By Monica C. Meinert
While the economic recovery from COVID-19 is underway, another problem could be looming on the horizon: rising credit risk, and a wave of potential defaults.
Overall, banks fared well through the pandemic—thanks to ample capital and liquidity levels and an assist from federal relief programs, banks kept a steady stream of credit flowing to the businesses they serve. The situation today is drastically different from the 2008 financial crisis, John Bourquard, principal at BKD, told attendees at ABA’s recent virtual Conference for Community Bankers. “In 2008, it was a real estate-based workout scenario. Today, it’s service-industry based, with some concerns about real estate.”
This time around, the pain was mostly concentrated in sectors like leisure, travel and hospitality, which took a massive hit during COVID lockdowns. But there’s even been some variation there, as Mike Hendren, senior credit officer at Nashville’s Pinnacle Financial Partners, points out.
“Those properties that haven’t been impaired . . . are generally economy, midscale, upper midscale limited service properties, as well as extended-stay facilities.” Generally, he notes, these are places in “drive-to” markets. To give a hospitality sector example, these would be the so-called “roadside motels” in suburban, interstate locations, where commercial loan values tend to be modest—usually under $10 million. “It’s as we move to properties that are more urban, catering primarily to the business traveler—that’s where we begin to see greater impairment in terms of valuations,” Hendren observes.
While the COVID-19 relief bills provided payment deferment options for borrowers and provided relief to banks when reporting troubled debt restructurings, these measures will not extend indefinitely.
So how can banks stay ahead of potential defaults?
1. Communicate with borrowers
Barbara Hart, SVP for credit risk at Washington Trust Company in Westerly, Rhode Island, emphasizes the importance of communicating with borrowers early and often. “Continue to ask your borrower: ‘What is [your] current status? Will you need more in terms of relief or extended deferments?’ Ask for financials to continue to monitor that and assess that,” she advises.
With the initial waves of the economic crisis now past, bankers should carefully scrutinize any requests for additional loan deferrals, as they could signal that the borrower’s financial condition may have deteriorated. “We must carefully consider safety and soundness and determine where current conditions have affected our collateral values,” Hart adds. “While payment deferrals do not automatically require a new appraisal, we should continue to assess that.”
2. Identify problems early
Good communication can help bankers identify potentially troubled loans early, and early identification always leads to better workout results, Bourquard says. “A lot of times, there’s a tendency to want to kick the can down the road.” But a wait-and-see approach can create bigger problems in the long run. A better strategy is to “downgrade it today and look at improvement to upgrade it next quarter,” he says.
At Washington Trust, Hart says her team carefully monitors loans that were granted COVID-related deferments, flagging those loans in the bank’s core system and creating watchlists that are periodically reviewed by lenders and senior and executive management teams. At those meetings, teams discuss “the status of the relationship, revenue drivers in the cases of CRE, risk rating affirmations and any need for additional deferments. Delinquency was always discussed, and we would continue to maintain those credits on our watchlist” until borrowers made three timely post-deferral payments—a sign that the business had returned to normal operations.
3. Be aware of red flags
Hart adds that there are several red flags that banks should be watching for as they conduct reviews of their loan portfolios and talk with their customers. While there’s likely to be some delays in customers’ financial reporting due to the pandemic, “if they continue to delay, that might be a red flag that they’re not paying their accountant or not able to continue to wrap up their year and move on,” she says.
Other red flags include bankruptcy, stalled communications, or overdrafts, if the business has its primary operating accounts with the bank. Reduced liquidity of the loan sponsor is also a major cause or concern, she adds. “During these times, we’re going to continue to look to them to continue to support the deficient cash flow. Any substantial drop in liquidity of the sponsor or guarantor could be a red flag that this is not going the right way.”
4. Monitor concentrations and stress test
To effectively manage credit risk, banks should stress test their loan portfolio to determine how regulatory capital could be affected in the event of widespread defaults.
“A 30 percent concentration is not going to cause you major problems, but if you have multiple concentrations of high-risk industries at 30 percent, that’s where it could be a big problem for you,” Bourquard says. Bankers should also bear in mind that delinquency rates and charge-offs are not currently occurring in real-time, due to COVID-19 relief. “Today, they’re low, and they’re artificially low due to how they’re being reported. [That’s] something to consider as you look at the performance of your bank.”
Monica C. Meinert is a senior editor at the ABA Banking Journal.
