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Preparing your financial institution to manage loan workouts, loan modifications

Mary Ellen Biery
Kylee Wooten
October 28, 2022
Read Time: 0 min

Managing loan workouts and modifications

Tips for preparing your bank or credit union to handle an increased volume of problem loans while ensuring prudent credit risk management.

You might also like this video, "A look at credit risk in a rising-rate environment."

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Signs of increased activity ahead
Why get ready for managing loan modifications and loan workouts?

Now’s the time to prepare for managing increased loan workouts and loan modifications.

Loan performance since the pandemic has remained strong across many U.S. financial institutions in recent quarters, but banks and credit unions are boosting provisions for credit losses in anticipation of tougher times ahead.

In addition, prudential regulators have repeatedly encouraged financial institutions to include loan modifications in their actions to mitigate adverse effects on borrowers resulting from extreme weather, COVID-19, rising interest rates, inflation, or other conditions. They’ve highlighted specific concerns about credit risk management practices, particularly for commercial real estate (CRE).

Below are several tips for banks and credit unions looking to get ready to handle potential loan modifications or even loan workouts so they can maintain strong credit risk management.

Workout volumes are low now, but indicators point to more ahead

Despite the low volume of modifications at many institutions since the pandemic began, signs point to increased activity in the quarters ahead.

Overall, FDIC-insured commercial banks and savings institutions aren’t seeing dramatic increases in net charge-offs (Chart 1) or rates related to declining asset quality (Chart 2), such as past-due rates and rates for non-current loans. However, institutions in recent quarters are seeing some indicators of weakening asset quality.

Chart 1. Loan performance since 2020

Managing loan workouts: Indicators of credit risk as seen in charge-offs


Chart 2. Charge-off, past due, and non-performing loan rates

Non-performing loans signal a need to prepare for managing loan workouts and modifications

Learn how credit unions can manage capital levels amid credit stress.

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Inflation, interest rates, hedging
What's behind the loan modification outlook?

“Right now… most institutions aren't seeing increased charged-off loans,” said Abrigo Advisory Consultant Zach Englert. “The only real deterioration we're starting to see is in subprime auto and credit card portfolios.” Even as news headlines announce that “the sky is falling,” many Abrigo clients are relaying they can count only six or seven charge-offs since 2015 or so, he added.

Nevertheless, some clients have said they recognize that more loan workouts could be on the horizon. Among the factors behind these concerns are:

  • inflation’s impact on costs
  • higher interest rates
  • labor shortages resulting in the use of higher-cost, outsourced labor
  • proactive hedging on supplies that can put stress on liquidity.

Earnings reports also point to some deterioration in asset quality. Several institutions in recent weeks have reported that third-quarter non-performing loan rates ticked higher this year, despite being flat or in some cases below rates from a year earlier.

In addition, financial institutions in the third quarter have boosted provisions to create increased allowances for credit losses, whereas a year ago, the release of previous provisions was benefitting net income.

In a recent Abrigo survey, more than three-quarters of C-level, credit management, and credit administration staff identified credit stress on current loans as a concern given the current rising interest rate and credit risk environment. Almost half of the nearly 200 bankers surveyed said they are concerned about an increase in modifications, workouts, and charge-offs, and 62% identified needing to enhance current credit risk management analyses and processes as a concern given the environment.

Meanwhile, regulators are focusing fresh attention on prudent credit risk management of loans, especially CRE, and loan modifications in general.

CRE loan accommodations
Regulators foster prudent loan modifications

Loan modifications include, but aren’t limited to, a forbearance agreement, a new repayment plan, or interest rate modification. More extensive loan workouts can include a renewal or extension of loan terms, an extension of additional credit, or a restructuring with or without concessions.

Loan modifications have played an important role in the ability of borrowers to endure the impact of the pandemic, and regulators continue to urge banks and credit unions to work prudently with borrowers facing stress.

In 2020, federal and state banking regulators eased pressure on coronavirus loan workouts, urging financial institutions to work with their borrowers and members affected by COVID-19. Agencies agreed that these FIs would not be required to categorize as troubled debt restructurings (TDRs) those loan modifications made in good faith in response to COVID-19.

Under normal circumstances, a modification would generally be considered a TDR when the new terms represent a concession – terms that are not market-available. The TDR designation prompted a requirement for separate accounting using discounted cash flow models.

More recently, regulators’ proposed Interagency Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts reiterated that in some cases, financial institutions may want to work with creditworthy CRE borrowers who remain willing to repay debts even if they face “diminished operating cash flows, depreciated collateral values, prolonged sales and rental absorption periods, or other issues that may hinder repayment.” Comments on the proposal were due Oct. 3.

Interagency guidance during COVID said examiners would not criticize a financial institution’s attempt to help borrowers impacted by the pandemic if the assistance was a part of a risk mitigation strategy intended to improve an existing loan that is beginning to display credit weakness. This principle was reaffirmed in the recently proposed policy on CRE loan accommodations and workouts.

“[F]inancial institutions that implement prudent CRE loan accommodation and workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts, even if these arrangements result in modified loans that have weaknesses that result in adverse classification. In addition, modified loans to borrowers who have the ability to repay their debts according to reasonable terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the outstanding loan balance.”


-Proposed Interagency Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts

The proposed updated policy statement also incorporates the Financial Accounting Standards Board’s (FASB) recent move to eliminate separate TDR accounting for institutions that have adopted CECL, the current expected credit loss model for reporting credit losses. Under CECL, certain modifications tied to a borrower experiencing financial difficulty will instead be labeled as modifications and have enhanced disclosure requirements.

Examiner focus
Keen regulatory eye on CRE, stress testing

Despite encouraging banks and credit unions to work with borrowers facing stress, regulators have repeatedly signaled a continued focus on credit risk management practices.

“Market and external conditions are changing the credit risk environment rapidly,” the 2023 OCC Bank Supervision Operating Plan said. “Examiners should evaluate banks’ actions to manage credit risk given volatile changes in market conditions, interest rates, and geopolitical events, as well as supply chain disruptions and areas of continued weakness from the pandemic such as urban commercial real estate performance (office, hotels, and retail). Supervisory efforts should focus on risk management functions to determine whether there is appropriate credible challenge. Examiners should evaluate banks’ stress testing of adverse economic scenarios and the implications, such as amplified impacts to retail and commercial borrowers experiencing increased operating and borrowing costs at loan origination, at renewal, or over the term of the credit.”

Managing commercial real estate (CRE) credit risk, especially managing CRE loan modifications and workouts, has received particular emphasis from regulators. Noting that 98% of banks engage in CRE lending, the FDIC has said CRE loans are the largest loan portfolio type for nearly half of all banks, and CRE loan volume (in dollars) is at a historic high.

According to a recent edition of the FDIC’s Supervisory Insights publication, examiners in the upcoming cycle will prioritize resources “toward areas presenting the highest risk at an individual bank, which often includes significant CRE lending concentrations.” Among other things, examiners will “assess management’s ability to implement prudent credit modifications and underwriting, maintain appropriate loan risk ratings, designate appropriate accrual status on affected loans, and provide for an appropriate reserve for credit losses.”

Given the environment and regulatory emphasis, financial institutions across the country should establish effective plans for managing loan workouts and modifications. 

Policies, people, processes
Create a plan to manage problem loans

So what can a financial institution do to prepare for an increased volume of loan modifications or loan workouts?

Abrigo advisors note that successful, high-performing financial institutions will:

  1. Review and update as necessary their policies, processes, and procedures for loan modifications or loan workouts. “If you haven’t updated your policies and procedures or dusted them off in 5 or 7 years, the time is now,” said Abrigo Advisory Services Senior Advisor Paula King, who has assisted institutions with policy reviews and updates.
  2. Add training on loan modifications and workouts. Many staff members may have joined since 2015 and therefore, lack experience working on modifications.
  3. Review any system to manage requests or identified loans at elevated risk. This assessment will help ensure the bank or credit union can prioritize loan accommodation needs and manage the associated risk while maintaining profitability. Automated loan modification can save time and improve efficiency, King said. Importantly, loan modification software can ease the burden of the numerous, highly manual steps typically involved in modifications and workouts. King and an Abrigo client discussed loan modification management advice in detail during a recent webinar on credit risk management.

Among prudent risk management practices for short-term loan modifications that were outlined in the proposed policy on CRE lending:

  • Updating and assessing financial and collateral information
  • Maintaining appropriate risk grading and ensuring proper tracking and accounting for loan accommodations
  • Obtaining proper management approvals
  • Having timely and accurate reporting and communication.

Automated models also enable institutions to better understand how much revenue a bank or credit union could lose based on different scenarios. This can be achieved using a discounted cash flow model that reflects missed, deferred, or interest-only payments, for example.

 

More planning advice for managing loan modifications, workouts

Abrigo Senior Advisor Rob Newberry has noted that lenders with successful strategies for managing credit risk related to loan modifications also incorporate the following:

  • Specific legal expertise in crafting agreements. As these agreements override the original loan documentation, the lender can gain more flexibility to call the loan or require additional collateral based on the new terms and covenants of the workout agreement.
  • Methods to include and track additional review and due diligence on the borrower’s existing loan documents
  • Straightforward, measurable new terms and covenants for the borrower
  • Expectations outlined to ensure the borrower has the ability – and desire – to follow through
  • Borrower’s potential recovery of their equity position tied to the par recovery of the original loan profitability basis, at minimum. Present-value recovery for the financial institution can inform an argument that the new terms do not represent a concession.
  • Negotiation between impacted customers and personnel who have a direct interest in the health of the financial institution
  • Timely, authoritative, accurate information on the state of the borrower, with all participants on the lender side communicating the same message
  • “What-if” scenario stress testing to examine the impact on the portfolio and capital levels if charge-offs increase as expected.

Getting prepared for additional volume in loan modifications and workouts is especially vital for smaller, less complex lenders that lack the resources of large financial institutions. Taking steps now will help these banks and credit unions provide personal, prudent service while scaling institutional resources to handle added volume.

Learn more about managing credit risk and examiner priorities in uncertain times.

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About the Authors

Mary Ellen Biery

Senior Strategist & Content Manager
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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Kylee Wooten

Media Relations Manager
Kylee manages and writes articles, creates digital content, and assists in media relations efforts

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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