Coming out of a global pandemic, financial institutions are navigating how to remain profitable amid government interventions, record inflation numbers, and rising rates. In a recent Abrigo webinar on credit risk management, four experts weighed in to pinpoint the following areas for focus and improvement in 2023.
Best practices for credit risk management in uncertain times
Fortify your credit risk management framework
How to prepare your organization for scrutiny of its credit risk management practices during your next exam or review.
You might also like this whitepaper, "Stress testing: Managing capital levels and credit risk."
Ensure training for lenders who don’t have loan modifications experience
Loan modifications, loan workouts, charge-offs, and special assets are a priority for financial institutions striving to prepare for unknowns as they observe macroeconomic trends like inflation impacting their customer base.
“Considering the uptick in the cost of living and interest rates, on top of the labor shortage, our customers are concerned,” said Steven Matzus, Senior Vice President and Managed Asset Division Manager at S&T Bank. “They are having to outsource a lot and increase their operating expenses without any offsetting revenue and while dealing with supply chain issues.”
Matzus says his bank’s most successful customers are proactive with their approach to staying in supply by hedging on materials they need. This is a good solution for many customers, but one that has the potential to put a strain on their liquidity.
So how can banks help customers keep up in uncertain markets? By getting their own credit risk management operations ready for potentially tougher times for borrowers, lenders can be more proactive in reaching out to assist those headed for trouble — helping both the borrower and the financial institution.
With government stimulus money to help get customers through the pandemic dwindling, Paula King, Senior Advisor for Abrigo, anticipates lenders will be dealing with more loan workouts toward the beginning of 2024 and continuing to increase from there.
A good place to start on tightening up credit risk management is updating policies and procedures for the new environment.
“If you haven’t updated your policies and procedures or dusted them off in 5 or 7 years, the time is now,” she said.
Most banks’ policies and procedures around loan modifications are outdated because they were not written in a rising rate and inflationary environment. Updating these for the current economic conditions can help banks prepare for the future. And by involving junior lenders in revision process, banks can cultivate and retain talent that is prepared to handle the new environment.
King recommends more staff training on loan modifications and workouts, particularly for banking staff that came on board after 2015 and may not have any experience with loan modifications.
“You have time to make changes before we see an increase in loan modifications,” she said.
Automate loan modifications, workouts, and special assets processes to ensure efficiency and consistent loan terms
King also recommends automating loan modification procedures, including processes tied to special assets management. Loan modification software can save time and increase efficiency related to the highly manual steps many institutions follow to complete and document loan modifications and workouts.
“Historically, special assets is one of the more manual procedures to track within the institution. Think about ways that you can automate that, whether you just need something basic, or you need to look to a third party to help.”
Know your limits
Examine stress testing techniques to better understand potential pitfalls
Stress-testing on a loan level or a portfolio level can help financial institutions understand their threshold for any future upheaval. Zach Englert, Consultant with the Abrigo Advisory team, recommends that banks perform a “what-if scenario” stress test to see what would happen if charge-offs do increase as expected. That’s especially important to do for variable-rate loans, where banks have seen more than a 3% increase in prime over the past six months.
“It's important for financial institutions to know their limits,” said Englert. “For example, what is considered an impairment or charge-off? If a bank must repossess a building and the building is now worth 20% less collateral value than it was when the loan originated 18 months ago, how will the situation be handled?”
Financial institutions wondering at what percent to stress test their real estate portfolios can use the Fed’s DFAST scenario document as a guide for creating boundaries based on where the different agencies think the market is headed. The document provides a baseline and severely adverse scenario that banks can use as a defensible starting point for stress testing worst-case scenarios.
Have a playbook
Get to know regulator expectations and priorities
Regulators’ risk management perspective is evolving, and financial institutions should expect to be held accountable for consistent stress testing. It is important to have a process for stress testing that includes the steps your institution is taking, how often testing is performed, and what numbers are used as a guide. Having a playbook will help institutions avoid regulatory scrutiny.
Having a playbook for loan modifications will also help come exam time. When it comes to loan modifications, King says regulators and banks are on the same team—they just want to see loans repaid.
“Regulators are not going to criticize you for these short-term loan accommodations or these workouts. They would prefer that scenario over a bank ending up with a charge-off.”
King cited a new interagency policy proposal and other pieces of FASB guidance that financial institutions should keep in mind when preparing to speak with regulators.
The proposed policy document includes an appendix with loan modification examples broken out by loan types. The examples define regulator expectations for what designates a loan workout arrangement, risk rating categorization, interest accrual categorization, and other controls that help risk mitigation.
Another new rule for financial institutions to be aware of is the Consumer Financial Protection Bureau’s 1071 rule, which has a March 2023 implementation date and is essentially an extension of the Equal Credit Opportunity Act.
This rule requires all organizations that originated 25 or more small business loans in the last two years to record and maintain about 25 data points for loans to women-owned and minority-owned small businesses. Financial institutions should have an LOS system in place or other means to cover this new reporting task before the compliance date arrives.
Finally, when it comes to CECL preparations, King says many clients are getting negative feedback from regulators and validators on the documentation component of the new standard.
“In their hurry to get compliant with CECL, it seems like maybe banks have forgotten the documentation piece. I would go back through the decisions made on your segmentations and methodology and just make sure that your documentation is firmed up.”
Adapt and adjust
Analyze loan pricing techniques and adjust to the current rate environment
According to Rob Newberry, Senior Advisor at Abrigo, pricing will play an important role in credit risk management in the current environment. Banks are constantly making a trade-off by accepting credit risk to get rid of interest rate risk.
“In today’s up-rate environment, the low interest rates from several years ago are now much higher,” Newberry said. “Financial institutions need to know how likely it is that their customers will qualify again and be able to make the payment structures they are willing to offer.”
Stress testing to understand how much margin for error banks have in their credit analysis will be critical, especially since loan demand has not been high after stimulus money. Financial institutions that are hungry for loans may be willing to price lower than they usually would but should be cautious about doing as much volume as possible considering the rising rate environment.
“I would look for opportunities in your product offerings to help not only increase your net interest margin but help with the credit risk of your borrowers,” he said. “For example, if you offer a term sheet, are you charging a potential lock fee? Create opportunities to regain some non-interest income. Be sure to include language in there that allows you to price to the current rate or potentially charge your rate lock fee. That will give your institutions some protection in uncertain times.”