Eight Tips for Managing COVID-19 Emerging Credit Risk
The SARS-CoV-2 virus and incidence of COVID-19 (COVID-19) outbreak is having a significant and sudden effect on banks’ loan portfolios. The current environment is affecting all businesses, and the pandemic’s overall risk is more difficult to assess than the recession 12 years ago when the major issues were concentrated in commercial real estate (CRE).
It is important to be in front of the emerging risk as much as possible, as most banks are attempting to do, versus being reactionary. There are a lot of unknowns, but anything beyond a 30-day slowdown is going to weigh heavily on loan performance. Cash-strapped commercial and CRE borrowers will need to decide between paying employees, vendors, landlords, taxing authorities and banks. In addition to issues for borrowers with generating revenue, the ability to timely bill and collect and obtain supplies as needed may come into play.
We offer a few thoughts for your consideration to supplement your current plans.
- Review your commercial concentrations and be as granular as possible in your assessment. While some industries may experience minimal effects from the current crisis, most will experience some issues, especially those in consumer-based services such as hotels and restaurants. Consider the potential impacts on each industry and rank the industries by risk. It is important to make a realistic assessment of how much of your portfolio will be significantly affected by COVID-19 (it will be a large number) because this should flow into your allowance for loan and lease losses (ALLL) analysis.
- While the total potential impact will be large, it is important to try to fine-tune this estimate and evaluate individual borrowers. It would be prudent to determine which businesses are shut down based on various geographic government restrictions. You also should request updated financial information, including monthly cash burn rates where applicable, and discuss capital plans and especially liquidity plans, e.g., access to lines of credit, personal liquidity and applying for SBA assistance, so you can decide which borrowers may be able to work through this and which ones will need additional assistance and attention. If you have the resources, you could consider stress testing the effects of a sales decline on cash flow and liquidity. Companies with limited working capital going into this crisis are going to have a difficult time.
For the higher-risk industries, consider the level of collateral protection afforded and your systems’ effectiveness in monitoring the collateral. Account for the fact that for CRE entities and hotels, the values are directly correlated with cash flow and will fall as cash flow falls, i.e., do not rely strictly on your existing appraisal. If you are relying on receivables and inventory or construction in process for collateral protection, it is imperative that your systems for monitoring these assets and advancing funds are appropriate and functioning well. Unforeseen gaps in these systems become evident in difficult financial times. In addition, any loans secured by marketable securities should be closely evaluated at this time given the market decline.
- You should consider a prudent workout policy and plan that analyzes the current financial information on the borrower or guarantor and supports the ultimate collection of principal and interest. This plan should establish appropriate loan terms, amortization schedules, curtailment, covenants or remargining requirements as applicable. Further, any plan should permit the institution to modify the workout plan if sustained repayment performance is not demonstrated or if collateral values do not stabilize. The plan should consider obtaining updated and comprehensive financial information on the borrower and any guarantor, as well as updated valuations of the collateral supporting the loan and the workout plan. Perform an analysis of the borrower’s global debt service, and establish processes to monitor performance against the workout plan.
- Your level of unsecured loans also deserves scrutiny. If you were generally conservative in your underwriting of these and limited the use to your strongest commercial borrowers, you may be fine. If you stretched in this area during the recent economic expansion, you should evaluate whether you have opportunities to shore this up with some collateral.
- We have focused on commercial credits above, but consumer portfolios also are at heightened risk levels given rising unemployment. The mix of loan types, employer concentrations in your markets, collateral on your loans and the ultimate level and timing of government support are going to greatly weigh on performance in this area. The trends in unemployment and the projected levels it could hit are alarming. You should consider the levels of employment in your community that are tied to high-risk industries such as restaurants, and this should all flow into your ALLL assessment.
- Make sure your risk grades are accurate and changes in grades are timely. Resist the temptation to defer recognizing a potential downgrade for another quarter to see if results improve. You cannot monitor what you do not identify, and it is critical in a time like this to have a full inventory of potential problems, even if you believe it will only be a short-term issue. From our observations of the 2008 recession, banks that were timely in risk identification generally had much higher levels of success than their peers that lagged in identification.
- Your regulators are not going to criticize you for appropriately restructuring loans—in fact, they support it. Sometimes workout actions are driven by the desire to avoid the troubled debt restructuring (TDR) classification. It is important that you separate the need to appropriately restructure credits to help your borrowers and protect the bank from the need to label the transaction as a TDR. The FDIC and other bank regulators recently released the “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus” (Interagency Statement), which provides some clarity on how regulators will view workouts and TDR classifications. Their intentions are favorable toward encouraging banks to engage in appropriate workout strategies without having to use the TDR classification in many cases. View our recent BKD Thoughtware® article for more information.
The new Interagency Statement is largely silent on risk grades, although it does state that “Examiners will exercise judgment in reviewing loan modifications, including TDRs, and will not automatically adversely risk rate credits that are affected by COVID-19, including those considered TDRs.” As you learn more about each borrower’s situation, you should appropriately assess the risk grade. Understandably, there is a viewpoint that financial difficulties are not the borrower’s fault and rather than moving the risk grade at this time, you should wait six months (as an example) in a manner more consistent with the approach on labeling TDRs. However, the risk exists regardless of the source or driver of the risk, and you need to appropriately identify it in your risk grades to properly manage your bank, know which borrowers need your attention and maintain an appropriate ALLL. Failure to do so in a timely manner could result in a large spike in classified loans in the fall/winter of 2020.
- Historical losses are a key component of incurred and expected loss methodologies. As the full effect of the COVID-19 crisis is unknown and losses have not had an opportunity to work through the system, the allowance will inherently be understated. Further, comparable periods will be lacking, as this effect is broad, touching most if not all industries. It will be important to focus on those segments considered to be most affected, and qualitative considerations and adjustments likely will need to be made at the end of the reporting period to account for this crisis.
For more information, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.