December 2023 Newsletters

Don’t Put All Your Eggs in One Basket (Without Some Risk Management)

When was the last time you reviewed your commercial real estate (CRE) lending portfolio?

The importance of risk management practices in the context of CRE and construction and development (C&D) concentrations was a point recently highlighted by the FDIC. Given current market conditions, including rising vacancy rates, reduced demand, and lower property values, CRE and C&D loan concentrations are clear vulnerabilities without robust planning. The following are excerpts from the FDIC’s six recommendations for ensuring your institution is prepared for any unexpected difficulties:

1. Maintain Strong Capital Levels – Institutions with significant C&D and CRE exposures may require more capital because of uncertainty about market conditions causing an elevated risk of unexpected losses.
2. Ensure that Credit Loss Allowances are Appropriate – Specifically, GAAP requires management to use relevant forward-looking information and expectations drawn from reasonable and supportable forecasts when estimating expected credit losses. While historical loss information generally provides a basis for assessing expected credit losses, management should consider whether further adjustments to historical loss information are needed to reflect current economic conditions.
3. Manage C&D and CRE Loan Portfolios Closely – Institutions should maintain credit administration practices that consider the risks of material C&D and CRE concentrations. This includes management information systems that provide the board and management with relevant data on concentrations levels and related market conditions, including for concentration or market segments.  Applying adverse scenarios while conducting stress tests or sensitivity analysis helps banks adjust risk management processes to prepare for credit risk problems before they impact earnings and capital. Additionally, appropriate risk management practices include maintaining a strong credit review and risk rating system that identifies deteriorating credit trends early. It is important for institutions to effectively manage interest reserves and loan accommodations, reflecting the borrower’s condition accurately in loan ratings and documented reviews.
4. Maintain Updated Financial and Analytical Information – Prudent institutions with CRE and/or C&D concentrations maintain recent borrower financial statements, including property cash flow statements, rent rolls, guarantor personal statements, tax return data, and other income property performance information to better understand their borrowers’ ability to repay and overall financial condition and enable timely identification of adverse trends (also key inputs to stress testing). It is important for management to consider the continued relevance of appraisals and evaluations performed during prior economic or market and interest rate conditions, and update collateral valuation information as necessary.
5. Bolster the Loan Workout Infrastructure – Well prepared institutions ensure they have sufficient staff and appropriate skill sets to properly manage an increase in problem loans and workouts. Likewise, institutions that have a ready network of legal, appraisal, real estate brokerage, and property management professionals to handle additional prospective workouts are better situated for more positive outcomes.
6. Maintain Adequate Liquidity and Diverse Funding Sources – It is important for institutions to have a comprehensive management process for identifying, measuring, monitoring, and controlling liquidity and funding risks. Recent industry events have underscored risks related to relying on funding concentrations, such as high levels of uninsured deposits, and the importance of interest rate and liquidity risk management and contingency funding planning. Institutions that have identified appropriate levels of cash and cash equivalents, that have identified and are able to use a stable and diverse range of funding mechanisms, and that have identified and tested sources of contingent liquidity, are better positioned to profitably support CRE concentrations.

Of course, the FDIC’s publication contains more information than the above, but feel free to reach out to us on the hotline with any questions about it, or any questions you might have about the risk management in general. It’s not always easy to sift through a wealth of general guidance and determine how to best manage your particular situation. Compliance Alliance is here to help.

Liquidity Risk Management: Trying to Expect the Unexpected

As we close out 2023 and look forward to the new year we’ve been discussing risks. Last week we discussed the basics of asset and liability management (ALM). ALM can be thought of as a coin. Heads is managing interest rate risks. This week we flipped the coin and we got tails: liquidity risk. At the most basic level, liquidity risk is the risk that a bank will not have sufficient cash to meet its financial commitments in a timely manner. The past couple years have increased liquidity pressures with the competition for deposits heating up and tougher economic conditions, so how should you be thinking about reducing these pressures? It’s a matter of planning for the unexpected.

The first line of defense is a cushion of unencumbered liquid assets, also referred to as a liquidity buffer. The bread and butter of a liquidity buffer are marketable and liquid assets such as U.S. securities and short- term, investment-quality, and Federal Reserve deposits. These highly liquid resources can generally be sold or pledged at little or no discount and serve as a banking institution’s life vest, keeping the bank above water in a crisis. If you’re ever feeling a liquidity crunch, having a pool of these assets is the best way to avoid a shortfall and while that’s all well and good, you may be wondering how you should be setting this buffer in the first place. Assessing historical cash flow needs during normal business conditions is a good starting point. From there, the cushion could be set by forecasting expected or unexpected needs. The liquid asset buffer can provide liquidity a time of stress, complemented by secondary funding sources.

Part of forecasting future needs is evaluating your concentration of “non-core” deposits. “Core” deposits are the primary funding source for most community banks. These deposits are generally stable and lower-cost. “Non-core” refers to funding sources other than insured core deposits. Such funding sources are typically more expensive and less stable than insured core deposits. They may be difficult or more costly to replace. In the recent past, banks with concentrated positions in less stable funding sources have experienced more liquidity stresses.

Contingency funding plans (CFP) are vital. A CFP is a strategy to address unexpected liquidity shortfalls. Liquidity strains are often linked to multiple risks and a comprehensive and up-to-to date CFP navigate funding at a time when resources and attention are split between multiple fronts. To address the CFP deficiencies, regulators have suggested enhancing scenario testing, understanding asset encumbrance, and aligning the CFP with the risk profile and activities of the institution.

While you cannot expect the unexpected, you can plan for it. We have a liquidity risk management audit worksheetthat you may find useful in and a variety of useful tools in our Asset and Liability Management Toolkit.

Back to ALM Basics

One of the most challenging aspects of banking is the interconnected risks that must be managed. Bank leaders must weight changing economic conditions, interest rates, liquidity risks, customer demand, and the list goes on and on. All of these risks and decisions make up what we refer to asset and liability management (ALM). With ALM being a noted concern of regulators as we enter 2024, we thought a brief refresher was in store.

ALM is at a basic level the process of managing the risks that result when assets do not match liabilities. Interest rate changes and illiquidity can cause a mismatch between assets and liabilities that hinders the ability to pay debts as they become due. ALM helps to ensure that this does not occur. While it sounds simple enough we’ve all witnessed the havoc that poor interest rate management and deposit concentration and other liquidity risks can bring over the past year.

As an example of ALM, consider interest rates. As we have previously detailed, interest rate management is critical because rate changes are at risk of changing for a multitude of reasons. When interest rates vary, the present value of assets and cash flows change as well. Interest rate risk management is thus critical to bank stability.

Secondly, consider how customer behavior impacts operations. Usually customers will prepay their loans or withdraw their deposits without much advance notice, if any. These conveniences can inadvertently cause unpleasant surprises for the bank because at a large enough scale it can result in interest rate and liquidity risks. For this reason, it is important for banks to monitor customer behavior to react quickly.

So, how do banks manage all these interconnected risks? It’s probably too complex to fully summarize here but there are a few common elements of ALM approaches. First, banks need liquidity buffers to offset risks, such as unexpected withdrawals. Buffers typically consist of cash and dependable assets, like government bonds. Next, banks must understand customer behavior and the effects of any changes to their behavior. This can involve modeling assets, such as prepayment of loans, and liabilities, like customer withdrawals. Lastly, performing scenario analyses and stress testing will keep the bank abreast of its risk profile and that should be combined with regular monitoring.

ALM plays a crucial role in the industry as a framework for managing risks and ensuring long-term financial stability and maintaining safe and sound banking. Through responsibly managing assets and liabilities, it’s possible to mitigate interest rate and liquidity risk, while optimizing profitability. As you think about your ALM entering 2024 you may find our asset & liability management toolkit useful, including our ALM policy, and as always please reach out to our Hotline team for assistance.

Have You Thought About Interest Rates Lately?

To the average person interest rates aren’t given a second thought until you need to buy something. “Oh, we really need a new car but wow I didn’t realize rates were so high!” is a statement you might encounter out in the wild but to those of us in the banking industry, it is a top of the mind concern. While rising rates are often welcomed by banks as they can allow for margin expansion, there are challenges that can come with a rising rate environment and Silicon Valley Bank and other events earlier this year showcased that fact.

Effective interest rate risk management is an essential component of safe and sound banking practices and that is an opinion shared by our federal regulators. Interest rate risk was one of the top noted concerns of the OCC in its 2024 Operating Plan which we wrote about previously. Have You Thought About Interest Rates Lately? due to inflation, geopolitical concerns, and rescission worries. While interest rate risk modeling will continue to be a challenge, there are several practices you can incorporate to ensure that the range of interest rate risks and any exposures are well understood. The following are a few things to keep in mind as you think about your new year.

Due to the rate environment during the pandemic and now the rising rates of the last year, many institutions reduced the focus on down rate scenarios given the unlikely scenario of a negative rate environment. However, given the current rate environment, it may be beneficial for management teams to reinstate down rate scenarios in their modeling practices as inflation worries seemingly taper off. Additionally, management may want to consider the importance of running and analyzing alternative rate scenarios given the movement in rates experienced this past year.

Deposit assumptions typically have a significant impact on interest rate risk model results and should be a consideration as you revisit your models. Given the current deposit and rate environment, it may be a good time for management teams to revisit deposit assumptions, to ensure that they accurately reflect current and forecasted customer behaviors.

Given the difficulty of developing assumptions that are accurate for all scenarios, banks may want to consider placing more focus on sensitivity testing to ensure that the range of interest rate risk is well understood by management. Effective sensitivity testing includes isolating one assumption and ensuring that it is appropriately stressed to understand how it drives a range of interest rate risk results.

You do not want to be the person caught off guard by interest rates. The FDIC has some very helpful resources on interest rate risk that we’d advise looking over. As always, please feel free to contact our Compliance Alliance hotline team with any questions or concerns.

HMDA Headaches

Preparing your HMDA LAR can simply be described as “Tedious,” with a capital “T.” The ins and outs of HMDA are one of the most frequently discussed topics on hotline. The Federal Reserve recently released its top consumer violations for 2022 and unsurprisingly a whopping 59.4% of all violations involved inaccurate collection of residential mortgage data pursuant to HMDA. We want to make sure you avoid the most common pitfalls so the following is a rundown of the some of the most frequent violations and how to fix them.

The first noted issue was loan purpose, specifically reporting that a loan was a refinancing when it was really a cash-out refinancing, or vice versa. The regulation defines a refinancing as “a closed-end mortgage loan or an open-end line of credit in which a new, dwelling-secured debt obligation satisfies and replaces an existing, dwelling-secured debt obligation by the same borrower.” On the other hand, a loan is designated as a cash-out refinancing if it is a refinancing as defined previously and the bank considered it to be a cash-out refinancing in processing the application or when setting the terms. Thus, whether a loan is a cash-out refinance is a bank-level determination. It depends on your internal standards instead of a specific regulatory definition.

Another common reporting issue is income, which is also dependent on your internal standards. When you evaluate income as part of a credit decision, you report the gross annual income relied on in making the credit decision, so, if you rely on only a portion of an applicant’s income, you do not report the portion of income not relied on. For example, suppose an applicant has $100,000 of income: $80,000 from salary and $20,000 from commissions. The bank chooses not to rely on this applicant’s commission income because it has been earned for less than 12 months, so the bank does not include the applicant’s commission income and reports $80,000 as the income relied on.

Examiners frequently cited banks for not reporting covered loans made primarily for a business or commercial purpose. Often, the root cause of the violation was a misunderstanding of the HMDA exclusion of a business or commercial purpose loan. People mistakenly tend to think that any business purpose loan is excluded from HMDA reporting. To clarify the meaning, business/commercial purpose loans are excluded from reporting unless they otherwise meet the definition of a refinancing, home purchase or home improvement loan under HMDA. So, if you have a business applicant taking out a loan to make improvements to their rental property, it is a business purpose loan but it is a reportable business purpose loan.

Scoring models were another common hiccup. Examiners observed lenders reporting the scoring model by the name of the credit reporting agency, such as TransUnion, when the regulation requires you to specifically identify the name and version of the scoring model used to generate the credit score. For example, instead of reporting TransUnion as the credit reporting agency used, an institution could comply with the regulatory requirement by reporting “FICO Risk Score Classic 04.”

Keep the above in mind next time you’re tediously reviewing your LAR and please feel free to submit any questions to our Hotline team. Together, I’m confident we can bring down that 59.4% number.