Following a statement issued by federal regulators late last year, 71 percent indicate they have implemented or plan to implement more innovative technology in 2019 to better comply with Bank Secrecy Act/anti-money laundering (BSA/AML) rules. Another 10 percent will work toward implementation in 2020.
  • Despite buzz around artificial intelligence, 63 percent indicate their bank hasn’t explored using AI technology to better comply with the myriad rules and regulations banks face.

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

What You Should Know About M&A in 2019



Deal values have been rising, and economic factors—including regulatory easing and increased deposit competition—could drive more deals for regional acquirers, explains Deloitte & Touche Partner Matt Hutton in this video. He also shares how nontraditional acquisitions could impact deal structures, and the importance of due diligence and stress testing at this stage in the credit cycle.

  • Today’s M&A Environment
  • Deal Structure Considerations
  • Expectations for 2019
  • Advice for Boards and Management Teams

Prepare Your Portfolio for an Economic Downturn


portfolio-11-12-18.pngAs we reach the 10-year anniversary of the inflection point of the 2008 financial crisis, it’s the perfect time to reflect on how the economy has (and hasn’t) recovered following the greatest economic downturn since the Great Depression. If you’ve paid the slightest attention to recent news, you’ve probably heard or read about the speculation of when the nation’s next economic storm will hit. While some reports believe the next downturn is just around the corner, others deny such predictions.

Experts can posit theories about the next downturn, but no matter how strong the current economy is or how low unemployment may be, we can count on at some point the economy will again turn downward. For this reason, it’s important that we protect ourselves from risks, like those that followed the subprime mortgage crisis, financial crisis, and Great Recession of the late 2000’s.

In an interview with USA Today, Mark Zandi, chief economist for Moody’s Analytics, explained, “It’s just the time when it feels like all is going fabulously that we make mistakes, we overreact, we over-borrow.”

Zandi also noted it usually requires more than letting our collective guard down to tip the economy into recession; something else has to act as a catalyst, like oil prices in 1990-91, the dotcom bubble in 2001 or the subprime mortgage crisis in 2006-07.

As the number of predictions indicating the next economic downturn could be closer than we think continues to rise, it’s more important to prepare yourself and your portfolio for a potential economic shift.

Three Tips for Safeguarding Your Construction Portfolio In the Event of an Economic Downturn

1. Proactively Stress Test Your Loan Portfolio
Advancements in technology have radically improved methods of stress testing, allowing lenders to reveal potential vulnerabilities within their loan portfolio to prevent potential issues. Technology is the key to unlocking this data for proactive stress testing and risk mitigation, including geotracking, project monitoring and customizable alerts.

Innovative construction loan technology allows lenders to monitor the risk potential of all asset-types, including loans secured by both consumer and commercial real estate. These insights help lenders pinpoint and mitigate potential risks before they harm the financial institution.

2. Increase Assets and Reduce Potential Risk While the Market’s Hot
If a potential market downturn is in fact on the horizon, now is the best time for lenders to shore up their loan portfolios and long-term, end loan commitments before things slow. This will help ensure the financial institution moves into the next downturn with a portfolio of healthy assets.

By utilizing modern technologies to bring manual processes online, lenders have the ability to grow their construction loan portfolio without absorbing the additional risk or adding additional administrative headcount. Construction loan administration software has the ability to increase a lender’s administrative capacity by as much as 300 percent and reduce the amount of time their administrative teams spend preparing reports by upwards of 80 percent. These efficiency and risk mitigation gains enable lenders to strike while the iron’s hot and effectively grow their portfolio to help offset the effects of a potential market downturn.

3. Be Prudent and Mindful When Structuring and Pricing End Loans
As interest rates continue to trend upward, it’s crucial that lenders price and structure their long-term debts with increased interest rates in mind. One of the perks of construction lending, especially in commercial real estate, is the opportunity to also secure long-term debt when the construction loan is converted into an end loan.

Due to fluctuations in interest rates, it’s important for financial institutions to carefully consider how long to commit to fixed rates. For lenders to prevent filling their portfolio with commercial loan assets that yield below average interest rates in the future, they may find it more prudent to schedule adjustable-rate real estate loans on more frequent rate adjustment schedules or opening rate negotiations with higher fixed rate offerings (while still remaining competitive and fairly priced, of course).

Though we can actively track past and potential future trends, it’s impossible to know for sure whether we are truly standing on the precipice of the next economic downturn.

“That’s one of the things that makes crises crises—they always surprise you somehow,” said Tony James, Vice Chairman or Blackstone Group, in an interview with CNBC.

No matter the current state of the economy, choosing to be prepared by proactively mitigating risk is always the best course of action for financial institutions to take. Modern lending technology enables lenders to make smart lending decisions and institute effective policies and procedures to safeguard the institution from the next economic downturn—no matter when it hits.

Concentration Risk Management Remains an Exam Focus: Stress Tests are Vital


risk-9-4-18.pngMake no mistake about it: If your bank has concentrations that are at or above regulatory guidelines, examiners will expect to see a stress test that supports your concentration risk management plan.

Stress testing has never been mandated for community banks—but it is a tool examiners expect banks to use if they have concentration issues in their portfolio. And this isn’t going to change, no matter what Congress does to ease regulatory burden.

In the past year, many community banks have had regulators question their concentration risk management practices. Examiners have said the stress tests will be the primary focus, and in some cases the only focus, of the inquiry.

In several cases, regulators downgraded the bank’s CAMELS score for not having adequate stress testing in place. Regulators are most focused on the management’s command of the tests, and how they make real and critical decisions related to capital and strategic planning.

Banks with New Concentration Issues of Interest
Commercial real estate (CRE) concentration risk management is not a new issue, but regulators are especially targeting banks without a long history of managing CRE concentrations, and are growing their CRE book at excessive rates. 

A BankGenome™ analysis shows that 2,004 banks have grown their CRE portfolios by more than 50 percent in the last three years, a level that has regulators concerned. As of the first quarter of 2018, 293 banks were over the 100 percent construction threshold and 420 banks exceeded the 300 percent total CRE guidelines. Of banks exceeding the thresholds, 54 banks also had 50 percent or more growth within the last three years – a sure sign they will face increased scrutiny under current guidance.

Anticipate Exam Scrutiny
If you are one of these banks, the worst thing you can do is overlook your next safety and soundness exam. Regulators will come in guns blazing, and you should prepare yourself accordingly.

There will be findings and perhaps even formal Matters Requiring Attention (MRAs), no matter how prepared you are.

Make Minor Findings a Goal
However, the key is to manage those findings. You want only minor infractions, such as not having enough loans with Debt-Service Coverage Ratios (DSCRs) in your core, or having to deal with model risk and model validation. Those are easy to address, while allowing examiners to show their boss that they extracted blood from you. 

You do NOT want examiners to say management doesn’t understand or use the stress test. Those type of findings are far more serious and could lead to CAMELS rating downgrades or worse.

Regulators Expect Stress Tests
Examiners expect banks with CRE concentrations to conduct portfolio stress testing, so bank management and the board can determine the correct level of capital the bank needs. 

Banks with concentrations would be smart to follow the stress testing best practices outlined by the Federal Reserve Bank of Richmond’s Jennifer Burns. Those include:

  • Running multiple scenarios to understand potential vulnerabilities
  • Making sure assumptions for changes in borrower income and collateral values are severe enough
  • Varying assumptions for what could happen in a downturn instead of just relying on what happened to a bank’s charge-off rates during the recession
  • Using the stress test results for capital and strategic planning
  • Changing the stress test scenarios to stay in sync with the bank’s current strategic plan

Burns’ article also notes that one new area of concern is owner-occupied CRE loans, which for years were considered extremely safe.

Report Finds Increased Scrutiny and Risk
The Government Accountability Office issued a report in March that warned of increased risk from CRE loan performance, though still lower than levels associated with the 2008 financial crisis. The GAO found that banks with higher CRE concentration were subject to greater supervisory scrutiny. Of 41 exams at banks with CRE concentrations, examiners documented 15 CRE-related risk management weaknesses, most often involving board and management oversight, management information systems and stress testing.

Prudential regulators acknowledge that proper concentration risk management is a supervisory concern for 2018.
The Office of the Comptroller of the Currency’s latest semi-annual risk perspective noted that “midsize and community banks continued to experience strong loan growth, particularly in CRE and other commercial lending, which grew almost 9 percent in 2017. Such growth heightens the need for strong credit risk management and effective management of concentration risk.”

A Multifaceted Approach to Managing CRE Concentration Risk


Concentration risk is drawing scrutiny from financial regulators, who are focusing on lenders’ commercial real estate (CRE) concentrations. Financial services organizations are responding to this by looking for ways to improve their CRE risk management and credit portfolio management capabilities.

Lending institutions with high CRE credit concentrations and weak risk management practices are exposed to a greater risk of loss. If regulators determine a bank lacks adequate policies, credit portfolio management, or risk management practices, they may require it to develop more robust practices to measure, monitor, and manage CRE concentration risk.

For several years, federal regulatory agencies have issued updated guidance to help banks understand the risks. In 2006, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued a guidance related to CRE concentrations followed by a statement in 2015 titled “Statement on Prudent Risk Management for Commercial Real Estate Lending.” Noting that CRE asset and lending markets are experiencing substantial growth, the 2015 guidance pointed out that “increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values” and said “many institutions’ CRE concentration levels have been rising.”

Since the 2006 guidance, additional regulatory publications related to CRE concentrations have been released. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010 began a shift, as banks with less than $10 billion in assets were exempt from more stringent requirements, according to a Crowe timeline analysis.

CRE-concentrations-small.png

Looking forward, the 2020 transition to the current expected credit loss (CECL) model for estimating credit losses will likely affect loan portfolio concentrations as well.

At the community bank level, CRE concentrations have been increasing. In 2016, CRE concentrations in smaller organizations had reached levels similar to mid-2007, according to Crowe’s analysis.

Comparison-small.png

These trends led regulators to sharpen their focus on CRE concentrations.

In one Crowe webinar earlier this year, 76 percent of the participants said their banks had some concern over how to better mitigate the risks associated with growing CRE concentrations.

In addition, 77 percent reported they received feedback within the past two years from regulators or auditors about CRE concentrations. The number of banks concerned about CRE concentration growth will likely continue to rise.

Approach to CRE Concentration Risk
The most effective methods for addressing concentration risk involve an integrated, holistic approach, which encompasses four steps:

  1. Validate CRE data. Banks must examine loan portfolio databases and verify the information is classified correctly. Coding errors and other inaccuracies often present a distorted picture of CRE concentrations.
  2. Analyze concentration risk. Banks can perform a risk analysis to expose both portfolio and loan sensitivity. Well-planned and carefully executed loan stratification can help management have a deeper understanding of their concentrations. Banks, even those not required to perform stress testing, should incorporate stress testing at the loan and portfolio levels.
  3. Mitigate CRE risk. Banks should establish policies and processes to monitor CRE loan performance and to adjust the mix of the portfolio as their risk appetite changes. Oversight of credit portfolio management is critical, as is an effective management information system.
  4. Report to management and the board. Reporting on a regular basis should include an update on mitigation efforts for any identified concentrations. Banks with higher levels of CRE loan activity might invest in dashboard reporting systems. The loan review and internal audit departments also should present additional reporting.

Loan Review and Stress Testing
Benefits can be gained by implementing a more dynamic loan review function that takes advantage of technology to identify portfolio themes and trends. The loan review function should identify if management reporting lacks granularity or other forms of risk associated with appraisal quality and underwriting practices.

Stress-testing practices can offer additional understanding of the effects economic variables might have on the portfolio. Tweaking several inputs can reveal how sensitive the bank’s models are to various scenarios. Stress testing can help facilitate discussions to better understand the loan portfolio and to identify better-performing borrowers and segments.

Other Best Practices
Other effective practices include establishing a CRE committee, creating a CRE dashboard, and adapting reporting functions to incorporate the loan pipeline. This approach can help management envision what concentrations will look like in the future if potential opportunities are funded. As CRE concentrations continue to attract regulatory scrutiny, risk management practices will become even more important to banking organizations.

Maximizing the Power of Predictive Analytics



Data analytics affects all areas of the bank, from better understanding the customer to addressing regulatory issues like stress testing. However, organizations face several barriers that prevent unlocking the power of predictive analytics. John Sjaastad, a senior director at SAS, outlines these barriers, and shares how bank management teams and boards can address these issues in this video.

  • The Importance of Predictive Analytics
  • Barriers to Using Predictive Analytics
  • Considerations for Bank Leaders

A Timely Reminder About the Importance of Capital Allocation


capital-7-6-18.pngCapital allocation may not be something bank executives and directors spend a lot of time thinking about—but they should. To fully maximize performance, a bank must both earn big profits and allocate those profits wisely.

This is why the annual stress tests administered each year by the Federal Reserve are important, even for the 5,570 banks and savings institutions that don’t qualify as systemically important financial institutions, or SIFIs, and are spared the ritual. The widely publicized release of the results is an opportunity for all banks to reassess whether their capital allocation strategies are creating value.

There are two phases to the stress tests. In the first phase, the results of which were released on June 21, the Fed projects the impact of an acute economic downturn on the participating banks’ balance sheets. This is known as the Dodd-Frank Act stress test, or DFAST. So long as a bank’s capital ratios remain above the regulatory minimum through the nine-quarter scenario, then it passes this phase, as was the case with all 35 banks that completed DFAST this year.

The second phase is the Comprehensive Capital Analysis and Review, or CCAR. In this phase, banks request permission from the Fed to increase the amount of capital they return to shareholders by way of dividends and share buybacks. So long as a bank’s proposed capital actions don’t cause its capital ratios from the first phase to dip below the regulatory minimum, and assuming no other deficiencies in the capital-planning process are uncovered by the Fed during CCAR, then the bank’s request will, presumably, be approved.

There’s reason to believe the participating banks in this year’s stress tests will seek permission to release an increasingly large wave of capital. Banks have more capital than they know what to do with right now, which causes consternation because it suppresses return on equity—a ratio of earnings over equity. And last year’s corporate income tax cut will only further fuel the buildup going forward, as profits throughout the industry are expected to climb by as much as 20 percent.

We probably won’t know exactly how much capital the SIFIs as a group plan to return over the next 12 months until, at the soonest, second-quarter earnings are reported in July. But early indications suggest a windfall from most banks. Immediately after CCAR results were released on June 28, for example, Bank of America Corp. said it will increase its dividend by 25 percent and repurchase $20.6 billion worth of stock over the next four quarters, nearly double its repurchase request over last year.

The importance of capital allocation can’t be overstated. It’s one of the most effective ways for a bank to differentiate its performance. Running a prudent and efficient operation is necessary to maximize profits, but if a bank wants to maximize total shareholder return as well, it must also allocate those profits in a way that creates shareholder value.

One way to do so is to repurchase stock at no more than a modest premium to book value. This is easier said than done, however. The only time banks tend to trade for sufficiently low multiples to book value is when the industry is experiencing a crisis, which also happens to be when banks prefer to hoard capital instead of return it to shareholders.

As a result, the best way to add value through capital allocation is generally to use excess capital to make acquisitions. And not just any ole’ acquisition will do. For an acquisition to create value, it must be accretive to a bank’s earnings per share, book value per share or both, either immediately or over a relatively brief period of time.

If you look at the two best-performing publicly traded banks since 1980, measured by total shareholder return, this is the strategy they have followed. M&T Bank, a $119 billion asset bank based in Buffalo, New York, has made 23 acquisitions since then, typically doing so at a discount to prevailing valuations. And Glacier Bancorp, a $12 billion asset bank based in Kalispell, Montana, has bolstered its returns with two dozen bank acquisitions throughout the Rocky Mountain region.

The point is that capital allocation shouldn’t be an afterthought. If you want to earn superior returns, the process of allocating capital must be approached with the same seriousness as the two other pillars of extraordinary performance—prudence and efficiency.