New Crisis = New Safety and Soundness Standards
Examination Expectations in the New Normal, Part I
This blog was co-authored with my colleague, Erica Crain, National Leader for Credit Risk Services at CLA.
As we move into the fifth month of the COVID-19 pandemic, economic fallout persists across the country. In many areas, certain businesses remain closed and others are struggling to find a new normal. Financial institutions continue to operate in the eye of the storm. Since March, financial institutions have worked tirelessly to modify borrower loans, rotate staff for safe operations, accelerate or improve digital access to customers, and for many, fund Paycheck Protection Program (PPP) loans at a never before seen pace. Coupled with these challenges have been continual updates, changes and mandates from our government and regulatory bodies.
On June 23, 2020, the agencies jointly issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions” (the June 2020 interagency guidance). With the constant influx of information to our email inboxes, many may have missed this communication that provides crucial information for financial institutions as they prepare for their upcoming safety and soundness examinations. While the agencies will continue to evaluate financial institutions under the appropriate rating system, such as CAMELS, examiners will also assess management’s responsiveness to the COVID-19 impact and distinctive stresses resulting from the pandemic.
Financial institution regulators have consistently stressed the need for flexibility during this unique time while still operating in a safe and sound manner. This message continues in the June 2020 interagency guidance. However, three overarching themes in the document that all financial institutions should consider and prepare for are (1) documentation throughout the pandemic, (2) appropriate risk assessment & management, and (3) supervisory actions. Today we are sharing the first part in a series highlighting key takeaways from the June 2020 interagency guidance to assist in preparing financial institutions for what comes next during this transition from normal to new normal.
Asset Quality
While the June 2020 interagency guidance is generally brief at eleven pages, it becomes evident Asset Quality, not surprisingly, will be a major area of focus for all examiners. Financial institution management teams should be very aware of the rising credit risk environment as their time has been consumed working with borrowers affected by COVID-19 in recent months. On top of being reactionary to the needs of customers, management’s ability to assess and document the risk in its loan portfolio will be crucial in conversations with examiners. Additionally, the expectation for financial institution management to be responsive, timely, and methodical in developing policies, procedures, and programs to help customers, borrowers, and communities during all periods of change remains.
The COVID-19 pandemic may present more obvious heightened risks, such as unemployment, but deciphering what issues were caused by external economic problems versus those arising from risk management and governance issues will be at the forefront of the examination. To do so, it is imperative that management strengthens objectivity when evaluating credit risk. It is no coincidence that just one month prior to the June 2020 interagency guidance, the federal regulators issued the “Interagency Guidance on Credit Risk Review Systems” (the May 2020 interagency guidance) with a repetitive focus on objectivity either through internal independent personnel or qualified external third parties for assessing credit risk. Credit risk review systems are not a new concept or requirement, but rather a renewed emphasis during this pandemic.
Credit Classification
Undeniably, credit risk is rising as a result of the COVID-19 impact on communities, businesses, and consumers locally and globally. With such a dramatic change in the economic environment, what does this mean for a financial institution and how they define credit risk? Simply put, the June 2020 interagency guidance indicates that financial institutions should review their current credit classification definitions and ensure they align with management policies and practices. It is not necessarily a matter of redefining your risk rating categories but rather re-evaluating your credits to determine what credit risk rating most applies given recent changes. The risk to a financial institution may have changed with many, if not all, borrowers therefore it is essential to ensure consistent application of credit classifications. In all times, having strong controls around policy and practice strengthens examiner opinions of asset quality and management’s risk management practices.
Furthermore, senior management should work closely with lending teams to identify those loans requiring additional attention during this time. For example, lenders should be actively requesting updated financial information from borrowers who are internally identified as watch or special mention or from those borrowers who operate in industries more directly impacted by the effects of COVID-19.
Credit Risk Review
The May 2020 interagency guidance emphasized the fundamental concept of credit risk review which echoes the significance of the process. An objective assessment of credit risk at this time is critical and not something a financial institution wants to glean during a regulatory examination. While temporary delays in an established loan review schedule are understandable, focus should be given to the word “temporary”. Examiners will expect documented support for a delayed credit review and an established plan for completing the review in a “reasonable amount of time”. So, what is reasonable? It may be reasonable to delay a credit risk review to allow lending staff time to gather financial information from borrowers affected by COVID-19. However, “reasonable” would not include a more-than-temporary delay in evaluating a credit to avoid a potential risk rating downgrade. As the regulators put forth in the May 2020 interagency guidance, we would remind financial institutions that the credit risk review function is a vital component of a sound credit risk management program. As such, any delays in the credit risk review schedule should be short term in nature.
New Loans
The June 2020 interagency guidance clearly acknowledges that eased underwriting standards during or after the pandemic are likely and may be legitimate to address the needs of a financial institution’s customer base. While the underwriting standards may have eased, the documentation and support for such decisions should not. Given the rapid change in the economy and the resulting impact to borrowers, lenders will be forced to place some reliance on pro forma financial information from borrowers to make underwriting decisions going forward. Factors to consider include, but are not limited to: what does the “new normal” look like for this borrower? Is the business/borrower able to pivot to an adjusted sales model or platform? Although these projections may not be precise as the roller coaster of change wreaks havoc on borrowers, the financial institution can more readily assess the likelihood of adaptability and gain a better sense of viability for the business and corresponding credit. Weak and loose underwriting standards can expose a financial institution to higher loss rates, negative capital impacts and the need to reassign or hire personnel to manage a larger number of problem loans. Therefore, financial institutions should review their underwriting standards and the new loans they have approved since the pandemic began. Any changes to underwriting standards, whether strengthened or loosened, should be documented in the appropriate policies and supported by additional procedures, controls or management oversight.
How can we help?
We will continue to explore the June 2020 interagency guidance over the next few weeks as we continue to go deeper on Asset Quality and the other supervisory risk categories. CLA is here to know you and help you, and we can help you prepare for your upcoming safety and soundness examination by being an objective voice in assessing your credit risk exposure and designing best practices for the impact of COVID-19. Please contact your CLA representative anytime for more information. We are here to help you navigate through this.
Susan is a CPA with more than 20 years of combined experience in public accounting and the financial institution industry, including experience with Fortune 500 financial services companies. Susan serves as the managing principal of CLA’s financial services group. Her responsibilities include providing engagement oversight in the areas of assurance and internal audit. In addition, Susan provides board advisory and management consulting services in the areas of strategic planning and mergers and acquisitions. Susan has been involved in multiple mergers and acquisitions of sizes ranging from $150 million to $500 billion with engagement at all stages of the process.
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