Advice General

Are We Stressing Yet?

Posted on April 6, 2020 Published by

Last month’s blog, “Get Ready, Get Set, Go,” emphasized that while we have experienced an unprecedented period of economic prosperity and growth, we need to prepare now for the inevitable downturn. When that was written, I had no idea how prophetic that would be and how relevant it would be for all financial institutions as we attempt to navigate the current health and economic crisis. Are We Stressing Yet?

In the closing paragraphs of that blog, we posed several serious questions for which we now have a much better appreciation. The first question was: How fast can the current economic growth cycle stop? We have learned that it can be pretty darn fast! And there has been very little time to adjust. Significant questions relative to the virus itself, fueled by hair-on-fire media coverage and broad government actions, have brought many industries to a near instantaneous halt. There goes the luxury of “wait and see”!

Our November 2017 blog – “The Importance of Repayment Sources” – is still highly relevant, as it discussed the necessity of fully and critically understanding loan repayment sources. What may be a bit different in the current economic environment is the need to take a much more critical look at those secondary and tertiary sources of repayment. How solid are those sources, particularly in a depressed general economic environment? If an entire market segment or industry collapses, what is the value of the collateral when there is a large inventory to work through? (Think about 2008/2009 housing collapse.)

A March 20, 2020, “Bank Strategy Briefing” prepared by Godfrey and Kahn discussed eight potential actions financial institutions should be considering to identify and minimize negative impacts from the current situation.

1. Stress Testing

Conduct a fresh review of loan concentrations either internally or with the help of a third party and develop a meaningful stress test. Particularly hard-hit industries currently include travel, lodging, restaurants and bars, entertainment, health and fitness, beauty and barbers, medical (dental, eye, elective procedures and tests), multi-family residential, etc. What is the impact of another 30 to 60 days under the current situation?

2. Increase Frequency & Scope of 3rd Party Loan Reviews

These reviews can help identify specific credit quality issues. The institutions can also target higher risk industries and increase the frequency of financial reporting and internal reviews. Pay close attention to any delinquent reporting and take prompt action on covenant defaults

3. Review Significant Loan Relationships

Review all significant loan relationships and identify both high and low risk borrowers. Develop a plan for those borrowers your institution would be unlikely to accommodate in a workout or other restructure. Make sure that you review current regulatory guidelines and your own loan policy on Troubled Debt Restructures (TDR’s).

4. Staffing

Review staffing levels in your credit department including those individuals tasked with handling work-out relationships and restructures. In addition, review relationships with third parties that you work with including lawyers, property managers, equipment appraisers, etc.

5. Asset Liability Management

Reassess your institution’s interest rate risk under different scenarios including a long-term Federal Reserve (near) zero interest rate environment.

6. Capital Plan

While not many of our readers are paying dividends or involved in stock buybacks, consideration should be given to when these would be discontinued to preserve capital, as well as other source of capital, in the event of material loan provision requirements or credit losses. Is there a source for subordinated debt or is a private placement possible? How would you prioritize assets for disposition if needed to shrink the balance sheet? Having lived through exiting relationships to shrink the balance sheet, I can vouch for how painful the process can be.

7. Liquidity Stress Test

Identify contingent liquidity sources such as brokered deposits, FHLB advances, sale of loans or securities, etc.

8. Communications

Develop a communications plan for both shareholders and customers. Be ready to reassure them of the safety of their deposits and steps being taken to address the affects of the current downturn.

The central theme here is one of planning and communication. We encourage all financial institutions to talk about their portfolios and borrowers as a team, including lending staff and credit partners, and then game plan a strategy to deal with each of them.

Consider not only the issues of the individual borrower but also less direct impacts. As an example, we would be quick to identify a hotel or restaurant as an “at risk” borrower. However, each of these industries employ hundreds of workers. These workers pay rent and/or mortgage payments if they have a job.

Accordingly, look at borrowers who own apartment buildings. How is the mortgage and home equity portfolio performing? What about auto, boat and RV loans? If people are not working, expect to see credit card balances increase along with delinquencies.

Be proactive in reaching out to your borrowers. Don’t wait until you have payment or covenant defaults. In your internal discussions, consider next steps if 30 to 60 days from now this has not passed. And finally, be prepared to adjust risk ratings to reflect the current reality and near-term expectations.

Many of us have been around long enough to have seen similar economic conditions in the past. The key is to maintain communication both internally and externally and be proactive in your planning. So… Are We Stressing Yet? Above all, do not panic even though the media demands it.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133

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“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection