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What Shall I Do… Or Not Do?

Posted on March 14, 2023 Published by

In last month’s blog we considered the question of whether or not the U.S. was in a recession. As part of the question, we looked at a number of economic factors that the National Bureau of Economic Research (NBER), which is generally recognized as the organization that would make the determination of recession, considers in their analysis of the economy.

Experts Agree

In the end, experts of all backgrounds and stripes will certainly debate the topic from a technical standpoint. However, a couple of points are clear. First, a “formal” declaration of whether we are in a recession or not will only come after months have gone by and we have the benefit of hindsight. Second, whether we meet a technical definition or not, consumers and businesses of the “real world” are facing serious economic headwinds. This will have an immediate and potentially lengthy impact on community banks and credit unions.

There is no debate that we are in an historic inflationary period. While the impacts of inflation are not uniform across all products and services, it is quite clear that costs are increasing. This puts pressure on the bottom line for all consumers and businesses. To stem rising inflation, the Fed has increased interest rates that will further reduce cash flow. It will also result in lower loan demand.

What Shall I Do… Or Not Do?

This has already been seen in declining mortgage and loan demand from consumers for major purchases including auto and home sales. The Purchasing Managers Index dropped for the third consecutive time to the lowest level since May 2020, at the height of the pandemic. The impacts of the economic decline are not felt equally by all consumers and businesses, and therefore each lending institution. So what are practical ”do’s” and “don’ts” for managing through this period?

DO

The most important step to working through difficult economic conditions is to focus on good “blocking and tackling”. On the loan origination side, detailed business projections at either a monthly or quarterly basis are required. Do use these projections to develop performance metrics for your borrower in terms of sales, profit, cash flow, and debt levels. This can be incorporated into covenants and/or borrowing base parameters.

Do pay attention to red flags. Be alert to reporting delays on covenant compliance and financial statements. Pay attention to changes in delinquency behavior at the borrower level. One delinquency isn’t a trend, but it can be the start of one. Most importantly, respond to changes; don’t “wait and see” for the next shoe to drop. Communicate with your borrower and be prepared to make loan structure changes in response to changing conditions. It is much easier to make accommodations at the beginning of financial difficulties rather than after too much time has passed. Options are fewer at this point.

Do be alert to any patterns in problem loans such as industries, collateral type, risk ratings, etc. Any systemic or industry correlations may be a good reason to invite Enlighten Financial to conduct a targeted loan review of the portfolio or assist with specific underwriting concerns.

DON’T

Not all geographic areas have the same industry concentrations. Nor are they affected equally by macro-economic conditions. Therefore, each lending institution will see its portfolio impacted differently. As loan demand declines in a particular region, it is tempting for the lending institution to shore-up its loan growth by one or more of the following “don’ts.”

Don’t begin chasing opportunities outside your footprint. It can be particularly problematic to go outside of your region or state. It is difficult to underwrite economic issues of a new area. It’s also hard to conduct a thorough character analysis of the borrower. No need to be the “greater fool” because “you ain’t from around here.”

Don’t begin lending to industries that you are unfamiliar with and/or do not have expertise. We usually find out the hard way that what we don’t know can hurt us.

Don’t relax credit standards to increase volume. Letting greed overcome fear in a weak economic environment can be costly.

Finally, don’t attempt to increase volume by buying participations in either of the following

  1. From institutions you have not worked with in the past
  2. In geographies or industries you don’t know (see above!).

You may find yourself with a small piece of a big deal with people you don’t know and who don’t share your credit culture. Because you will not control the management of the credit via voting rights, you will truly find yourself “along for the ride” which may be quite bumpy and with no way out.

A New Economic Reality

While we can debate whether the economy is in a recession or not, there is no debate that we are entering into a new economic reality. Not long ago, the rising tide was raising all boats. The tide is now receding. How each financial institution responds to this “new normal” will challenge all lending and credit professionals to be the best they can be. And we at Enlighten Financial are ready, willing, and able to help.

 

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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— 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