To Downgrade or Not To Downgrade

I am pretty sure William Shakespeare did not have the challenge of managing and assessing business credit risk during a pandemic when he penned Hamlet. “To be (downgraded) or not to be (downgraded), that is the question.” However, the dilemma and challenges may be similar (can you say slings and arrows?).

Commercial lending institutions attempt to navigate the turbulent waters of a pandemic with their borrowers. All of this is against a backdrop of uncertainty and regulatory oversight. And management will face many new and unique challenges.

To Downgrade or Not To Downgrade

Federal regulatory agencies for financial institutions (Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and the National Credit Union Administration) issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions” in June 2020. While providing some insight as to how examinations will be handled in the near term, there were also some issues that were less clear. Examiners were urged to exercise flexibility in their supervisory response. This stated “…examiners will continue to assess institutions in accordance with existing agency policies and procedures” including “downgrade on institutions composite or component ratings when conditions have deteriorated.”

References are made in the Examiner Guidance that encourage the examiner to do the following. They should give “appropriate recognition to the extent to which weaknesses are caused by external economic problems related to the pandemic versus risk management and governance issues.” Examiners are also to consider “the extent to which institutions have taken actions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of the pandemic.” The Guidance indicates that examiners will not criticize institutions for working with borrowers as part of a risk mitigation strategy intended to improve existing loans.

So, what does this mean?

Management at several financial institutions with whom we have had conversations have worked on interpreting this language. They see it to mean that examiners will be more flexible in the assessment of credit modifications made for borrowers whose businesses have been adversely impacted by the pandemic. This may be true as it relates to their review of credit structure modifications that are approved for otherwise satisfactory borrowers. But it is unlikely that this should be expanded to the point of ignoring necessary adjustments to a risk rating. Even though performance issues are related to the pandemic.

In fact, it is entirely reasonable to think that examiners will focus on how an institution’s management responds to an assessment of credit risk and asset quality given the prevailing economic conditions. This means each institution will have some latitude as it relates to prudent credit modifications. However it will be incumbent on the institution to maintain appropriate risk ratings (including accrual status) on all affected loans.

Institution Standards

Each institution should apply appropriate credit classification and charge-off standards in a timely manner. This would be when information becomes available that a loan will not be repaid under reasonable terms. It may include downgrading to watch status credits that have enjoyed a very favorable rating prior to any business disruption caused by the pandemic. Does an institution’s credit portfolio includes bars, restaurants, hotels/motels, some medical practices, etc.? They do not need to wait (in fact, you should not wait) to see year-end financials to make risk rating adjustments. A move to watch rating may be warranted based upon reasonably available interim information. That would be while acknowledging that supporting documentation may be limited and cash flow projections highly uncertain.

Our July 2020 blog discussed a recent RMA publication on risk rating and analysis. This was using less traditional and/or alternative methods to stay up to date with credit risk ratings. Some of these methods included analysis of inflows and outflows from deposit accounts. Also, use of projections, and proxy data for a particular borrower.

What is the takeaway?

The obvious challenge is how management of financial institutions respond to these unprecedented challenges. Professional lenders and credit teams will need to look to less traditional and alternative sources to make informed decisions. Regulators have signaled a willingness to be flexible in their review of prudent management actions taken to restructure loan terms and conditions to increase the probability of being repaid.

However, each institution must be clear-headed. This would be in assessing the changing credit risk of its individual borrowers and overall portfolio in a timely manner. We must not wear blinders. We certainly must not be afraid to downgrade credits consistent with credit risk rating standards. Undoubtedly this will result in an increase in the number of “watch” or even “criticized” credits. However, it is important to protect the integrity of the risk rating system and, more importantly, focus credit resources to the highest needs.

Richard Rudolph is Senior Consultant at Enlighten Financial. Enlighten is a specialized consulting firm focusing 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 also 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.