Opening the Post-COVID Bank Books

By John Hintze

Early in the pandemic there was a herculean push by the federal government to provide relief to consumers and businesses, driven by legislation that facilitated access to new loans and modifications of existing debt. The burden to deliver that relief fell to banks, whose employees had unexpectedly found themselves working remotely, often in challenging circumstances for analyzing and documenting transactions and with babies crying and pets barking in the background.

Consequently, lenders and their regulators generally acknowledge there are likely to have been compliance gaps.

“The rules were changing quickly and had to become operationalized for a significant number of people who all of a sudden were working from home,” says David King, managing director in FTI Consulting’s financial services practice. “It wouldn’t be surprising for examiners to find things.”

As the economic recovery oscillates between vaccine optimism and new COVID-19 outbreaks, what will examiners be on the lookout for in banks’ portfolios? How will they react to the less-than-perfect transactions lenders may have completed, and how can bankers proactively address the potential problems?

Digging into details

One area regulators are almost certain to consider—particularly under the incoming Biden administration—is fair lending laws, which they pointed to in an April 7 interagency statement, one of several since late March providing guidance. “When working with borrowers, banks should adhere to consumer protection requirements, including fair lending laws, to provide the opportunity for all borrowers and communities to benefit from these arrangements,” the statement said.

To do so, banks must understand each customer’s circumstances and ensure that benefits, such as extending credit, increasing credit limits and otherwise modifying loans, are provided consistently.

“State attorneys general and federal agencies will be looking into now how one borrower received relief and another did not,” says Peter Dugas, executive director for the center of regulatory intelligence at Capco, a consultancy focusing on financial services.

Changes in state and federal laws and regulations as the pandemic unfolded may add a wrinkle. For example, in seeking to provide urgent relief a bank operating in the tri-state area may have applied requirements under New York State law to all customers, but those requirements may be interpreted differently by regulators in nearby states.

“Like any crisis, regulators and examiners will look back on activities and may forget or not have the benefit of understanding the situation and the immediate need at that time for a bank to respond in a certain way,” Dugas says.

Another potential issue involves troubled debt restructurings. The CARES Act allows banks to avoid categorizing loan modifications as TDRs until the end of 2020 if they are related to Covid-19 and meet other conditions. However, banks are being advised—despite their burdened staff—not to interpret the CARES Act’s transactional relief too broadly, says Mike Gullette, SVP for tax and accounting policy at ABA.

He adds that banks must maintain sufficient documentation to justify their actions, and while Congress and regulators provided a hiatus in terms of TDR accounting requirements, banks must still analyze and document credit risk. When that period expires, banks will have to recognize whether further forbearance deserves TDR status.

“In the meantime, examiners have wanted to see a solid risk-rating analysis with accompanying documentation, whether it was a TDR or not,” Gullette said.

Documentation is key

In fact, documentation is the key to resolving most examination-related issues. The regulators have conducted exams fairly regularly, if remotely, since early on in the pandemic. They have stepped cautiously, understanding the challenges many banks have faced. However, problems are likely to arise if examiners conclude bank management is unprepared, indicated most clearly by the bank inadequately documenting activities and decisions.

“When the bank doesn’t have a handle on this situation, regulators may respond differently to it than for one that has addressed the situation well and is working within the guardrails,” says Giulio Camerini, principal and head of the loan review practice at Crowe, a public accounting and consulting firm that ABA endorses for governance, compliance and risk management consulting.

In the first three months that banks provided deferrals and other loan modifications, Camerini explains, lenders should have tracked basic details, such as dollar amounts and borrower types. The second round of relief, which most banks have provided to a much smaller percentage of customers, requires “meatier” documentation and tracking, including by industry sector and geography.

“Trends start to emerge by the second round of deferrals, and it becomes important for banks to show they have narrowed their focus to clients who have been most impacted and they expect will need some other form of assistance after the second round burns off,” Camerini says, adding that communication with examiners and data readiness before exams can smooth the process.

Perhaps the most important element is how banks have handled their credit risk. Sharon Whitaker, VP for commercial real estate finance policy at ABA, says that the June 23 interagency guidance encourages banks to aid borrowers but also to grade and account for loans properly and ascertain portfolio risks. And while banks have been given a reprieve on TDR requirements, whether loans fit that category now is an “almost irrelevant” question, since banks must still review loans for each credit-quality element, Whitaker says. She adds that a bank may have downgraded credits in highly affected sectors such as hospitality, and after six months of forbearance, recovery may be underway for some but take much longer for others.

“Properly managing and grading those credits and the various actions, and documenting where that risk is within the bank’s portfolio is critical,” Whitaker explains.

The exam experience

Tom Broughton, president and CEO of Birmingham, Alabama-headquartered ServisFirst Bank, says that the lender’s recent examination was unchanged from previous years, with examiners emphasizing that banks facing credit losses must take them.

“If you have a problem, you need to go ahead and recognize it,” Broughton said. “A forbearance agreement is not going to stop a downgrade, and you need to downgrade the loan as you always have.”

For banks in parts of the country where lockdowns were more severe and more mistakes may have been made, there’s work to be done. “It’s important to take the right steps to identify [problems], apply the appropriate risk-management methodologies, and if necessary address and remediate them as needed,” King says. “We have clients that are leveraging either their own compliance groups or internal audit functions to go back and look at what they did previously” and compare that to guidelines regulators issued earlier this year.

Lenders short on the human resources are also turning to technology to apply metrics quickly to identify transactional issues, especially for consumer loans, such as charging fees that should have been waived under the CARES Act. “So we can just pull a report or look at some data analytics to see if there are certain fees charged on accounts in forbearance,” King says.

Providing examiners with such information is becoming increasingly important. King says many consumers entered forbearance during the first three months of the pandemic, and those periods have recently ended or will soon, prompting examiners to start asking more probing questions.

“As bank clients start exiting that process, risks will increase, and that is something we would expect examiners to begin paying more attention to,” King said.

Meanwhile, a lender who has yet to go through an exam should develop a timeline to show the status of its loan book before the pandemic, how its approach to rating credits and providing loan deferrals and other modifications has evolved, and how it foresees its situation playing out, Camerini says. “Show examiners you have a plan in place. You may need to adjust it if the situation changes, but this is the plan today.”

It is also time for bank boards to consider management’s performance. Camerini says several banks have reported that regulatory agencies have scrutinized how management reacted during the crisis.

“Regulators can look to management as a sort of pre-identifier for credit quality issues,” he says. “If they’re not confident in management or the plan it put in place, they may take a harder stance.”

John Hintze is a freelance writer whose work has appeared in Asset Securitization Report, National Mortgage News, CFO, the Global Association of Risk Professionals’ Risk Intelligence and other business outlets.