New Crisis = New Safety and Soundness Standards, Part 2

• August 4, 2020
• Susan Sabo

Examination Expectations in the New Normal, Part 2

This blog was co-authored with my colleague, Erica Crain, National Leader for Credit Risk Services at CLA.

Last week we introduced this blog series highlighting key takeaways from the “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions” (the June 2020 interagency guidance) to assist in preparing financial institutions for what comes next during this transition from normal to new normal. Additionally, last night, the FFIEC issued a “Joint Statement on Additional Loan Accommodations Related to COVID-19” which stresses the above aspects of credit modifications and puts additional emphasis on the management information systems and reporting, remaining engaged with your borrowers and strengthening internal control systems. We incorporate key aspects of that statement in this post.

We began to evaluate the asset quality section of the June 2020 interagency guidance. As expected, asset quality, including management’s efforts to document and assess credit risk, will be a major focus for all regulatory examinations.  More specifically, credit classification, credit risk review and new loan underwriting in the midst of this pandemic along with an eye for the long-term impact to loan portfolios are necessary.

Asset Quality…continued

As we continue to explore the June 2020 interagency guidance, we remain focused on the three overarching themes that all financial institutions should consider and prepare for: (1) documentation throughout the pandemic, (2) appropriate risk assessment & management, and (3) supervisory actions. Today we will highlight the remaining key takeaways in asset quality regarding Paycheck Protection Program loans, credit modifications, and non-accrual standards addressed in the asset quality section of the June 2020 interagency guidance as well as points of view on the FFIEC statement mentioned above.

Paycheck Protection Program (PPP)

The PPP has provided a lifeline to many businesses across the country and community financial institutions were instrumental in that process. Financial institutions are now facing a longer than anticipated forgiveness period for borrowers which has these loans staying on their balance sheets longer. Financial institutions should assess the impact to their balance sheets for participation in the PPP and consider, where appropriate, using the PPPLF to negate the impact to a financial institution’s leverage ratio. The Federal Reserve Bank has recently extended the PPPLF from September 30, 2020 to December 31, 2020. With a longer timeframe for borrowers to request forgiveness, extending this facility gives financial institutions more opportunity to use the PPPLF.

Additionally, the June 2020 interagency guidance states that regulatory agencies view the PPP as an “important program to help institutions continue to lend to customers in need”.  However, very important words are used to finish that thought in the guidance which is “so long as the institution follows SBA’s program guidelines.”  This begs the question of who in the financial institution is responsible for staying up-to-date and monitoring compliance with the SBA’s PPP guidelines?  Loans that are made in accordance with the SBA program guidelines will not be subject to criticism therefore, program oversight and loan compliance is critical. 

Overall, financial institutions would be well served to have an analysis of their PPP loan portfolios including number of loans, amounts outstanding, estimated forgiveness and the fees receivable. As financial institutions anticipate the pending forgiveness process, providing analysis on the forgiveness rates and trend analysis to examiners will support their assessment of a financial institution’s participation. Although these loans are 100% guaranteed by the SBA and this guarantee should be considered in evaluating the allowance for loan losses by the financial institution, the risk of loss is not considered to be zero. Management should consider a small qualitative factor for this portion of the loan portfolio. We explored the accounting for PPP loans in an earlier blog.

Credit Modifications and Nonaccrual Loans

In early March, even before the regulators could issue a statement, many financial institutions were working diligently to assist their borrowers affected by COVID-19. Some relied on skip-a-pay programs, while others provided an immediate three-month payment holiday. Regulators stressed then, and continue to stress, their support for financial institutions working prudently and in a safe and sound manner with borrowers through the pandemic. As such, what does “prudent” look like in your financial institution?  Has management established an approach to making loan modifications on a shorter term basis versus longer periods?  What, if any, documentation is required in considering requested modifications?  Will management offer credit modifications or are adjustments only available upon request?  These are a few considerations to consider when documenting a loan modification strategy to work with borrowers impacted by COVID-19. 

The FFIEC goes on to further explore the need for additional accommodations for certain borrowers. There is a general expectation that financial institutions are actively engaging with these borrowers and obtaining current and projected financial information to assess the viability of additional accommodations. Now more than ever, a financial institution’s expertise in problem loan management will come into view. While loan modifications provide assistance and relief to borrowers affected by COVID-19, it is anticipated that the level of problem loans will rise as the pandemic persists.  Therefore, it is necessary for financial institutions to review and update problem loan management policies and procedures. For some financial institutions, problem loans have been minimal and never amounted to a level requiring specific policies to be formalized.  Alternatively, it may have been several years since a financial institution has had to foreclose on property or engage in active collection efforts.  As such, management teams should be dusting off old policies to test relevancy for this period of time and/or devise policies and strategies for handling what could become problem credits. 

Regarding troubled debt restructurings (TDRs), the Coronavirus Aid, Relief, and Economic Security (CARES) Act went so far as to temporarily suspend certain requirements under GAAP.  The regulators followed up with clarification but generally remain in support of this measure (see table below). By not requiring financial institutions to classify these loans as TDRs there is less operational burden and less pressure on risk-based capital. The regulators will assess management’s risk grading of these loans along with accrual status decisions.

	Section 4013 of the CARES Act	Regulatory Guidance
Modifications terms allowed (safety and soundness principles still apply)	Applies only to the following modifications: forbearance agreements, interest rate modifications, repayment plans or other arrangements that defer/delay principal & interest payments.	Applies only to the following modifications made to due to the COVID-19 pandemic: short-term modifications, such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant under ASC 310-40, government-mandated programs.
Evaluation date of whether borrower was current (< 30 days past due)	May apply to borrowers not more than 30 days past due at December 31, 2019.	Applies on the date which an FI implemented a modification program for borrowers less than 30 days past due.
Time period of when the modification occurs	Applicable period began on March 1, 2020 and ends on the earlier of December 31, 2020, or 60 days after the termination date of the presidential national emergency.	Applicable period not specified but is expected to be temporary in nature.
Duration of non-TDR designation	Remaining life of the loan. Subsequent modifications must be evaluated if they are not also eligible under the criteria.	Remaining life of the loan. Subsequent modifications must be re-evaluated.

A consistent message from the regulators is that most of these short-term modifications should not be reported as nonaccrual. However, management should be actively monitoring these loans and considering new information as it becomes available. Tracking loans that have been modified as a result of the COVID-19 impact is essential and documenting the number of loan modifications granted is also a valuable monitoring tool for management.  Nonaccrual and charge-off policies should be reviewed and practiced consistently. Management should prepare for these questions and ensure (a) there is regular communication with lending teams, (b) loans modified during this time period are easily identified, and (c) notes or other documentation are provided in each file.

Throughout this process, and further stressed by the FFIEC, financial institutions should be promoting clear and consistent communication to borrowers and adhering to applicable laws and regulations, including fair lending laws. Now more than ever, a management team’s ability to assess, document, and account for these risks and lead objectively is crucial.

Allowance for Loan and Lease Losses (ALLL) or Allowance for Credit Losses (ACL)

The review of the estimation of the ALLL (or ACL, for those who have adopted CECL) is routinely included as part of a regulatory risk management examination. Management’s application of regulatory guidance, it’s understanding of the loan portfolio and inherent risks, and use of qualitative factors are often reviewed in detail as the ALLL represents one of the larger estimates on a financial institution’s balance sheet.  At a time when losses are expected to increase, the adequacy of the ALLL account will be closely reviewed.  Leading up to this pandemic, financial institutions operated in a long period of recovery and expansion. Credit quality remained strong and loss rates were at historical lows.

There are two major points of consideration when assessing the ALLL in this period of time. The extent of a financial institution’s loan modifications, along with the potential for additional accommodations, should be analyzed and reviewed through the lens of the ALLL process. Financial institutions should consider the various loan types in their portfolios that experienced the higher levels of loan modifications and may want to consider segmenting these loans or possibly evaluating certain loans on an individual basis.

Because of these factors, the use of the qualitative factors available in the ALLL will inevitably take on more focus. The regulators have indicated they expect to see some level of additional ALLL as a result of the pandemic. In response, management is encouraged to review its qualitative factors and consider how the pandemic is introducing additional risk at least quarterly. One of the main reasons these factors exist are for times of uncertainty and with almost overnight changes occurring since the pandemic hit, uncertainty is ongoing reality.  There are several approaches for financial institutions to consider with their qualitative factors such as incorporating economic data on unemployment, using ranges that can be adjusted as the pandemic evolves and using the “other” factor to specifically address the pandemic. Above all, documentation of management’s assessment of the ALLL will be scrutinized.

 How can we help?

Tune in next week for the next part of our series where we begin to explore some of the other aspects of supervisory risk. 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.

Tags: Asset Quality, COVID-19, Safety & Soundness, Auditing/Accounting, COVID-19 accounting and financial statement guidance, COVID-19 regulatory and tax updates, Financial Services General | Comments Off on New Crisis = New Safety and Soundness Standards, Part 2