By: Tommy Troyer, Executive Vice President

Concentrations of credit are certainly not a new risk for community banks, but for many banks they are an increasing challenge. While effective concentration risk management involves much more than we have room to discuss here, we would like to use this article to highlight a few timely considerations related to concentration risk management.

Growing Concentrations
We all know that, though we can calculate statistical averages for various measures across community banks, there is no “average community bank” in the real world. Each bank has its own unique combination of characteristics. However, concentrations of certain types of credit do seem to be increasing across community banks as average loan-to-asset ratios have been increasing and banks are, for the most part, still trying to stick to in-market lending and to loan types with which they have experience.

Continued regulatory emphasis on prudent concentration risk management practices, especially related to CRE, has been one result of these trends. One of the ways some banks have experienced this attention is to have examiners note a greater interest in measures of total CRE exposure, including owner occupied loans, as opposed to the more traditional measures of non-owner occupied concentrations described in the well-known 2006 interagency guidance on CRE concentrations. (This emphasis has been driven in part by the growing realization that the industry’s loss history on these two types of CRE loans has not been that different over the last decade.)

As a simple example of the growth in credit concentrations for community banks, I collected some data on commercial banks and savings banks in four Midwestern states (Ohio, Michigan, Indiana, and Illinois) with less than $2 billion in total assets. While we work with community banks nationwide and with some banks larger than this threshold, I thought this would be a sample of banks of interest to many of the readers of this newsletter. Of these banks, 700 met these criteria as of 2017Q3. I compared selected concentration levels for these banks to their levels five years earlier, as of 2012Q3.

• The number of banks with construction and land development loans totaling 100% or more of total capital doubled, though it certainly remains low at just 2% of the sample.
• The number of banks with non-owner occupied loans totaling 300% or more of total capital increased from 29 to 42.
• The number of banks with total CRE loans totaling 400% or more of total capital increased from 50 to 66.

None of the figures above total even 10% of the banks in the sample, but I have also chosen to test quite significant concentration levels. Our consulting work indicates that many more banks, which have chosen to set their internal concentration limits at more conservative levels than described above, are experiencing challenges as they near internal limits. This applies for both broad categories of concentrations, such as non-owner occupied CRE, and for more narrowly defined categories, such as hotels.

In some other cases, concentrations that banks have always understood were necessary given the community they serve have become more concerning. For example, many community banks operate in markets where agriculture is a dominant industry. Such banks have always accepted the risk associated with heightened ag concentrations, but continued challenging ag conditions have made such concentrations more of a concern in recent years.

Risk Management Considerations
The fundamentals of effective management of concentration risk are well-known, and can be found in a variety of regulatory sources. I will not rehash all of them here, though I do feel obliged to emphasize that concentration risk must be factored into capital planning and must be appropriately evaluated as a qualitative factor impacting the ALLL. I would also like to highlight a couple of trends in concentration risk management we have noted recently:

• Incorporating concentration considerations into strategic planning. Yes, detailed analysis of concentration risk and recommendations for concentration limits will likely be provided to the board by management. However, such limits should reflect the board’s risk appetite and desired strategic direction for the bank. It has been encouraging to me to hear in several recent strategic planning retreats thoughtful, forward-looking discussion about what the bank should look like in the future and what that means for the bank’s approach to credit concentrations.
• Incorporating a proactive approach to monitoring and managing relationship levels. We have seen an increasing number of clients take what can be described as a more proactive and sophisticated approach to monitoring and actively managing concentration levels. Instead of testing concentration levels quarterly and simply “turning off the spigot” when a limit has been reached, these banks incorporate a proposed loan’s impact on their concentration profile into their underwriting analysis. They also use their pipeline and runoff projections to forecast their various concentration levels in coming quarters, and then manage prospective and existing borrowers to maximize the quality and profitability of a given portfolio. This can help prevent, for example, a couple of marginally profitable and purely transactional deals that may be easy to “win” from crowding out prospective deals that can lead to profitable long-term banking relationships.
• Utilizing portfolio stress testing. Portfolio stress testing has long been a tool for evaluating concentration risk, but more community banks seem to be making efforts to implement forms of portfolio stress testing than ever before.
• Utilizing collateral valuation and collateral management. One important way of ensuring that downturns in an industry in which a bank has a concentration do not cause excessive losses is to have in place effective practices for both managing the initial valuation and assessment of the collateral (especially for real estate collateral) and for monitoring collateral on an ongoing basis. The ongoing monitoring of the status and value of collateral can be especially important for banks with ag concentrations. While we see plenty of good work done by banks in both of these areas, we would also note that these seem to be some of the most common areas about which we, and also often examiners, provide recommendations for improvements in practices.

Conclusion
Effectively managing concentrations of credit will remain important for as long as lending remains a primary source of income for banks (in other words, forever). Young & Associates, Inc. has assisted clients by providing portfolio stress testing services (both CRE and ag), loan reviews, and more targeted consulting focused on enhancing collateral valuation processes or credit policies. We also assist clients by facilitating strategic planning sessions that encourage the board and management to think about and plan for the future of the bank. This can result in a bank better defining its lending strategy and ensuring its lending approach is consistent with its overall strategy. To discuss this article or any of our services further, please contact Tommy Troyer at ttroyer@younginc.com or 330.422.3475.

By: Tommy Troyer, Executive Vice President

I have been writing about CECL in this newsletter and providing CECL educational programs to community banks for several years. The overall theme I’ve tried to communicate in all of these settings has been: CECL is manageable for community banks, but it requires planning and preparation starting now.

I’m quite encouraged by the fact that the second part of that message, about the need to actively prepare for CECL now, seems to have been accepted by the majority of community bankers. In this article, I will provide a brief overview of a few noteworthy recent developments related to CECL, as well as some brief comments on what we are seeing from banks with respect to CECL preparation.

Regulatory FAQs Updated
On September 6, 2017, the federal financial regulators released an updated version of the interagency FAQs on CECL that were first issued in December 2016. All CECL FAQs are being consolidated into one document, so the most recent release includes both questions 1-23 from December and new questions 24-37. The information conveyed in the new questions is broadly consistent with the things I have tried to communicate in my articles and in my teaching about CECL and contains no surprises. This lack of surprises from the regulators is, of course, a good thing. I specifically recommend the expanded discussion in questions 28-33 regarding the definition of a Public Business Entity (PBE), as the PBE definition is a FASB concept that is fairly complex. The definition is important to understand because institutions can be PBEs without being “SEC Filers,” and PBE status determines the effective date of CECL for an institution. Questions 34-36 also include some helpful and fairly detailed examples of how the transition to CECL should work for call reporting purposes for institutions in various situations with respect to PBE status and whether or not an institution’s fiscal year lines up with a calendar year.

These are helpful clarifications since non-PBEs do not need to adopt CECL for interim periods, only for the year-end financials, in the first fiscal year of adoption and because call reports are completed on a calendar year basis irrespective of a bank’s fiscal year.

FASB TDR Decisions
The final CECL standard has been in place and has been public for over 15 months at this point. CECL is not going to magically disappear before implementation, and there will not be substantial changes to CECL’s requirements. However, there are still some decisions related to CECL that are being made by FASB, specifically through its Transition Resource Group (TRG), which exists to help identify potential challenges to implementing the standard as written. The TRG met in June and a number of issues were discussed, though many of the issues discussed are unlikely to have an impact on the average community bank. However, several issues related to Troubled Debt Restructurings (TDRs) were discussed and ultimately clarified by FASB in September. These issues are relevant to community banks and are worth noting.
The first decision that community banks should be aware of is one that will generally be viewed favorably by community banks. The issue at hand is that CECL requires estimating expected losses over the contractual term of loans and states that the contractual term does not include “expected extensions, renewals, and modifications unless [there is] a reasonable expectation” that a TDR will be executed. The issue FASB considered was just how expected TDRs should factor into an institution’s allowance.

The options presented were, essentially, to estimate losses associated with some level of overall TDRs that you expect to have in your portfolio even though you don’t know on what loans these TDRs might occur, or to only account for expected TDRs when you reasonably expect that a specific loan in your portfolio will result in a TDR being executed. FASB chose the latter option, which should prove to be much more manageable for community banks.

The second decision that FASB made is one that might generally be viewed less favorably by community banks. The CECL standard, when released, seemed to provide more flexibility around measuring expected losses on TDRs than current rules, which requires a discounted cash flow approach unless the practical expedients related to the fair market value of the collateral or the market price of the loan apply. The CECL rules essentially said that any approach to estimating losses on TDRs that was consistent with CECL’s principles was acceptable. However, FASB ultimately decided that the cumulative requirements in the CECL standard and in existing accounting rules for TDRs require that all concessions granted to a borrower in a TDR be accounted for through the allowance. The brief summary of FASB’s decision is that, in fact, a discounted cash flow approach to measuring the impact of TDRs will still be required under CECL in any circumstance where such an approach is the only way to measure the impact of the concession (the best example of such a concession is an interest rate concession). The TRG memo dated September 8 and available on FASB’s website is a good resource for a more detailed discussion of the above issues.

What Community Banks are Doing
What are some of your peer community banks doing to prepare for CECL? There does of course remain a wide range of preparation and some banks still haven’t gotten started in any serious way. However, many banks have at least informally assembled the team that will work on CECL, and while not as many have adopted simple project plans as we might wish, many do at least have informal steps and deadlines in mind. Many have started giving thought to data availability and needs, though again perhaps not enough have yet gotten very serious about fully evaluating the data they have, how they will store and use it on an ongoing basis, and what additional data they would like to begin capturing. Nearly all banks have undertaken at least some educational efforts around CECL, and this is an area of focus that should continue through implementation and even beyond. Options for third-party solutions are being explored by some banks, though in order to make sure that an informed decision is made, it is critical that banks go into these explorations with a good fundamental understanding of CECL as well as with an awareness of the regulatory position that such solutions are perfectly fine options but are neither required nor necessary for CECL implementation.

How We Can Help
We have presented and will continue to present webinars, seminars, and talks on CECL. Please visit our website or call or email me for an overview of these sessions, which are specifically designed for the community banker and which are not designed to try to sell any particular software solution.

Additionally, we are ready and willing to work with banks in a consultative role on CECL. Like everything else we do, there is no fee associated with an initial phone conversation or email exchange about CECL, and if we can help provide you with clarity about something related to CECL, then we are happy to do so. We are of course also happy to discuss various approaches in which we might provide consulting support in one or more capacities to assist your institution in preparing for CECL.

To discuss CECL further, contact Tommy Troyer at ttroyer@younginc.com or 330.422.3475.

By: David Dalessandro, Senior Consultant

In the summer of 1987, the savings and loan I was working for at the time sent me to a “cash flow” seminar in Norman, OK. I had graduated from Penn State a few years before and had recently accepted my first of what would prove to be many positions in banking as a credit analyst. At that point, my experience at financial analysis was limited to what I had absorbed from two accounting firms I had worked for and studying for (and passing) the CPA exam. The seminar topic was “The Implications of FASB 95.”

FASB 95, for those of you asking, was issued in November 1987 and was to be utilized in all financial statements finalized in fiscal years ending after July 15, 1988. The requirement replaced the famous APB 19, Statement of Changes in Financial Position, which we all knew and loved as a pretty worthless financial statement at the time, because no one without a CPA attached to their name understood it, and most CPAs had difficulty explaining it.

The seminar turned out to be one of the most beneficial events in my life. As it was explained, the Statement of Cash Flows, as required by FASB 95, was a financial disclosure that would trace every dollar of cash through an accounting period. How awesome, I thought, because only cash pays back loans. So now if I have a tool to trace every dollar of cash, credit analysis would be a cinch.

Well, fast forward 30 years…and the Statement of Cash Flows is still not a household name in Credit Analysis. Most financial institutions, even the largest, still hang onto EBITDA for “cash flow” or multiples of EBITDA for “value.” The EBITDA analysis may approximate real cash flow for real estate rental properties, but for those thousands of enterprises that carry Accounts Receivable, Accounts Payable, Inventory, Other Assets, and Other Liabilities, pay distributions, report gains and losses on sales of assets, take charge downs on intangibles, write off bad debts, and enter into other “non-cash” transactions, the Statement of Cash Flows is the only real way to “follow the money.”

The question here is, why would any financial institution NOT at least include FASB 95/UCA in cash flow analysis when it was appropriate? EBITDA, or even EBITDA adjusted for one-time items, may give the analyst an estimate of total cash flow, but true operating cash flow can only be obtained from a properly and timely prepared Statement of Cash Flows. The Statement separates the movement of cash into three primary categories: Operations, Investment, and Financing. From a bank or financial institution standpoint, if there is positive cash flow from the Investing segment or from the Financing segment, then the enterprise is selling assets or obtaining more loans or selling stock in order to make its loan payments. Are those sources sustainable? Are those sources where you want your customer to come up with the funding to make your loan payments? Is the quality of cash flow from Investing or Financing equal to that of Operating Cash Flow? Probably not. But if the cash flow from operations is positive, and it has been positive for a number of years and it is sufficiently positive to fund all loan payments, then that should be a sustainable source of cash flow far into the future. If the Operating Cash Flow is positive enough to fund loan payments, pay distributions/dividends, AND fund capital expenditures, then that enterprise is more than likely to enjoy a very strong financial condition with relatively easy debt coverage.

If your underwriting protocols do not include UCA/FAS 95/Statement of Cash Flow analysis, then you risk being surprised when a borrower who had “good” EBITDA coverage shows up past due or comes to you needing more money. Use this tool in conjunction with your standard analysis and it will enable you to rethink loan structures where the expected cash flows do not match up.

If you would like to discuss incorporating UCA/FAS 95/Statement of Cash Flow analysis in your institution, please contact me at 330.422.3487 or ddalessandro@younginc.com.

By: Bob Viering, Senior Consultant

In our loan review practice, we have an opportunity to work with ag banks throughout the Midwest. In general, our findings are similar to what you may have read from many ag economists. Working capital is dwindling quickly, and the debt to asset ratio is increasing as is short-term debt. Many banks have been refinancing intermediate- and long-term assets to fix working capital declines and carryover debt. Some borrowers have sold land to reduce debt. We have seen many instances where borrowers have been able to reduce input costs and, most importantly, cash rents to bring them back to the point where they are either producing positive debt service coverage or are coming much closer to positive debt service coverage than they were in 2014. But overall, balance sheets are weakening and repayment is a continuing challenge. Credits that were barely a pass credit in better times have, in many cases, dropped to Special Mention or Substandard. Solid pass credits from a couple of years ago are now one weak year from a criticized level.

For many bankers, having struggling ag borrowers is a relatively new experience. I have more recently been through the experience in working with struggling ag borrowers while working at a western bank that had many cattle ranches that were severely impacted by low cattle prices and drought conditions. Many of the lessons learned there are just as applicable to the situation many of us face here in the Midwest.

As you head into renewal season, here are a few items to consider:

1. Complete information is critical. There is an old Russian proverb, “Trust but verify.” This is good to keep in mind when analyzing your borrower. As things get tougher, there is a temptation by some borrowers to not include every liability or to see some liabilities as something not worth mentioning. When short-term borrowing gets tougher, some borrowers will turn to using the local co-op for some inputs, borrowing from family and friends, or using online lenders (FinTech has hit agriculture too) or credit cards. At renewal time at our bank, we would send out a renewal package that had not only financial statement requests but a complete debt schedule form and inquiry about other loans or bills from any source, including family. We ran a new credit bureau report and compared it to prior ones to see if any new credit card or other type of debt was taken out since the last renewal and looked for any significant increases in balances, especially on credit cards. We completed a new UCC search for the same reason. In the end, we wanted to be sure that all debts were accounted for and had a source of repayment.

2. Restructure only if it helps. Often we see banks terming out any carryover debt or being quick to term out short-term debt to improve working capital. Before you restructure debt, make sure the underlying problem is fixed. Carryover debt usually occurs because the farmer didn’t make enough from crop/livestock sales to pay all term debt, operating lines, and living expenses. Given that revenue isn’t likely to grow in the next few years, improving cash flow is about expense control. Has the operation cut input costs, cash rents (this is the big one), and living costs to a level they can produce enough profits to cover their debt payments and family living? If so, then they are a perfect candidate for a restructure. If those tough choices have not been made and the operation won’t operate profitably, then you are likely to find yourself with even more carryover, more debt, and far fewer options not far down the road.

3. Income taxes may become an issue. Section 179 deductions were very helpful to reduce/eliminate income taxes in the past. But with far fewer pieces of equipment being purchased, those deductions have decreased significantly. Prepaying expenses and holding over grain sales can put off taxes for a while but, at some point, the timing can get tougher and some operations will now show taxable income when their accrual earnings may be negative. Those tax payments are often not planned for and can create a significant cash outflow at exactly the wrong time. It’s important that you encourage your borrowers to work with their tax professionals to plan as far ahead as possible to minimize any tax consequences.

4. Be empathetic and be realistic. Many of your borrowers were on top of the world a few short years ago. Everything they did went well and equipment dealers (and friendly bankers) made expansion with few tax consequences a reality. With today’s reality of weak (if any) earnings and less ability to add debt, it has become a very stressful time for many farmers and their families. It’s a lot tougher to be a banker too. Good bankers help their customers succeed. It’s not always easy and it’s often stressful, but letting customers operate unprofitably and not trying to help them make tough decisions usually only makes the problem get worse. It’s so important to be empathetic with your borrowers and to have a thick skin when they get mad. They may seem like they’re mad at you when they are really frustrated about their current situation. However difficult the conversation may seem today, it’s a far easier conversation than to have to tell someone that they have to quit farming and start over.

Ag lending is a key part of many banks’ loan portfolios and is important to their local market. Even in these tough times, it’s critical to work with your customers and do all you can to help them succeed. At Young & Associates, Inc., we work with many banks with ag portfolios. If we can help you with your loan review, policy reviews, process/underwriting reviews, and improvement plans, give us a call at 1.800.525.9775 or send an email to bviering@younginc.com.

By: Tommy Troyer, Executive Vice President
A look back over recent issues of the 90-Day Note, or a more general scan of industry news and regulatory comments, would reveal the industry’s focus on underwriting standards and possible industry-wide changes in underwriting standards over the last several years. As we have noted previously, for any individual community bank, the important consideration is not simply how conservative or liberal underwriting standards are or whether underwriting standards are loosening or tightening. Instead, the question that is critical for the ultimate health and profitability of the bank focuses much more on whether underwriting standards, and any changes in underwriting standards, are accurately understood and monitored, consistent with an institution’s risk management capabilities, and regularly assessed to ensure that the risk/return calculus and the institution’s level of capital are appropriate for the loan portfolio’s characteristics.

The above considerations, as well as overall industry trends in risk appetite and underwriting standards, are quite naturally of interest to regulators as well. In addition to other regulatory tools (such as loan officer surveys) for measuring underwriting standards, the OCC has launched within the last year an initiative to try to standardize and collect assessments of underwriting practices during safety and soundness examinations. We have heard OCC leadership discuss this initiative at banking conventions and have heard from clients who have had OCC safety and soundness exams over the last year. While the OCC’s overall approach to assessing underwriting can be informative or, at the minimum, a great reminder of critical factors for controlling credit risk, our intention here is to highlight an aspect of controlling underwriting standards and credit risk that should not be, but sometimes is, overlooked: the role of credit policies.

The Important Role of Credit Policies
Credit policies represent perhaps the most important tool for the board of directors and bank management to define underwriting standards and credit risk appetite. While it can be appropriate for some details of underwriting criteria to be maintained outside of formal loan policy, it is not appropriate or effective to employ an overly generic credit policy that provides little specific detail about the characteristics of credits the institution desires to originate. The OCC’s assessment of an institution’s underwriting considers the range of important factors one might expect (for example, loan structure, presence of appropriate covenants, etc.). Importantly, this assessment also extends to whether loan policy provides enough detail and information to control these important characteristics of credit underwriting. Without a policy that defines the bank’s limits on factors such as amortization periods, collateral advance rates, etc., underwriting standards can loosen and credit risk can grow without the intention or even the knowledge of the board. An appropriately detailed policy sets limits on the extent of any loosening that might occur and, assuming exception tracking and reporting is effective, allows for the board to receive better information about any changes in underwriting quality.

Some institutions try to avoid having too much specificity in policy because they do not want to create too many policy exceptions or provide examiners or auditors with more opportunities to “catch” them in violation of their own policy. There certainly is such a thing as a policy that is too specific or detailed to be effective, as at a certain level of detail it is not possible for lenders and analysts to actually know or easily find all of the policy requirements. However, it is also important to recognize the risks that come with overly generic policies, primarily, the inability to effectively control the terms of credit extended and the possibility of regulatory concern about the bank’s effectiveness in defining risk appetite and controlling risk.

The amount of detail is certainly not the only factor that determines the effectiveness of a credit policy. The content of the actual details certainly matters (a well-defined minimum debt service coverage ratio of 0.75 and maximum collateral advance rate against work-in-process inventory of 150%, for two extreme examples, are specific but do not effectively control credit risk). The organization and consistency of policy also matter, as a credit policy can only be effective if it is a usable tool for lenders and credit personnel.

Many credit policies at community banks have been in place for a long time, with small or ad hoc updates put in place as needed. Young & Associates, Inc. offers a policy review service that takes advantage of our exposure to the credit policies of many community banks around the country to evaluate the adequacy of a bank’s policy and to make recommendations for enhancements. We will not tell you what your risk appetite should be, but we can and will assess the content of your policy against regulatory expectations, compare your specific risk limits to what is common across the industry so that you can have better information about where your risk appetite stands relative to peers, and evaluate the effectiveness of your policy’s layout, language, and internal consistency.

If you would like to discuss the importance of credit policies or believe your institution may benefit from a policy review, please contact Tommy Troyer at ttroyer@younginc.com or 1.800.525.9775.

By: Debra Werschey, Consultant and Manager of Secondary Market Services

In determining whether there is a significant defect on a loan, the quality control reviewer must give due consideration to the severity of the defect. In addition, the defect must relate but not be limited to one of the following:

1. The underwriting of the borrower’s creditworthiness and capacity. This would entail the borrower’s income, credit, liabilities, and assets.
2. The borrower’s eligibility and qualification. Things to consider are the area median income, first time home-buyer status, and status as lawfully present in the United States.
3. The underwriting criteria related to property or project eligibility. Is the property for residential use or condo eligible?
4. The property appraisal or the physical condition of the property. A close examination of the property appraisal is required. Are the comparable sales similar to the subject?
5. The loan and product terms and criteria. Criteria such as LTV ratio, occupancy, credit score, and loan purpose must be reviewed. The terms for ineligible transaction types, products that may require special lender approval as a prerequisite for delivery, limitations on cash out to borrowers that determines the type of refinance, and any negotiated exception or variance must be considered.
6. The requirements applicable at the time of loan purchase. This would include making sure that there are no defaults, all taxes and insurance premiums have been paid or escrows established, and no modification, encumbrance, subordination, or release of mortgage has occurred.
7. The existence, sufficiency, or enforceability of any required insurance or guaranty. The property must have sufficient hazard insurance coverage in place.
8. The form and/or execution of required loan documents that without which made the loan ineligible for sale or limit the enforceability of the required loan terms. The file must contain the Uniform Residential Loan Application,
any power of attorney used, and any nonstandard and special purpose documents such as living trusts.

All of the above factors and more should be taken into consideration when a reviewer is completing a post-closing quality control review to identify defects. Young & Associates, Inc. is a trusted provider of mortgage quality control reviews and can assist your bank in this area. For more information on our quality control services, contact me at 1.800.525.9775 or click here to send an email.

Loan Review Observations and Recommendations for Effective Risk Management

By: Tommy Troyer, Executive Vice President

Over the recent past, there have been a number of public assertions, warnings, or observations that credit risk is rising in the banking industry. These statements have come in many forms, and while we do not intend to present an exhaustive review of such statements here, it is easy to present a brief list showing the various forms and messengers: ƒƒ

• Public Comments by Regulatory Officials: Thomas Curry, the Comptroller of the Currency, devoted his speech to the RMA Annual Risk Management Conference in November of last year to evidence that credit risk was rising and to the need for the industry to respond with appropriate risk management tools and ALLL decisions. Similarly, at the Ohio Bankers League’s CEO Symposium in May, Julie Blake, Assistant Deputy Comptroller, shared with attendees that credit risk had moved to the top of the OCC’s risk priorities and provided some evidence of increases in risk appetite over recent years.
• Formal Regulatory Publications: This category includes issuances of regulatory guidance, such as the December 2015 CRE guidance (discussed in a previous 90-Day Note) that was issued not to provide new guidance to banks but simply to highlight what regulators believed to be increasing risk in the CRE space and to remind banks of risk management expectations. This category also includes more informational publications, such as the OCC’s Semiannual Risk Perspective, which has been highlighting some increases in credit risk recently.
• Private Sector Commentary: Any bankers who may be inclined to brush off such regulatory comments as simply arising from regulatory conservatism should pay special attention to comments about credit risk originating from bankers themselves. The July-August edition of the Risk Management Association’s RMA Journal includes an article written by a banker and quoting numerous other private sector risk executives about their feelings that credit risk has likely increased and that heightened diligence on the part of banks is needed to appropriately manage that risk.

Ultimately, all of these comments are based on observations that underwriting standards have loosened and concentrations of credit may be increasing. Unlike typical asset quality measures that provide lagging indicators of credit risk (such as nonaccrual or charge-off rates), underwriting standards can provide a leading indicator of changes in credit risk.

Loan Review Observations
Given these industry-wide observations, what does the situation look like for community banks? Our contribution to this topic is primarily anecdotal, and is based on observations gleaned from the independent loan reviews we perform for community banks. While it must be acknowledged that the diversity of community bank practices and circumstances means that no generalization will apply to all community banks, our anecdotal observations would seem to support the belief that credit risk has risen in recent years. For our community bank clients, the loosening of credit standards is actually less evident in changes to formal underwriting standards (in part because community banks often do not employ as detailed of a set of underwriting standards as larger banks) and more evident in the decisions banks are making on what might be described as “borderline” credits. In other words, our clients have not slashed their required minimum debt service coverage ratios or FICO scores as much as they have begun saying “yes” a little more often on deals that could go either way. Healthy debate in credit committees is important and should be encouraged. One interesting piece of information for banks to consider is whether more deals have recently been approved in credit committee by a split vote rather than unanimously, which may indicate that banks are saying yes to a few more “on-the-fence” deals than they have historically.

Closely related to the concept of approving the borderline deal, and an issue commonly discussed by regulators, is the increase in loans approved with one or more exceptions to loan policy. Making commercial loans on a non-recourse basis is perhaps the classic community bank commercial credit policy exception, and these types of deals may well be increasing.

Other examples of increasing risk include an increased willingness to finance start-up ventures or significant expansions of current businesses and, in some cases, a reflection of the eased CRE terms referred to in the aforementioned 2015 regulatory guidance, such as longer interest-only payment periods. Especially in more urban markets or markets where larger banks are active, competition is undoubtedly a major factor in some of these developments, as banks unwilling to make any concessions on terms or price today can quite quickly find themselves with a shrinking loan portfolio.

What Should Community Banks Do?
Young & Associates recognizes, as do most community banks, that an increase in risk appetite is not necessarily a bad thing. However, an increase in risk appetite that is not matched by a corresponding increase in risk management is a bad thing. So how should community banks ensure that any loosening credit standards now do not result in major issues later? The following actions are a good start:

• Monitor and report to the board forward-looking measures of asset quality. If a bank’s appetite for credit risk is increasing, it should be because of a conscious decision of the board. It should not be something the board discovers several years later when asset quality problems begin to manifest. Forward-looking measures are key to monitoring changes in credit risk before it is too late. Such measures include reporting on the rate of policy exceptions (including loans with multiple exceptions); tracking loan performance by vintage, which can provide an early warning when the performance of a recent vintage early in its time on book is notably weaker than that of previous vintages; and even a measure as simple as monitoring the rate of loan growth compared to peers.
• Enhance risk management practices. At a time when credit risk may be increasing, banks should be sure that risk management practices are also heightened. In such a situation, it may be appropriate to increase the scope of independent loan review so that a greater percentage of credits, and especially new originations, are reviewed.  Steps to quantify risk, such as stress testing higher-risk portfolios or portfolios that represent concentrations, are even more important at times of increased risk. And personnel should not be overlooked: increased volumes of higher-risk loans without a corresponding increase in the credit staff’s capacity may be a recipe for trouble.
• Ensure that capital planning factors in any increases in risk. As noted, a measured and controlled increase in the credit risk a bank is willing to accept can be a positive for its shareholders and community. For this to be true over the long term, however, the bank’s capital planning process must appropriately account for this increase in risk. Regulatory minimum capital ratios are but a small part of capital planning, and capital planning can only be effective when it is sensitive to changes in a bank’s risk profile. Banks must ensure that their capital planning process accounts for changes in risk across the bank and that they are able to effectively identify such changes.

Conclusion
We have not seen from our clients (nor do we expect to see) the type of extremely risky loans that people write books and movies about in the aftermath of a credit crisis.  However, there is anecdotal evidence to support the widely-held belief that credit risk in the banking sector is higher than it was a few years ago. It is crucial that banks effectively identify and manage any such increases.  Young & Associates, Inc. can assist banks in both identifying and managing credit risk. Contact Tommy Troyer at 1.800.525.9775 or click here to send an email to discuss loan review, stress testing, or capital planning services.

By: Debra L. Werschey, Consultant and Manager of Secondary Market Services

Banks and other financial institutions face increased focus on quality control of the loan origination and closing process.

Lenders’ quality control programs are more important than ever. Our Quality Control services help ensure your quality control program is effective in meeting Fannie Mae, Freddie Mac, HUD, FHLB and other investors’ requirements and in mitigating post-purchase risk.

With Young & Associates, you have a trusted partner for quality control outsourcing.

Why Outsource Quality Control?

Outsourcing quality control to Young & Associates allows lenders to correct loan processes, help mitigate loan file errors, and obtain data to develop quality control solutions.

By outsourcing the quality control (QC) process, it’s easier for banks—particularly community banks—to navigate new regulations and optimize their internal resources (time, staffing, and expertise).

Additionally, when you outsource and shift the QC workload to us, you can achieve high-quality results at a lower cost to your organization.

Increasing Industry Regulation

Fannie Mae and Freddie Mac and other mortgage investors demand higher loan quality standards from lenders who want to sell their loans to them.

As the mortgage industry struggles with the best ways to incorporate QC processes into a qualified mortgage (QM) world, be prepared. Recent financial history has shown that this trend of increasing regulation is likely to continue. Help control your risks by outsourcing quality control related to regulatory requirements.

Benefits of Quality Control Outsourcing

Organizations with a commitment to quality control recognize quality begins before an application is taken and continues throughout the entire mortgage process.

By outsourcing quality control to Young & Associates, you get oversight and assistance with:

• QC Plan Development
• QC Reviews – approved, denied, and defaulted loan files
• FHA Branch Audits
• FHA/VA Denied Loan Review
• Pre-Closing Reviews Reverse Audits

Why Choose Young & Associates for Quality Control Outsourcing

We’ve developed our strong reputation through consistently providing quality services, assuring our clients the highest level of professional service available today.

Through our QC outsourcing services, you benefit from our comprehensive and extensive knowledge of the mortgage industry. We work diligently to keep apprised of the regulatory requirements.

Committed to Your Success

Young & Associates has provided education, outsourcing, and a wide variety of consulting services to community financial institutions since 1978. We are committed to your future success and look forward to assisting you.

To learn more about quality control outsourcing for mortgage compliance, call 1.800.525.9775 or contact us online.

By: Tommy Troyer, Executive Vice President

Those who have been following the Financial Accounting Standards Board’s (FASB) nearly decade-long effort to revamp the accounting rules impacting the recognition of impairment on financial assets (and thus how community banks determine the level of their ALLL) have heard for years that the project was nearing completion. While the project has indeed been moving forward over all these years, the anticipated date of finalization has been repeatedly pushed back. However, this time really is different: on April 27, FASB voted to direct FASB staff to prepare the final draft of the proposed update for a vote by written ballot. FASB hopes for the standard to be formally approved by June 30, but any delays beyond that point should be minimal as FASB has clearly reached a level of comfort with the current draft language.

The new approach to loss recognition is known as the CECL, or Current Expected Credit Loss, model. It represents a significant change to current practices, with the heart of the change being that the ALLL should cover expected lifetime losses on held-to-maturity loans and most other financial assets, rather than simply covering “probable” losses that are deemed to have been “incurred” as of the balance sheet date. In simplified terms, this means that the foundation of the ALLL estimate for community banks will not be an estimate of losses over the next year but will instead be an estimate of all losses expected over the life of the loans held on the balance sheet as of the date of the ALLL calculation. Additionally, the standard requires a forward-looking aspect, as institutions must consider the impact of “reasonable and supportable forecasts” on their loss estimates.

FASB also decided on April 27 to delay the implementation date of CECL by one year from the implementation dates originally determined in November. This means that CECL will need to be implemented in the first fiscal year following December 15, 2019 (2020 for banks with January-December fiscal years) for banks that are “SEC-filers,” and in the first fiscal year following December 15, 2020 (2021 for January-December fiscal years) for banks that are not “SEC-filers.” Early adoption beginning in the first fiscal year following December 15, 2018 (2019 for January-December fiscal years) is permitted.

The Balancing Act: Prepare, but Don’t Panic
The proper approach for any community bank is to attempt to find a balance between complacency about CECL and panic about CECL. Complacency about CECL (including believing that the extra year FASB provided before implementation means an additional year before a bank needs to start preparing) will lead to issues down the road. The methodology and data used to estimate the allowance under CECL will need to be meaningfully different from what banks use today, and as such, preparation to collect data and develop a methodology should begin now. Banks should understand that nearly all community banks base their current ALLL methodology on data that measures net charge-off rates on a monthly, quarterly, or annual basis. Such data does not describe lifetime loss rates, however, which is what is needed to comply with CECL’s lifetime expected loss standard. Thus, some basic data collection and evaluation efforts should begin now, in part to allow some time to accumulate the data needed by the implementation date.

At the same time that banks recognize the need to begin preparing, they need to also recognize that CECL does not represent any reason to panic. CECL will require some additional work for an effective transition, but it is not an existential threat to any community bank. We believe that some of the most extreme concerns discussed publicly in recent years about CECL and the complexity of approach it might require were overstated, given comments from FASB, financial regulators, and the wording of the 2012 draft Accounting Standards Update. All of these sources emphasized that the approach used by an institution should be appropriate for that institution’s size and complexity. However, the most recent draft released by FASB does represent a notable improvement in the clarity with which this fact is communicated: community banks will not be expected to use unduly complex or expensive approaches. Further, it seems that in every opportunity financial regulators have to speak about CECL, they emphasize that they intend to tailor their expectations for approaches to the size and complexity of financial institutions. Regulators have also repeatedly noted that they do not believe that a community bank will need to purchase an expensive software solution or vendor model in order to comply with CECL.

The Path Forward
At this point in time, banks have all of the information about CECL that they could need to develop a project plan for the transition. Such a plan should incorporate all relevant areas of the bank (for example, in many community banks the IT area will need to provide support with data gathering and warehousing), and updates on progress should regularly be provided to the board or a committee thereof. Evaluating the adequacy of existing credit risk data and planning to improve its collection and storage should be a high priority. Data should be collected in a way that allows institutions to measure lifetime losses and to understand the most important drivers of risk that impact loss rates.

Young & Associates, Inc. is closely following CECL and what it means for community banks. We have presented and will continue to present educational offerings on CECL through various state banking associations. We are also prepared to provide consulting services to help assist community banks in the preparation process. This can include helping banks understand the types of methodologies that can be acceptable means of estimating lifetime losses under CECL and the types of data that will be needed to support such methodologies.

To discuss CECL further, contact Tommy Troyer at 1.800.525.9775 or click here to send an email.

By: Tommy Troyer, Senior Consultant and Loan Review Manager

Over the last several months, it has become increasingly difficult to miss the fact that the federal regulatory agencies (the FDIC, Federal Reserve, and OCC) believe that credit risk is on the rise across the banking industry and particularly within Commercial Real Estate (CRE) portfolios. While industry-wide developments are of course not necessarily reflective of the situation of any single bank, it is the case that regulatory concerns about building credit risk in CRE portfolios makes it more likely that your bank’s CRE policies, underwriting, and portfolio management will be closely scrutinized in your next safety and soundness exam. Note that in this context, CRE refers to what are sometimes called non-owner occupied commercial real estate loans: loans for which the sale of the property, take-out financing, or third-party rental/lease income are the primary sources of repayment.

Recent Comments on Increasing CRE Risk
On December 18, 2015, all three federal bank regulatory agencies issued the interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, an existing guidance on CRE lending. In fact, the statement itself contains no new guidance or regulatory expectations. Its purposes, instead, appear to be to “remind financial institutions of existing regulatory guidance on prudent risk management practices” for CRE and, perhaps more importantly, to highlight the belief that credit risk in CRE portfolios is increasing and must be carefully monitored and managed. The guidance highlights several reasons to believe that CRE portfolios may experience some strain over the next several years. These include both market factors (historically low capitalization rates are cited) and findings from recent exams (easing of underwriting standards along several dimensions, increasing frequencies of underwriting policy exceptions, and insufficient monitoring of market conditions).

The new interagency statement is far from the only suggestion of increased concern regarding the CRE market. The OCC’s Semiannual Risk Perspective for Fall 2015 cites easing underwriting standards, increasing CRE concentrations (especially in multifamily), and for community banks, strong growth in CRE lending as possible risks. The December 2015 – January 2016 RMA Journal includes the final installment of the publication’s annual rundown of “Today’s Top Credit Risk Issues.” Multifamily lending makes the list, suggesting that the Risk Management Association, a respected industry group unaffiliated with any financial regulators, also sees notable risk in the CRE market.

The fact that the CRE market remains competitive in many areas, combined with low interest rates, has thus far meant that several traditional but lagging indicators of credit risk (for example, delinquency and non-accrual rates) have not yet shown signs of weakening. Nonetheless, as has been demonstrated in past credit cycles, the risk factors cited above can often lead to increases in credit risk that do eventually result in deteriorating asset quality and increasing charge-offs.

Prudent CRE Risk Management for Community Banks
The good news is that the keys to effectively managing risks in the CRE portfolio are not mysteries and are achievable for any disciplined and committed community bank. The recent interagency statement provides a good summary. It notes that, in part, banks that successfully manage CRE risk:

• Establish and adhere to appropriate policies, underwriting standards, and concentration limits
• Conduct accurate cash flow analysis on the project, borrower, and global levels at underwriting and on an ongoing basis
• Effectively monitor market developments (supply and demand, vacancy and rental rates, etc.)
• Implement appropriate appraisal review and collateral valuation processes

In addition to the factors described above, two additional critical features of CRE risk management, CRE Stress Testing and Independent Loan Review, are mentioned. These processes can be performed internally by community banks, but due to resource and other constraints may be both more efficient and more effective if outsourced.

Stress Testing the CRE Portfolio
The interagency statement notes that “market and scenario analyses” that “quantify the potential impact of changing economic conditions on asset quality, earnings, and capital” are an important aspect of CRE risk management. This is a reference to stress testing the CRE portfolio. Further, the 2006 interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices states that any institution with a CRE concentration “should perform portfolio-level stress tests.” Even if your bank does not meet the concentration thresholds defined in the 2006 guidance for identifying institutions with “potentially…significant CRE concentration risk,” stress testing the CRE portfolio can have a number of important benefits. By quantifying the impact of several adverse scenarios on asset quality, earnings, and capital, a CRE stress test can inform your bank’s strategic and capital planning processes, your internally established credit concentration limits and practices, and your credit policy and underwriting requirements.

Young & Associates, Inc. offers a CRE Portfolio Stress Testing service that provides an insightful and efficient stress testing solution. Our service uses data specific to your bank’s portfolio to stress your CRE portfolio across several factors. Our report will assist in quantifying the possible impact to earnings and capital that could result from decreases in collateral value, property net operating incomes, or increases in interest rates. In the current environment in which interest rate increases are likely over the next several years and decreases in collateral values are at least a distinct possibility, understanding your bank’s possible exposure is key to maintaining a safe and sound bank and demonstrating effective risk management to your examiners. Our CRE Stress Testing service is performed remotely, meaning that no travel expenses are associated with the service. More importantly, once the project has been discussed and you have provided a response to our initial data request, bank management can remain free to work on the many other initiatives that require attention, while we make use of our existing systems and expertise, making the stress testing process an efficient one. Our service includes a detailed report documenting the results of the stress test and, if desired, a phone presentation of the findings to management or the board.

Independent Loan Review
An effective independent loan review function is critical to assessing asset quality in the CRE portfolio, determining the accuracy and effectiveness of both underwriting and the ongoing monitoring of CRE credits, and identifying whether exceptions to credit policies or underwriting standards are being appropriately identified and approved by the bank. Any issues identified by loan review can be proactively addressed by the bank, helping to ensure risk mitigation is in place before the issues are identified by examiners or are revealed by deteriorating asset quality.

Most community banks find that their size and the requirement that loan review be performed by a qualified, independent party means that outsourcing loan review is the best option. Young & Associates, Inc. has extensive experience providing loan reviews for community banks. Our loan review of a sample of your CRE portfolio may identify individual credits of concern, but more importantly, will provide perspective regarding whether your credit standards, credit analysis, and ongoing monitoring of existing credits are adequate for the nature of your CRE portfolio. In this way, our findings not only inform management and the board about existing risks in the portfolio, but provide recommendations for effectively managing that risk. We can perform loan reviews on-site or, if your technological capabilities allow, remotely, allowing you to reduce or eliminate the travel expenses associated with the loan review.

For information regarding Young & Associates, Inc.’s CRE Stress Testing service, please contact Kyle Curtis at 1.800.525.9775 or click here to send an email. For information regarding Young & Associates, Inc.’s Independent Loan Review service, please contact Tommy Troyer at 1.800.525.9775 or click here to send an email.

By: Tommy Troyer, Consultant and Loan Review Manager

In “Agencies Issue New HELOC Guidance,” published in the August 2014 issue of the 90 Day Note, we presented an overview of what was at that time brand new safety and soundness guidance for HELOC portfolios (Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods). We also presented a few practical steps for community banks to consider in order to address the issues raised in the guidance. As a brief reminder, the guidance was issued by the regulatory agen­cies to encourage financial institutions to properly manage the risk associated with HELOCs that were reaching the end of their contractual draw period. The draw pe­riod is the time during which the borrower has access to the line of credit feature of the HELOC. Minimum monthly payments during this time can be quite low, in many cases interest-only. When the draw period ends, HELOC structures either require a transition to payments that amortize the outstanding debt over a defined number of years or require a balloon payment to repay the outstanding balance in full. The risk associated with this transition is that the borrower will experience a “payment shock” because the terms after the draw period ends can require significantly higher minimum monthly payments than were required during the draw period. Higher monthly debt service, all else equal, increases the risk of delinquency and default.

It was the potential for payment shock risk associated with end-of-draw HELOCs, coupled with the fact that across the industry the peak of HELOCs reaching end-of-draw was expected to occur from 2014-2017, that prompted the interagency guid­ance. We are now about a year down the road from the issuance of the guidance, and the idea of elevated risk embedded in some HELOC portfolios continues to receive regulatory, media, and analyst attention. We wanted to briefly revisit the issue to point out two important facts for community banks with HELOC portfolios. First, the avail­able evidence is suggesting that regulators and bankers were right to worry about payment shock risk, as borrowers who have reached the end-of-draw period thus far have demonstrated, in the aggregate, the intuitively expected decline in timely pay­ments. Secondly, it is important to note that it is not too late to take important steps to help mitigate end-of-draw risk.

End-of-Draw Performance Thus Far
Aggregate data on HELOC and mortgage delinquencies does not demonstrate any notable increases that we can attribute to end-of-draw risk. However, one needs to dig deeper to measure the issue with any accuracy, primarily because end-of-draw HE­LOCs still represent a relatively small share of the overall mortgage market (and even the HELOC market), and any increases in delinquency due to end-of-draw payment shocks can easily be masked by the overall improvements in mortgage delinquency rates associated with continued economic improvement and continued progress in most states in working through foreclosure backlogs (which reduces the number of long-term, seriously delinquent loans and improves overall delinquency rates).

Several more specific pieces of data on end-of-draw risk are worth noting: