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Experts Know Best, But How To?

Posted on July 10, 2020 Published by

Even though I am a dinosaur by technology standards, I have been nothing short of amazed at the “how to” instruction that is available online.  From how to change out storm windows and screens in storm doors, to putting new fishing line on a spinning reel, to cooking recipes. It is all there, at the click of a mouse! While these videos have a wide applicability to many tasks, as credit risk management professionals on both the lending and credit side of the equation, we are in unparalleled times as it relates to “how to” accurately update risk ratings in the commercial loan portfolio.  The team at Enlighten Financial has been discussing this issue. We are now considering several methods to work proactively in addressing this critical responsibility.

Thankfully, the experts at Risk Management Association (RMA) stepped in to provide some very useful and timely guidance in their June 2020 bulletin entitled “Guidelines for Risk Rating Loans in the COVID-19 Period”.  What follows are some of the highlights from that bulletin, although a full reading would be very worthwhile.

Experts Know Best, But How To?

As indicated in the article, the suddenness, scale, and duration of economic shutdown caused by stay-at-home orders make the impact on credit quality difficult to accurately quantify.  The timing of the shutdown spanning the quarter end will probably result in financial statements for the quarter ended 3/31/2020 being of minimal predicative value or an honest assessment of current credit risk.

Contributing banks for the RMA article recommended using alternative information to make near-term risk rating adjustments.  Alternative information varied by industry. However, it would include: extensive use of projections, proxy data available from bank account inflows and outflows, proxies such as retail paper flow from dealerships, rent rolls that include delinquencies, and/or rent deferment and government actions which reduce rental income or limit eviction.  Other institutions added a note that the risk rating is COVID-impacted while maintaining the same pre COVID-19 risk rating grade.  This approach was limited to borrowers that were previously healthy and had significant mitigants. These include liquidity and guarantor support.  Depending on the extent an institution relied upon company-prepared projections in the risk rating decision, a tighter trigger would be set for negative performance versus plan.

What is the Expected COVID-19 Impact?

Other suggestions to focus credit risk attention included a “Triage Approach” to borrowers in their portfolio. This is based upon expected COVID-19 impact.  Three “buckets” could include:

  1. Significant impact (shutdown, production interruption)
  2. Medium impact (revenue decline, not complete shutdown)
  3. Low/Minimal/Unknown impact.

Borrower and industry knowledge by the lending team is critical to assessing a borrower’s perceived liquidity. This would also include cash flow, open/close status, balance sheet strength, etc.

RMA also addressed varying approaches to PPP loan risk ratings.  Some institutions chose not to assign a risk rating and treated the loans as free bridge equity.  Others assigned the same risk rating as the existing borrower loans.  Still others chose to downgrade to watch or criticized until more clarity was available on borrower performance. Especially if the borrower was near the lower boundary of the currently assigned rating.

The foregoing discussion provides a summary of the RMA findings. Also, the article reveals more detail that would be helpful to every institution in developing a response to this critical issue. As well as addressing the rapid changes in the current economic situation.  In particular, the Appendix to the article gives an excellent list of considerations for assessing commercial credit risk. This would be whether we are operating in a “business as usual” environment or a “COVID-19 period.”

 

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. We 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