Credit Risks in Investment and Loan Portfolios: Controls to Consider in a Recessionary Environment

With the evolving COVID-19 situation and the related impact on the markets and economy, consensus is building that we may be heading into a recession. On March 9, 2020, banking agencies issued the following press release:

“Federal financial institution regulators and state regulators today encouraged financial institutions to meet the financial needs of customers and members affected by the coronavirus. The agencies recognize the potential impact of the coronavirus on the customers, members, and operations of many financial institutions and will provide appropriate regulatory assistance to affected institutions subject to their supervision. 

Regulators note that financial institutions should work constructively with borrowers and other customers in affected communities. Prudent efforts that are consistent with safe and sound lending practices should not be subject to examiner criticism. The agencies understand that many financial institutions may face current staffing and other challenges. In cases in which operational challenges persist, regulators will expedite, as appropriate, any request to provide more convenient availability of services in affected communities. The regulators also will work with affected financial institutions in scheduling examinations or inspections to minimize disruption and burden.”

Now is the time to be proactive in evaluating your investment and loan portfolios for credit risks. Adhering to strong internal controls can help guide and document your decision-making process, and we recommend that bankers consider the following controls to ensure credit risk is appropriately managed.

Investments:

• Municipal & Corporate Bond Review – When reviewing corporate and municipal bonds, critically consider potential erosion in the tax base stemming from local economic conditions. In extreme cases, this may impact a bond’s investment grade classification. It’s important that you thoroughly document credit reviews of bonds and, if you identify credit issues, report the review results to ALCO for consideration.
• Other-Than-Temporary-Impairment (OTTI) Analysis – In conducting OTTI analysis, critically evaluate each security that is in a loss position. Be sure you understand why a potential loss is there and whether the institution really intends to hold the bond. Keep in mind that liquidity pressures could affect your ability to hold the bonds for an extended period. Be sure to retain detailed records that explain why the bonds are not in an OTTI position and report to ALCO.
• Portfolio Valuation – Recognize that volatility in the bond market could impact how bonds are valued. When performing alternate valuation procedures, confirm that a tolerable variance is established and any variances over this threshold are researched and formally documented. 

Loans:

• Troubled Debt Restructures (TDRs) – Ensure that any renewals or modifications are formally considered for TDR status. Likewise, concessions made to borrowers due to their financial condition are often considered to be TDRs. As each of these are evaluated for TDR status, be certain to formally document the decisions made throughout the assessment process.
• Portfolio Monitoring – Management-level loan portfolio meetings should be held on a frequent basis to specifically discuss vulnerable borrowers, adverse trends and potential concessions. Be sure to formally document any decisions made in these meetings. As indicated in the Interagency press release, regulators want banks to work with borrowers, so we strongly recommend you keep detailed records of any concessions made along with the reasons for those decisions.
• Credit Memos – For credits that don’t go to committee, concessions and/or other modifications should be subject to the same evaluation criteria, and should be recorded in credit memos and approval documentation. In this anticipated downturn, cash-strapped businesses may turn to banks for new loans or to restructure existing loans, and many of these customers will be small businesses. As such, their loans may be small enough that they don’t go to committee for approval, so remember to keep comprehensive credit memos and approval documentation.
• Charge-Offs – Some borrowers may become past due on their loans and exceed the bank’s policy thresholds for charge-off. Lenders may decide to defer charge-off to give customers additional time to bring the loan current. If you make policy exceptions for charge-offs, then formally document these decisions and the approvals.
• Allowance for Loan and Lease Losses (ALLL) – Critically evaluate necessary changes to qualitative factors (such as whether concessions are being proactively or regularly granted, or for economic risk and lending policies). Also, thoroughly assess all problem loans for appropriate grading, analysis of impairment and booking of reserves.
• Principal Payments – Recognize that liquidity forecasts generally assume scheduled principal payments are made. If you expect significant changes in payment volume, be sure to clearly communicate this to ALCO or other designated committee so they can proactively identify potential impacts to liquidity.
• Other Real Estate (ORE) – A prolonged recession could lead to increases in ORE or other repossessions. Establish controls to confirm that ORE is recorded at fair value (using appropriate supporting documentation, such as a third-party appraisal) less estimated selling costs. Formally document all foreclosure or repossession decisions.
• Credit Cards – For banks that offer credit card loans, lenders should closely monitor balances and delinquencies, and proactively reach out to borrowers whose balances show unusual increases. Many banks understandably pulled back credit limits on credit cards after the 2008 recession, but the recent Interagency statement encourages banks to constructively work with their borrowers. 

Financial Reporting: 

• Debt Covenants and Balance Sheet Items – Evaluate the impact of COVID-19 on debt covenants and other balance sheet items in order to assess whether financial statement disclosures are sufficient, including subsequent events.

Do you notice a theme as you read our recommendations for controls? Documentation is key! It is very important to keep thorough records as you make decisions regarding credit risk.

If you would like to talk through your processes, assess your controls or ask questions about your credit risks in this COVID-19 environment, we welcome you to contact our team at Weaver.

© 2020