White Paper Summary:  By 2021, weakening credit portfolios will drive bank consolidations. Survivors have and continue to invest in risk management infrastructure to strengthen their resiliency. This article:
  • Compares the COVID-19 banking cycle to the Great Recession
  • Illustrates direct and indirect credit vulnerabilities
  • Highlights strategic risk management solutions and best practices to mitigate risk

COVID: Will your bank survive? 

Best indicator is the Risk Management program

As permanent business closures mount, the U.S. is effectively in the Great COVID Recession.  Banks are vital to the economy and have pumped government funds into the hands of businesses; however, banks are the “last line of loss” when the economy sours.  Their survival is critical.  Strong risk management programs are key indicators of those that will survive consolidation.

Bank consolidations happen in cycles that follow disruptive economic events, and there is no debate that COVID-19 fits that category.  The leading edge of such consolidations may start by late 2020 with more throughout 2021.  Different from past experience, the winners and losers in the next round of bank mergers and acquisitions (M&A) will not be solely based on the quality of credit underwriting when onboarding a customer. 

Surviving banks will also have a strong risk management culture and mature programs.  Ideally, banks will have incorporated ownership of risk management into their DNA, with all employees understanding their role and that management of risk is not limited to one department.  Banks with known enhancement opportunities for their risk management programs need to make the investment, even if it feels like changing a tire while the car is in motion.

Banks controlled their destiny leading up to the Great Recession through internal credit risk policies.  Residential and consumer lending was focused on growth at the expense of credit worthiness and the commercial credit markets migrated to “covenant-light” transactions that did not trigger performance defaults. 

External forces related to the pandemic health crisis will adversely impact bank portfolios through the Great COVID Recession.  Generally speaking, banks did not foster credit vulnerabilities to the same extent as the last cycle.  At this point intense focus on managing and building the bench depth of skills to mitigate a broad host of risks is critical.

Pre-COVID 2020 Credit Outlook

While the last Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve publication, January 2020) showed that banks reportedly eased some key terms on Commercial and Industrial (C&I) loans, especially to large and middle-market firms, the 2020 bank outlook expected tighter standards and a deterioration in loan performance for most loan categories during 2020.  Further, with a few exceptions, banks expected loan demand to remain unchanged.

COVID-19 changed all of that.  Credit demands far exceeded government-supported lending, companies drew down their unused credit lines, demand deposits grew, companies have announced suspension of dividends, share buybacks have been curtailed or stopped, and the first large bankruptcies have been announced. 

Lessons Learned from the Great Recession

The Great Recession was highlighted by banks that failed due to their weak credit portfolios.  Weakened banks were supported by the Troubled Asset Relief Program (TARP) until they were acquired or liquidated.  Since that time the Dodd-Frank Act stress test (DFAST) requirements have helped assess whether large institutions have sufficient capital to absorb losses during adverse economic conditions.

During February 2020, the economic variables of the DFAST were published (slight changes from 2019) for large banks to conduct their testing.  Table 1 compares the severe adverse scenario metrics, consistent with a sharp recession, to the current market conditions.  While the regulatory costs for large banks increased after the Great Recession, the economic impacts of COVID-19 compared to the scenario guidelines demonstrate that regulations designed to test large banks did in fact prove to be a valuable exercise for individual institutions as well as the Fed’s monitoring capabilities.

The OCC and FDIC encourage community banks to adopt a stress test method that fits their unique business strategy, size, products, sophistication, and overall risk profile.  The open question is how many of them conducted testing using a scenario this severe as part of their risk management program.

The Great COVID Recession

The economic shock of COVID moved several of these DFAST variables to or past the severe scenario threshold levels in a matter of 60 days, adversely impacting first quarter earnings even though only one partial month of the COVID shutdown was included.  Quarterly earnings were below expectations for 56% of companies included in Merrill Lynch’s Financial Services sector coverage. 

Job postings for bank work-out specialists have already begun and firms that specialize in bankruptcy and liquidation activities are also seeing an uptick in demand. 

The bank impact of the COVID lock-down will not be fully disclosed until November 2020.  The Fed publishes Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks 60 days after each quarter end.  Banks adjust their reserves and allowance accounts for consumers more quickly than commercial loans.  Commercial exposure reserves and allowances are adjusted quarterly after receiving financial statements from borrowers; however, this lags a quarter-end by 45 days. 

Consequently, the financial performance of commercial borrowers during 1Q20 will become visible to banks mid-way through the second quarter.  Reserves will in due course appear on the June 30, 2020 financial statements, which will subsequently be reflected in the August Fed report.  The full impact of the April COVID shut down will thus appear in the next publication cycle reflected in the November Fed report.

Economic Recovery Cycle Will Signal Bank Health

Whatever shape you anticipate for an economic recovery (e.g., U, V, W, L, or the Nike swoosh), the financial health of borrowers serves as a leading indicator of a bank’s health. 

Banks are the defacto “last line of loss,” and everyone needs to understand their vulnerabilities.

An example helps highlight a bank’s credit exposure. A large restaurant near a sports stadium that closed declares bankruptcy with no bank loan but does have creditors they cannot pay. The landlord, wholesale food distributors, and restaurant supply company are all left with losses on what they are owed and no cash flow. In turn, they may have bank loans for the commercial real estate mortgage, working capital loans for inventory, or term loans. The bank has no direct exposure to the restaurant; however, the bank may have loans to borrowers in the supply chain that now have a weakened financial position.

This example demonstrates why regulators encourage each bank to conduct risk assessments unique to their profile.  National and regional banks have more granular portfolios compared to community banks that may not be as geographically diversified and may have concentration risks in certain business sectors that could weaken their portfolio.

Credit Impairment

Financial institutions are converting to new accounting standards to account for current expected credit losses (CECL).  The industry change is intended for banks to better estimate expected losses over the life of a loan rather than the recognition of loss when probabilities increase that contractual amounts will not be collected.  In many cases this conversion will increase the level of reserves.  This new estimate calculation compounds a bank’s need to assess appropriate credit impairments for borrowers adversely impacted by COVID closures and anticipated shifts in buying patterns.

As the example showed, looking at the portfolio on the surface or simply by NAICS code and declaring that the risks have been identified is not good enough.  Second and third-degree credit risks need to be recognized and managed.  These direct borrower and derivative credit risks can be thought of as downstream or upstream dependencies, which are critical to managing portfolio risk. 

Another factor to consider during the recovery cycle is the double-edged sword of oil prices.  As an input to raw materials in the supply chain, the lower cost is a great benefit and will help control inflation.  At the same time, the infrastructure to support the oil industry including extraction is not sustainable at current pricing.

Each of the borrowers in the example as well as in the oil sector may need to be evaluated and potentially downgraded because there is a high probability that EBITDA will decrease.  The ability to estimate this kind of impairment needs to be factored into CECL estimates.

Bank Winners and Survivors

During the next nine months to a year the economic impact to individual banks will start to become clearer.  While everyone wants the economy and in turn the banks to recover quickly, some sectors and banks will not. 

Banks with strong risk management programs will talk about their activities during earnings calls and investor conferences (although these will be different too) including how they prepared before and adjusted during the COVID-19 events.  Their narratives will be thematically similar: 

  • Various business segments and internal operations were evaluated, and the risks understood relative to defined risk appetite.
  • Risk frameworks and risk statements will have been considered and memorialized for the key functions of the bank. 
  • Risk assessments were not designed to be “one and done” and have been evolving over time with measurement and governance processes established. 

Good management teams understand that best practices include going beyond table-top exercises for business continuity planning (BCP) and disaster recovery planning (DRP), recognizing that these are just a starting point and generally internal in nature.

COVID-19 has highlighted the need for BCP exercises to evaluate aspects of business interruption that impact the company more holistically.  Many areas of the bank should be addressed routinely such as capital planning, liquidity, operations, etc. 

Bank management teams must critically assess the current state of their other risk management programs.  Entering the Great COVID Recession with anything less than strong programs could pose an undue risk for stakeholders and decisions should be made in consultation with Board about the organization’s objectives. 

Risk officers are protective of their banks and programs because it is in their nature; however, they cannot afford to be complacent as risks are becoming more dynamic and mitigation requires constant evolution.  In this environment, especially when risks are changing rapidly, banks need to evaluate all aspects of the organization for better ways to stay ahead of emerging risks.  The best practices below differentiate banks that will win with strong, strategic programs from banks that may merely survive.

Know Your Customer (KYC):  Compliance with Bank Secrecy Act (BSA) KYC regulations may be applied by banks differently when a checking account is opened versus when there is a loan.  This caused some reputational frustration during the Payroll Protection Program (PPP) loan application process because banks prioritized existing borrowers based on deeper banking relationships with loans as well as more KYC information on hand.  Focusing on better customers was absolutely the right thing to do. 

Best practice: Banks that do the full KYC, due diligence, and negative news assessments using technology at the time any customer is onboarded. Advanced technology and effective upfront processes provide a return on investment by helping remove friction points when new products are added as well as reduce fraud risk during disruptive times Adapting this best practice may be appropriate as to align with a bank’s risk-based approach.

Credit Impairment:  While CECL and the general impairment process was outlined previously, when banks understand and track customer vulnerabilities, management can act quicker, either to support customers or protect collateral as economic forces change. 

Best practice: Understand which events could “kill a business” at the time of underwriting and manage a database to track these dependencies. In the restaurant example, if events stop happening at the sports arena the restaurant will close, the commercial real estate value decreases, and the mortgage is at risk. The ability to identify that the arena closure will adversely impact a quantifiable portion of the portfolio is important. You cannot manage what you cannot see.

Enhanced Credit Diligence (ECD):  Core credit underwriting processes at banks need to evolve.  Credit analysis that evaluates a borrower based on ratios and historical EBITDA (earnings before interest, taxes, depreciation, and amortization) are just the basics.  Better practices evolved during the past ten years to include qualitative credit analysis focused on business model vulnerability. 

Best practice: Include a proportionate level of assessment of a borrower’s risk management and compliance programs. The larger the credit exposure relative to allocated capital or policy limits, it is prudent to have a more in-depth understanding of a borrower’s risk programs.

The challenge is that front-line lenders do not currently have the depth of skills to complete such ECD assessments; it is not their core competency. Protocols need to be developed to train lenders on the basics as well as how to detect and escalate risks. Reviews of larger borrowers may require banks to build in-house ECD teams or use third-party ECD analysis teams to help recognize if a borrower has a weak risk management infrastructure. These potential risks are amplified based on U.S. sanction programs if the borrower has an international nexus through their supply chain or customer base.

Customer Needs Change:  The fulfillment of PPP loan requests to the SBA was a basic service change that banks had to provide to most customers to help them weather the economic storm.  While other bank customers thrive in the displacement. 

Best practice: Have a “SWAT” person or team dedicated to financing customers with growth requirements while the majority of the team supports adversely impacted customers. One example is textile and clothing manufacturers that need financing to rapidly change their business model to stitching masks. Another is a lab that uses 3D printers for specific low demand printing now needing to finance the purchase of more printers and materials to produce PPE shields. The ability to lead through tough times will pay big dividends.

Talent Management:  Management of a bank’s employee base is multi-faceted.  Leadership looks to maintain staffing levels, provide tools to enable staff to work, and most importantly the emotional support necessary in challenging times.  Containing these efforts within a framework that resembles business as usual is limiting.

Best practice: Developing specifically targeted cross-training programs that can be deployed rapidly will provide great benefits to employees as well as the bank. Different from onboarding new employees, the ability to “inboard” existing employees to a department that is being overwhelmed with demand (e.g., PPP loan processing, mortgage processing) from a department with low demand (e.g., retail branches) has many advantages that:

    • Keep the workforce fully engaged during periods of disruption
    • Develop new skill sets
    • Provide a future career path for top performers
    • Reduce more expensive temporary staffing needs
    • Enhance the appreciation for skills across silos
    • Instill the bank’s culture for all involved

Paradigm Shifts:  Adaptation was required to overcome tactical barriers when stay-at-home orders were put into place.  These barriers, real or imaginary, may have kept old ways of doing business from evolving, such as allowing employees to work from home.  However, forced adaptation to temporary processes may prove to be valuable, even worthy of becoming permanent. 

Best practice: Removing the framework of “this is how we did it,” banks that embrace a blank piece of paper to develop ways to meet customer needs in a new environment will thrive. It is important to incorporate feedback from employees as well as customers to rethink how services look when the majority of the workforce is remote. Digital capabilities have become critical. Being able to onboard and service a customer electronically is now the “new norm” (e.g., electronic disclosures, agreements, notary, etc.). Banks should work with their internal audit teams to build an agile risk framework to properly introduce and vet changes developed in response to external forces.

Signals for M&A activity during 2021

Investment in a strong risk management program through the business cycles can be a strategic advantage; it will reduce performance volatility in good times and will yield material benefits during and after economic events. 

Throughout 2020, banks will signal how they are working through the early stages of the Great COVID Recession.  Key indicators will include customer engagement for new lending, disclosure of credit or geographic concentrations, management of the credit portfolio through aging and forbearance, and incorporation of CECL requirements.  A key leading indicator will be the increase of job postings for work-out and liquidation specialists.

Bank stakeholders need to have and should expect greater visibility into their institution’s risk management program to understand how upcoming consolidation and potential M&A transactions may affect them.  Banks that want to be positioned for market leadership with operational strength to acquire weaker financial institutions need consistent investment to build and evolve solid risk management programs. 

Organizations with operational areas not yet modeled on best practices should assess where and how to make their risk management investment to be prepared for bank consolidation.  Signals that indicate potential urgency include, but are not limited to, recent experience with choppy business continuity transitions, having concerns about current recovery plans, feeling uncertain about compliance activities, or needing to mitigate other risks.  Although it may be challenging, now could be the time to change the tire and tune-up the engine, even while the car is moving.  If not now, when?

Please contact Gordon Risk Solutions if your bank needs support to create a strong risk management program (or to mature an existing program). If the leadership team, including the Board, wants a review of existing practices or to identify enhancement opportunities, our partnership approach translates into aligned interests. Gordon Risk Solutions offers a risk-free initial conversation.

About the co-authors:

Larry Gordon, CAMS, is an experienced risk management professional in financial services focused on credit underwriting and assessment, anti-money laundering, and sanctions. M&A due diligence experience in financial services, healthcare, retail, and manufacturing.

Julie Pemberton, RIMS-CRMP, ARM, is an experienced risk management professional in various industries including consumer packaged goods, logistics, food / agriculture, retail, airport and port operations.

Rick Neighbarger, RIMS-CRMP, is experienced in IT and enterprise risk management, operational excellence and quality management, in multiple industries including healthcare, insurance, information technology, telecommunications, government, and energy.

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