Risks Within the Community That Community Banks Need to Address

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States and counties are starting to open back up after a prolonged period of sheltering in place due to the COVID-19 pandemic. As of today, community banks, which are the primary lenders to small businesses in the rural Midwest, haven’t yet seen a significant negative financial impact because of the shutdown.

In fact, many community banks will be receiving significant loan origination fees from the U.S. Small Business Administration for participating in the Paycheck Protection Program (PPP). They’re also flush with cash, as many borrowers haven’t used their PPP loan funds and consumers have been holding their stimulus payments in their checking accounts.

Just because things look good from a financial perspective right now doesn’t mean there isn’t risk in your community and to your bank. Let’s take a brief look at some of the issues community banks should be monitoring today:

  1. Increasing personal debt caused by prolonged unemployment – Unemployed Americans received an unprecedented amount of unemployment benefits. But the increased benefit amount ended on July 31, 2020. What are Americans doing now? Some furloughed employees were brought back, but others weren’t. When income is scarce, the use of credit cards, overdrafts, and personal loans increases. What is your bank doing to monitor the increasing financial pressure of your individual borrowers and account holders?
  2. Delayed business closures – Small businesses without a significant online presence are finding it difficult to survive. Throughout the economic shutdown, “nonessential” small businesses survived by using government funds, furloughing employees, drawing on credit lines, or using personal savings. The lost sales, in many cases, weren’t deferred to a later date. Instead, they were truly lost and won’t be recaptured. Without a fast and heavy recovery for small businesses, they may be forced to close and may not be able to support their current debt load. How are you monitoring the performance of your small business customer?
  3. Reduced need for office and retail space – With the increase in employees working from home, especially in businesses that typically use commercial office space, the perceived need for office space is declining. Once a lease term expires, community banks should expect their commercial borrowers to experience reduced rental income as tenants negotiate for less square footage or overall lower rates. Are you tracking the going rate for rent per square foot in your market?
  4. Increased fraud risk – When people succumb to all three sides of the fraud triangle (rationalization, opportunity, and pressure), they’re more likely to commit fraud. The identification of fraud, however, is usually significantly delayed. A bookkeeping employee whose spouse has been laid off can rationalize the need for the company’s money, has the opportunity to take it, and feels the financial pressure to use that money for personal needs. This person will likely do a solid job of covering the fraud for a short time, but as it grows and more funds are misappropriated, covering it becomes more difficult. That can happen within your community bank or at any of your commercial borrowers. 

Community banks, to this point, haven’t seen dramatic increases in past dues or downgrades in loan ratings due to the above factors. However, it’s likely too early to see a borrower’s financial stress. The time it takes for that stress to show (called “loss emergence period” in accounting terms) is longer than many think.  

Several community banks are adding additional reserves to the allowance for loan losses earmarked in each loan category as “COVID-related.” That practice may be acceptable as the future effect of COVID is unknown. However, community banks should carefully evaluate loans that were “on the bubble” prior to the shutdown, loans that were granted some form of deferral by the bank or certain industries like hospitality. Interagency guidelines permit banks to not account for these loans as troubled debt restructures (TDR) if they meet certain criteria, but banks also are still responsible for maintaining a proper allowance. Therefore, a loan in deferral may need an increased reserve even if it isn’t accounted for as a TDR.

Two other significant financial impacts to banks relate to overdraft fees and interchange fees. As the economy shut down and people stopped moving around freely, consumer spending decreased. As spending decreased, so did overdrafts. Thus, banks’ fee income on overdrafts declined. Likewise, without the discretionary swipes of debit cards, interchange fees fell significantly as well.

How much of the above information will you use as you prepare the 2021 budgets this fall? What will your baseline be? Will you start with 2019 results to plan for 2021, or will you use 2020? Regardless, assess the risks to the bank and plan accordingly.

Reach out to your BKD Trusted Advisor™ or use the Contact Us form below to discuss best practices for moving forward as you review the potential risks facing your institution.

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