New Crisis = New Safety and Soundness Standards, Part 3

• August 11, 2020
• Susan Sabo

Examination Expectations in the New Normal, Part 3

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

Over the past two weeks, we have highlighted 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. Our focus has been on Asset Quality, as the majority of the guidance centers on review procedures to monitor credit risk as it rises from the COVID-19 impact.  However, it is time to pivot to the other areas for evaluation that are also being impacted by the pandemic.  In this next blog post, we will examine Earnings, Capital, Liquidity and Sensitivity to Market Risk. The final piece of this series, expected next week, will explore the evaluation of Management. We will also be holding a live webinar on Tuesday September 1, 2020 at 2pmCST to explore this four part blog series. More details can be found at the end of this post.

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.

Earnings

From a regulator’s perspective, earnings of a financial institution are essential to absorb losses and augment capital.  While many financial institutions have experienced several years of strong earnings, the guidance clearly communicates a distinct possibility for reduced core earnings caused by the pandemic.   If there were ever a year for recast budgets, this is it.  A topic of conversation for each financial institution management team should be what may or may not happen this year because of COVID-19 and how will that detract from or enhance your earnings potential?  During this period of uncertainty, the use of periodic projections and ongoing documentation will be critical. Management teams should consider assessing and evaluating their financial institution’s earnings through several points of view:

• Impact of asset quality – the immediate thought goes to the provision for loan losses but management should also be considering potential impacts to interest income, lost opportunities as some businesses contract and consumers are more debt averse, additional costs such as third party services (like loan review or appraisals), new personnel with problem asset management experience, and legal costs.
• Operational expenses – the almost overnight shift to remote operations may have caused an increase in several costs for some financial institutions such as additional equipment or office supplies and technology investment.
• Trend analysis – if not already in place, management should be comparing current earnings to the same period in the prior year and documenting any unforeseen impacts to earnings. It would be prudent for management teams to comprise a list of earnings-related triggers they could enact to improve revenue or reduce expenses. Including this analysis in senior management and board discussions ensures everyone is appropriately focused on the risks and opportunities facing the financial institution.

 Capital

One of the more critical pillars of a sound financial institution is a strong and executable capital plan. The purpose of a financial institution’s capital plan is always important but increasingly so now as losses are anticipated to rise and public confidence is shy.  Additionally, dramatic balance sheet shifts have occurred over the last several months.  Loan growth due to the Paycheck Protection Program (PPP), deposit growth resulting from a flight to  safety and the inflows from government stimulus have happened quickly and in many situations without an opportunity to fully assess the capital impact. For years, capital has largely been a non-issue during an extended period of recovery and expansion. However, in this current pandemic and period of economic uncertainty management should take time to review the current capital plan and objectively challenge the levers and limits within the policy. Specifically, the guidance encourages financial institutions to use their capital buffers to promote lending activities in a safe and sound manner.  Management must assess the overall risk profile of the financial institution and what forecasted risks are on the horizon.  In response, capital plans should include strategies to address such risk while maintaining an adequate capital position.  For example, if credit concentrations in largely affected industries impacted by COVID-19 exist and borrowers continue to suffer because of reduced or eliminated operations, management should assess the impact on a go- forward basis and plan accordingly for capital purposes.  Finally, regulatory capital ratios will continue to be evaluated for adequacy.  Although the call report establishes regulatory minimums, management should ensure internal limits are appropriate and ready to weather immediate shifts in the balance sheet and potential asset quality issues.

Liquidity

For the past several years, most financial institutions have been liquid and lessons learned from the last recession linger with less dependency on third parties for funding.  Also, as experienced during the last recession, financial institutions are currently seeing an inflow of funds from consumer savings as the future remains unknown.  The guidance readily admits there remains significant uncertainty regarding liquidity profiles for financial institutions as a result of the COVID-19 impact.  Yet, amongst the uncertainty, expectations remain for management teams to employ well thought out strategies for utilizing any influx of liquid funds.  Conversely, a financial institution may experience significant outflows placing greater emphasis on what the overall funding strategy and contingency plans. Some funding sources, such as secured lines of credit with a third party, like the Federal Home Loan Bank, may be temporarily modified.  As such, it is critical that management stay informed of any changes that may occur to these funding sources and address this in the overall liquidity plan.  Like the capital plan, management should take time to review its current liquidity policy and objectively challenge the adequacy given the current operating environment. 

Sensitivity to Market Risk

Last but not least, an evaluation of sensitivity to market risk (primarily in the form of interest rate risk), is imperative in assessing the impact to a financial institution’s earnings or capital.  As previously mentioned, effective management over earnings and capital at this time is critical to navigating uncertainty caused by COVID-19. Therefore, it goes hand-in-hand for management teams to reassess the financial institution’s asset liability management (ALM) policies and models. Management teams should identify those changes to their interest rate risk profile that are temporary and those that will have longer-term effects.  For many institutions, ALM models may have been means to an end to fulfill a regulatory requirement but they can be useful tools in identifying and addressing potential balance sheet issues. The assumptions and data in these models should be reviewed and adjusted to consider the impact of loan modifications and payment timing as well as deposit growth experienced in response to the pandemic.  Additionally, stress testing procedures take center stage during a crisis.  This pandemic presents opportunities for management teams to identify industries at risk in their loan portfolios and perform various stress scenarios including partial and complete loss, fluctuations in unemployment, and the impact of possible future shutdowns.  An independent review of this function, much like credit review, is recommended to ensure the integrity, accuracy, and reasonableness.   

How can we help?

Tune in next week for the final part of our series where we explore Management’s role. 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 in these core areas in response to COVID-19. We encourage you to join us for our live webinar on Tuesday September 1, 2020 at 2pmCST where we will explore this blog series in more detail. You can use this link to register. Please contact your CLA representative anytime for more information.

Tags: 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 3