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The importance of appraisal reviews in protecting financial institutions

Written by admin on . Posted in Blog, Risk Management.

By Casey Simpson; consultant and manager of appraisal review services, Young & Associates

In the real estate industry, accurate and unbiased property appraisals are critical. These influence lending decisions, investment strategies, tax assessments and legal outcomes. Appraisal reviews are a safeguard for financial institutions, investors and the public. Additionally, the regulators outlined this process as a requirement.

Accurate and unbiased property appraisals drive critical decisions in lending, investment strategies, tax assessments and legal outcomes. Appraisal reviews provide safeguards for financial institutions, investors and the public, and regulators mandate the process.

Although appraisal value thresholds have changed over time, the obligation to review appraisals has not. Financial institutions must still conduct a review whenever an appraisal supports a transaction.

The Interagency Appraisal and Evaluation Guidelines from 2010 specifically states, “As part of the credit approval process and prior to a final credit decision, an institution should review appraisals and evaluations to ensure that they comply with the Agencies’ appraisal regulations and are consistent with supervisory guidance and its own internal policies. This review also should ensure that an appraisal or evaluation contains sufficient information and analysis to support the decision to engage in the transaction.”

Appraisal Disciplinary Actions chart
Disciplinary cases show that nearly all appraisal deficiencies could have been remediated or prevented through proper reviews. Data: Ohio Appraiser Disciplinary Actions 2020-2025

What are real estate appraisal reviews?

A real estate appraisal review evaluates an appraisal report for completeness, accuracy, consistency and compliance with applicable standards.

Qualified professionals who are independent from the subject transaction and have experience in the relevant property type should perform appraisal reviews to maximize the benefits. Use consistent review checklists with a clear understanding of the client’s scope of work. Align with client-specific requirements and regulatory compliance. Provide a detailed narrative of the transaction appraisal that documents findings and highlights deficiencies or recommendations.

Key benefits of real estate appraisal reviews

  • Enhances accuracy and reliability: Errors, omissions, or flawed assumptions in an appraisal can result in inaccurate valuations. A review identifies discrepancies and unsupported conclusions to ensure the final report is accurate and defensible.
  • Mitigates financial risk: For lenders and investors, misvalued properties carry significant risks. Reviews serve as a risk.
  • Ensures regulatory and standards compliance: Financial institutions are subject to strict regulatory requirements, including the Uniform Standards of Professional Appraisal Practice (USPAP), the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Dodd-Frank Wall Street Reform and Consumer Protection Act. Appraisal reviews help ensure compliance with these requirements, protecting the institution from legal or regulatory penalties.
  • Improves consistency across valuations: For organizations managing multiple appraisals, reviews promote consistency in methodology, terminology and value conclusions. This supports transparency and establishes quality standards.
  • Cost limitations: Financial institutions with qualified in-house reviewers can use them as a resource to reduce risk. However, third-party providers can provide review services, with costs passed on to the customer as a line item on the closing settlement sheet.

Regulatory compliance explained

Uniform Standards of Professional Appraisal Practice (USPAP)

The purpose of USPAP is to promote and maintain a high level of public trust in appraisal practice by establishing requirements for appraisers. It sets forth standards for all types of appraisal services, including real property, personal property, business, appraisal review and mass appraisal. It is essential that appraisers develop and communicate their analyses, opinions and conclusions to intended users in a manner that is meaningful and not misleading. (source: www.appraisalfoundation.org and www.appraisers.org)

The Dodd-Frank Wall Street Reform and Consumer Protection Act

Commonly known as Dodd-Frank, it is legislation that was passed by the U.S. Congress in response to financial industry behavior that led to the financial crisis of 2007–2008. It sought to make the U.S. financial system safer for consumers and taxpayers. It established a number of new government agencies tasked with overseeing the various components of the law and, by extension, various aspects of the financial system. The Dodd Frank Act aimed to protect the independence of appraisers, reasonable and customary appraisal fees, appraiser certification and education standards, requirements for Appraisal Management Companies (AMC’s), standards for Automated Valuation Models (AVMs) and Broker Price Opinions (BPOs), additional provisions for high-risk mortgages, among other issues. (source: www.investopedia.com by Adam Hayes updated February 01,2025 and Regulatory Issues Facing the Real Estate Appraisal Profession)

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)

FIRREA has reshaped lending practices, particularly in real estate and mortgage financing. Lenders must adopt rigorous underwriting standards to ensure loans are extended to creditworthy borrowers, reducing the risk of defaults and enhancing financial system stability. Certified appraisals are now required to ensure accurate property valuations, critical for mitigating systemic risk in mortgage-backed securities. (source: www.accountinginsights.org Published Feb 13, 2025 and Regulatory Issues Facing the Real Estate Appraisal Profession)

Financial institutions face heightened risk if appraisals are not thoroughly reviewed. Independent reviews reduce risk, ensure adherence to standards and save valuable staff time. At Young & Associates, we provide independent appraisal reviews that give your team confidence in lending decisions while reducing compliance burdens. Let Young & Associates help you navigate appraisal compliance with confidence and efficiency. Reach out for a consultation.

Breaking down agricultural production revenue cycles for ag lending

Written by admin on . Posted in Blog, Lending & Loan Review.

By Craig Horsch, Consultant, Young & Associates

With Ag borrowers facing tight margins in 2025, financial institutions must carefully examine agricultural production revenue cycles to measure each borrower’s actual crop and livestock production against annual projections.

Additionally, measuring and testing each different revenue stream the farmer produces crops (corn, soybeans, wheat, oats, milo, hay, etc.) or livestock (beef cattle, dairy cattle, hogs, chickens, turkeys, sheep, goats or other livestock)

Financial institutions have historically analyzed the grain crops (corn, soybeans, wheat, oats, milo, hay, etc.) revenue production cycle very well; however, livestock revenue streams are not as frequently monitored to evaluate the borrower’s efficiencies within their respective revenue production cycles.

Analyzing the agricultural production revenue cycles

Measuring the revenue production cycles also provides the bank with an opportunity to identify the following:

  • Assess the borrower’s management skills.
  • The accuracy of the borrower’s projections.
  • The efficiencies within the production cycle.
  • The weakness within the production cycle.
  • Financial trends (negative or positive) within the production cycle.
  • Compare actual performance with projected revenue and expenses.
  • Where did the production cycle provide a benefit to the operations?
  • Where did the production cycle provide a detriment to the operations?
  • Were there any surprises (positives or negatives) during the production cycle?
  • Were projections within 10 percent of the actual performance?
  • Were there any critical or unusual events that occurred during the production cycle that negatively impacted revenue?

When underwriting an Ag borrower, consider analyzing and discussing each of the borrower’s revenue streams that contribute toward the repayment of the loan, such as the number of livestock or acres they farm overall, acres owned and leased, the projections for the upcoming year and the percentage each revenue stream contributes to the overall revenue stream. If livestock, discuss the type of livestock (dairy, beef, hogs, chickens, turkey, sheep, goats, etc.), the number of head, if a cow/calf (beef or dairy cattle) or dairy operation, a farrowing only, a finishing only or a farrow to finishing (hogs), a poultry or other livestock operation.

The USDA-ERS projects 2025 net farm income at $179.8 billion, up $52 billion from last year on record livestock prices and government payments.Not all sectors share in the gain. Crop receipts are forecast to fall 2.5 percent, led by declines in corn, soybeans and wheat, while fruits, nuts and cattle continue to rise. These swings, shown in the chart, reflect a long history of volatility. For lenders, the bottom line is clear: repayment risk depends on where borrowers are in the cycle, not just on headline numbers.
The USDA-ERS projects 2025 net farm income at $179.8 billion, up $52 billion from last year on record livestock prices and government payments. Not all sectors share in the gain. Crop receipts are forecast to fall 2.5 percent, led by declines in corn, soybeans and wheat, while fruits, nuts and cattle continue to rise. These swings, shown in the chart, reflect a long history of volatility. For lenders, the bottom line is clear: repayment risk depends on where borrowers are in the cycle, not just on headline numbers.

Discuss production projections for the upcoming year or the number of turns per year (hogs & poultry), etc. By completing this analysis, the bank may be able to identify which revenue stream is the strongest and weakest and which is the largest and smallest contributor to the overall revenue stream.

Identify the sources of revenue, such as grain, dairy, beef, hogs, poultry, sheep, goats or other livestock. Indicate each source’s share of total production in dollar amounts or percentages and explain how often the cycle for each source is completed. It is important to confirm that the producer is accurately capturing pertinent data for each revenue stream.

Projections vs. reality in agricultural production revenue cycles

Compare the production cycle actual performance with the borrower’s projections for the ag related cycle being measured.

  • Are they very accurate based upon the conditions of the respective cycle?
  • Is their revenue production within 10 percent of their budgeted projections?
    1. This is a way to assess the borrower’s budgeting capabilities
    2. Farm management skills
    3. Knowledge of costs
    4. Are they realistic pricing costs & selling commodity prices?
  • Do they know their costs?
  • Provide a look-back period: Are their projections reasonable compared to their actual costs?

Stress Test the borrower’s projections by 10 percent on price and 10 percent on yield to determine where the projected cash flow would be if a major adverse event occurred during the crop or livestock cycle, such as drought, bird flu, hoof & mouth, mastitis, etc.

By analyzing each revenue cycle, banks can identify strengths and weaknesses in a borrower’s management, budgeting, marketing and knowledge of costs and markets, thus improving the credit risk analysis of current or requested facilities.

Federal Crop and Livestock Insurance programs and what’s changing in 2025

Written by admin on . Posted in Advice, Blog, Commercial Underwriting, Consultation, Lending & Loan Review, Management & Planning, Risk Management, Strategic Planning.

By Craig Horsch, Consultant, Young & Associates

Overview of Federal Crop and Livestock Insurance programs

Federal Crop Insurance and Federal Livestock Insurance are supplemental insurances that cover losses which are unavoidable and caused by naturally occurring events. They do not cover losses resulting from negligence or failure to follow good farming practices related to crops and/or livestock.

Federal Crop Insurance Programs include three main programs—Price Loss Coverage (PLC), Agriculture Risk Coverage (ARC), and the Marketing Assistance Loan Program (MALP)—as well as the Whole-Farm Revenue Protection Plan 2025 (WFRP), per the USDA Risk Management Agency.

  • PLC overview:

    PLC program payments are issued when the effective price of a covered commodity is less than the effective reference price for that commodity. The effective price is defined as the higher of the market year average price (MYA) or the national average loan rate for the covered commodity. PLC payments are made to owners of historical base acres and are not tied to the current production of covered commodities. Covered commodities include wheat, corn, sorghum, barley, oats, seed cotton, long- and medium-grain rice, certain pulses, soybeans/other oilseeds, and peanuts.

  • ARC overview:

    There are two types of Agriculture Risk Coverage: Agriculture Risk Coverage–County (ARC-CO) and Agriculture Risk Coverage–Individual (ARC-IC).

    • The ARC-CO program provides income support tied to the same historical base acres—not current production—of covered commodities. ARC-CO payments are issued when the actual county crop revenue of a covered commodity is less than the county ARC-CO guarantee for that commodity.
    • ARC-IC provides income support based on a farm’s revenue from current production of covered commodities, compared with a benchmark average of that farm’s production of those commodities. However, payments are limited to a portion of the farm’s historical base acres. This page focuses on ARC-CO; the ARC-IC program has not been widely adopted.

  • MALP overview:

    The MALP allows producers to use eligible commodities they have produced as collateral for government-issued loans. Eligible commodities include wheat, corn, sorghum, barley, oats, upland and extra-long-staple cotton, long- and medium-grain rice, soybeans and other oilseeds, certain pulses, peanuts, sugar, honey, wool, and mohair.

  • WFRP overview:

    WFRP insurance provides coverage against the loss of revenue that you expect to earn or obtain from commodities you produce or purchase for resale during the insurance period, all under a single insurance policy. WFRP offers benefits such as:

    • A range of coverage levels from 50% to 85% to fit the needs of more farming and ranching operations;
    • Replant coverage for annual crops, except Industrial Hemp;
    • The ability to consider market readiness costs as part of the insured revenue;
    • Provisions to adjust the insurance guarantee to better fit expanding operations;
    • An improved timeline for farming operations that operate as fiscal year filers; and
    • Streamlined underwriting procedures based on the forms used for WFRP.WFRP is designed to meet the needs of highly diverse farms that grow a wide range of commodities and sell to wholesale markets. The WFRP policy was specifically developed for farms that market directly to local or regional buyers, sell through identity-preserved channels, and produce specialty crops, animals, and animal products. The amount of farm revenue you can protect with WFRP insurance is the lower of the revenue expected on your current year’s farm plan or your five-year average historic income, adjusted for growth. This represents an insurable revenue amount that can reasonably be expected to be produced on your farm during the insurance period. All commodities produced by the farm are covered under WFRP, except timber, forest and forest products, and animals used for sport, show, or as pets.It is important to understand that WFRP covers revenue produced during the insurance period. For example, if a calf weighs 800 pounds at the beginning of the insurance period and is sold at 1,200 pounds during the insurance period, the value of production will be the additional 400 pounds gained. Inventory adjustments are used to remove production from previous years and to add revenue for production that has not yet been harvested or sold.

Understanding USDA Livestock Insurance programs

Per the USDA Risk Management Agency website, the Federal Livestock Insurance Programs are as follows:

  • Livestock gross margin – Cattle:

    The LGM for Cattle Insurance Policy provides protection against the loss of gross margin (market value of livestock minus feeder cattle and feed costs) on cattle. The indemnity at the end of the 11-month insurance period is the difference, if positive, between the gross margin guarantee and the actual gross margin. The LGM for Cattle Insurance Policy uses futures prices to determine both the expected and actual gross margins. Adjustments to futures prices are based on state- and month-specific basis levels. The price the producer receives at the local market is not used in these calculations.

    Eligible producers are those who own cattle in the states of Colorado, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Montana, Nebraska, Nevada, North Dakota, Ohio, Oklahoma, South Dakota, Texas, Utah, West Virginia, Wisconsin, and Wyoming. Only cattle sold for commercial or private slaughter — primarily intended for human consumption—and fed in one of the eligible states are covered under the LGM for Cattle Insurance Policy.

  • Livestock gross margin – Dairy Cattle:

    The LGM for Dairy Cattle Insurance Policy provides protection against the loss of gross margin (market value of milk minus feed costs) on milk produced from dairy cows. The indemnity at the end of the eleven-month insurance period is the difference, if positive, between the gross margin guarantee and the actual gross margin. The LGM for Dairy Cattle Insurance Policy uses futures prices for corn, soybean meal, and milk to determine the expected and actual gross margins. The price the producer receives at the local market is not used in these calculations.

    Any producer who owns dairy cattle in the contiguous 48 states is eligible for LGM for Dairy Cattle Insurance Policy coverage. Only milk sold for commercial or private sale—primarily intended for final human consumption—from dairy cattle fed in any of the eligible states is covered under this policy.

  • Livestock gross margin – Swine:

    The LGM for Swine Insurance Policy provides protection against the loss of gross margin (market value of livestock minus feed costs) on swine. The indemnity at the end of the 6-month insurance period is the difference, if positive, between the gross margin guarantee and the actual gross margin. The LGM for Swine Insurance Policy uses futures prices to determine both the expected and actual gross margins. The price the producer receives at the local market is not used in these calculations.

    Any producer who owns swine in the 48 contiguous states is eligible for LGM for Swine insurance coverage. Only swine sold for commercial or private slaughter—primarily intended for human consumption—and fed in the 48 contiguous states are eligible for coverage under the LGM for Swine Insurance Policy.

 

Policy outlook: Projected spending impacts of proposed PLC and ARC-CO changes

In light of potential 2025 farm policy changes, the article “Spending Impacts of PLC and ARC-CO in the House Agriculture Reconciliation Bill” by Schnitkey, Paulson, Coppess (University of Illinois), and Zulauf (Ohio State University), published in farmdoc daily, offers valuable insight into the budgetary and structural implications of proposed revisions to two cornerstone commodity programs: Price Loss Coverage (PLC) and Agricultural Risk Coverage at the County Level (ARC-CO).

Key proposed changes

Under the House Agriculture Reconciliation Bill, four primary changes to PLC and ARC-CO are proposed:

1. Statutory reference price increases:

From 2025 to 2030, statutory reference prices for major program crops would increase—for example, from $3.70 to $4.10 per bushel for corn (an 11% increase), from $8.40 to $10.00 for soybeans (19%), and from $5.50 to $6.35 for wheat (15%). Similar increases are also proposed for seed cotton, rice, and peanuts (Schnitkey et al., 2025, Table 1).

2. PLC payment floor adjustments:

The bill proposes new price floors for PLC payments—$3.30 for corn and $0.30 per pound for seed cotton—to limit downside price risk. These new thresholds would reduce outlays in low-price environments by capping PLC payment escalation.

3. ARC-CO enhancements:

Changes to ARC-CO include increasing the coverage level from 86% to 90% and the maximum payment rate from 10% to 12.5% of benchmark revenue, making the program more responsive during periods of reduced revenue.

4. Loan rate increases:

The bill also proposes a 10% increase in the loan rates for the six largest program crops, further enhancing the income safety net (Schnitkey et al., 2025).

Budgetary and distributional impacts

The authors estimate that these program changes would raise federal outlays for PLC, ARC-CO, and marketing loan programs from $46.5 billion to $76.4 billion between 2025 and 2035—a 64% increase (Schnitkey et al., 2025, Table 2). However, this increase is not evenly distributed across commodities or regions:

  • Southern crops—notably peanuts, rice, and seed cotton—would see the largest increases in payments per base acre. In contrast, traditional Midwestern crops such as corn and soybeans would receive more modest increases.
  • For farms with 500 base acres, estimated average annual payments under the proposed changes would be:

This disparity stems from differences in statutory reference prices across crops. Southern crops historically have higher relative reference prices, leading to larger government payments — an imbalance that would be widened under the proposed bill (Schnitkey et al., 2025).

Political and policy implications

To fund these increased outlays, the House Agriculture Committee is proposing spending reductions from the Nutrition Title, particularly the Supplemental Nutrition Assistance Program (SNAP). This cost-shifting pits agricultural and nutrition interests against each other and introduces politically sensitive trade-offs that could impact the outcome of future Farm Bill negotiations (Schnitkey et al., 2025).

Why this matters

For agricultural lenders and risk managers, particularly those serving Midwestern crop producers, the proposed updates could affect the farm income landscape, collateral valuations, and overall credit risk. Although support increases are significant for crops like rice and peanuts, the more moderate gains for corn and soybeans mean Midwest producers may see less benefit from the bill in its current form. Understanding the potential outcomes of these policy shifts can help financial institutions refine their risk assessments and prepare clients for what lies ahead.

Staying ahead in a changing agricultural risk landscape

As federal crop and livestock insurance programs evolve — and legislative proposals like those in the 2025 House Agriculture Reconciliation Bill signal substantial shifts in farm subsidy distribution — lenders must be prepared to navigate increased complexity in agricultural credit risk. From changes in PLC and ARC to adjustments in federal loan programs and WFRP, these developments have direct implications for borrower cash flow, collateral valuation, and overall lending strategy.

For financial institutions serving agricultural clients, now is the time to reassess risk management frameworks, update lending practices, and evaluate credit exposures in light of these changes.

Young & Associates has deep expertise in agricultural lending and credit risk analysis. Our team can help your institution proactively adapt, with services that include portfolio review, credit risk management consulting, and tailored support for ag-specific lending challenges. Whether you’re seeking to strengthen underwriting processes or prepare for policy-driven shifts in borrower performance, we’re here to help you respond with confidence.

Explore our lending and credit risk consulting services to learn how we can support your institution’s success in this evolving environment.

References

Coppess, J., C. Zulauf, G. Schnitkey, N. Paulson and B. Sherrick. “Reviewing the House Agriculture Committee’s Reconciliation Bill.” farmdoc daily (15):89, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, May 14, 2025. Permalink

Kalaitzandonakes, M., B. Ellison, T. Malone and J. Coppess. “Consumers’ Expectations about GLP-1 Drugs Economic Impact on Food System Players.” farmdoc daily (15):49, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, March 14, 2025. Permalink

Schnitkey, G., N. Paulson, C. Zulauf and J. Coppess. “Price Loss Coverage: Evaluation of Proportional Increase in Statutory Reference Price and a Proposal.” farmdoc daily (13):203, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, November 7, 2023. Permalink

Schnitkey, G., C. Zulauf, K. Swanson, J. Coppess and N. Paulson. “The Price Loss Coverage (PLC) Option in the 2018 Farm Bill.” farmdoc daily (9):178, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, September 24, 2019. Permalink

Schnitkey, G., N. Paulson, C. Zulauf and J. Coppess. “Spending Impacts of PLC and ARC-CO in House Agriculture Reconciliation Bill.” farmdoc daily (15):93, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, May 20, 2025. Permalink

The importance of field examinations in asset-based lending

Written by admin on . Posted in Advice, Blog, Commercial Underwriting, Lending & Loan Review, Management & Planning, Risk Management, Strategic Planning.

By Ollie Sutherin, chief financial officer, Young & Associates

Asset-based lending is a creative financing alternative that will unlock additional working capital for businesses. While it appears more complex than traditional commercial real estate transactions, the appropriate training and education eliminate intimidation. Many community financial institutions tend to avoid asset-based lending opportunities due to the perceived burden of ongoing monitoring. However, with the appropriate due diligence at the outset of a lending relationship, the process becomes significantly more manageable and efficient.

The reality of ongoing monitoring in asset-based lending

Having worked at a small regional bank, I experienced firsthand the detail-oriented process of handling asset-based lending monitoring. Line of credit renewals often relied heavily on borrowing base certificates (BBCs) — many of which lacked accuracy and detail. Field examinations were seldom part of the equation, and decisions were often based on whether the BBC appeared “sufficient” to support the requested loan amount, whether payments were current, and whether principal was being retired in a frequent manner. What was consistently overlooked were several critical elements:

  • Early detection of fraud or irregularities.
  • Evaluation of internal operational controls.
  • Comprehensive and consistent collateral eligibility testing.
  • Longitudinal trend analysis and risk monitoring.

Field exams: A vital tool for risk mitigation

In today’s competitive lending environment, speed and efficiency are crucial. However, it’s imperative not to sacrifice thorough due diligence for the sake of expediency. Relying solely on BBCs without incorporating periodic field examinations introduces significant risk — risk that could far outweigh the relatively modest cost of performing a field exam. The reality is clear: a field exam provides the lender with a deeper understanding of the borrower’s financial health, operational integrity, and collateral quality. The field exam also provides information that can be used to set appropriate advance rates for the various collateral types.

You don’t know what you don’t know

One illustrative example comes from a colleague who shared her first field examination experience shortly after completing her training and certification. She was tasked with examining receivables for a large borrower. Drawing on the tools and methodology she had just mastered, she uncovered a serious case of fraud whereby the borrower was systematically crediting and rebilling invoices once they aged past 90 days. This practice inflated the eligible receivables reported in the BBC and granted the borrower significantly more borrowing availability than permitted… Without the field exam, this fraud would likely have continued undetected — exposing the financial institution to considerable, non-avoidable risk.

While instances like these may not occur every day, they underscore an essential truth: you don’t know what you don’t know. Field examinations offer lenders a proactive mechanism to confirm the integrity of a borrower’s financial reporting and ensure continued creditworthiness. In asset-based lending, that peace of mind over your relationships far outweighs the small investment.

How Y&A can support your lending program

Asset-based lending can open new avenues for community financial institutions, but it also introduces unique risks that require careful, ongoing oversight — particularly through field exams and detailed collateral monitoring. As illustrated, relying solely on surface-level reporting leaves institutions vulnerable to inaccuracies and potential fraud.

Our Y&A Credit Services team provides a wide range of solutions that support strong credit risk management, including credit underwriting, underwriting reviews and credit administration. These services can help your institution build a solid foundation for managing more complex lending relationships like asset-based lending.

If your team is looking to enhance credit processes, improve documentation quality or strengthen internal controls, Young & Associates is here to help you prepare — strategically and confidently — for what’s ahead. Reach out to us today for a free consultation.

CRE stress testing for banks: A crucial tool in a post-COVID world

Written by admin on . Posted in Advice, Blog, Consultation, Contingency Planning, CRE & AG Stress Testing, Interest Rate Review, Interest Rate Risk, Lending & Loan Review, Liquidity Management, Liquidity Review, Management & Planning, Regulatory Enforcement, Risk Management.

By Jerry Sutherin, CEO at Young & Associates

Despite having limited requirements as defined by interagency guidance, the case can be made for requiring community financial institutions to have regular stress tests performed on their commercial real estate loan portfolios.

Emerging challenges in commercial real estate lending

Recent post-COVID events have resulted in a heightened concern with regulators as it relates to commercial real estate. Most notably, interest rates have increased 525 bps from March 2022 through July 2023. This correlates with the level of commercial loan delinquencies over that same period as noted in the chart below. This is further exacerbated the “work from home culture” and office vacancies increasing over the same period.

The ultimate impact on the commercial real estate sector is weaker NOIs, coverage ratios that are insufficient to meet loan covenants, higher Cap Rates and lower valuations. For those loans locked into a lower rate, the issue now becomes; what happens when loans mature or reset? That is occurring now.

CRE Composition and Delinquency at US Banks Chart - S&P Global

Regulatory expectations for bank stress testing

Regulatory expectations for community bank stress testing initiatives have been set in both formal regulatory guidance and through more informal publications and statements. An interagency statement was released in May 2012 to provide clarification of supervisory expectations for stress testing by community banks.[1]

The issuance specifically stated that community banks are not required or expected to conduct the types of enterprise stress tests specifically articulated for larger institutions in rules implementing Dodd-Frank stress testing requirements, the agencies’ capital plan for larger institutions, or as described in interagency stress testing guidance for organizations with more than $10 billion in total consolidated assets.

OCC guidance on stress testing practices

However, in October 2012, the OCC provided additional guidance to banks on using stress testing to identify and quantify risk in the loan portfolio and to help establish effective strategic and capital planning processes.[2] The guidance reiterated that complex, enterprise-wide stress testing is not required of community banks. It also states that some stress testing of loan portfolios by community banks is considered to be an important part of sound risk management.

In the guidance, the OCC does not endorse a particular stress testing method for community banks; however, the guidance also discusses common elements that a community bank should consider, including asking plausible “what if” questions about key vulnerabilities; making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and incorporating the resulting analysis into the bank’s overall risk management process, asset/liability strategies, and strategic and capital planning processes.

The OCC bulletin also provides a simple example of a stress testing framework for community banks. In the summer of 2012, the FDIC also provided further guidance related to community bank stress testing in the Supervisory Insights Summer Edition.[3]

Interagency guidance on commercial real estate risk

Perhaps the most significant piece of guidance related to loan portfolio stress testing for community banks is the 2006 interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.[4] The continuing importance of and regulatory emphasis on this guidance was made clear in December 2015 when the interagency Statement on Prudent Risk Management for Commercial Real Estate Lending[5] was released, which reiterated the importance of the principles described in the 2006 CRE Guidance.

The 2006 CRE Guidance describes several important practices for effectively managing the risks associated with CRE lending, especially concentration risk. Portfolio stress testing of the CRE portfolio is described as a critical risk management tool for institutions with CRE concentrations.

Examiner expectations for portfolio-level stress testing

While community banks have not been pushed to perform the enterprise-wide stress testing that the above guidance specifically states is not expected of them, examiner expectations for portfolio-level loan stress tests have continued to increase over time and are becoming more prevalent during a bank’s recurring exams. These expectations are centered on portfolios that represent significant concentrations and, given the perceived level of risk and the existence of the 2006 CRE Guidance, are therefore most focused on CRE portfolios.

A reasonable and well-documented approach to CRE portfolio stress testing, undertaken at appropriately frequent intervals such as on an annual basis, is the most effective way for community banks to meet examiner expectations and to contribute toward effective risk management of CRE concentrations.

Regulatory criteria for CRE concentration risk

The guidance also states that strong risk management practices (with stress testing being one of the most important) and appropriate levels of capital are important elements of a sound CRE lending program. Particularly when an institution has a concentration in CRE loans. It then lays out the criteria regulatory agencies utilize as a preliminary means of identifying institutions that are potentially exposed to significant CRE concentration risk:

  1. Total reported loans for construction, land development, and other land represent 100% percent or more of total capital, or
  2. Total commercial real estate loans (as described above) represent 300% or more of the institution’s total capital. The outstanding balance has increased by 50% or more during the prior 36 months.

Concentration Levels Chart

The guidance is clear that these thresholds do not constitute limits on an institution’s lending activity and are instead intended to function as a high-level indicator of institutions potentially exposed to CRE concentration risk. Conversely, being below these thresholds also does not constitute a “safe harbor” for institutions if other risk indicators are present such as poor underwriting or poor performance metrics such as deteriorating risk rating migration and delinquency.

Case study: Loan portfolio concentration levels

As noted in the example above, the figures indicate that the bank does not have a high level of construction, and land development loans as the balances do not exceed the 100% threshold level as a percentage of total capital. However, the Bank has exceeded the 300% threshold of non-owner-occupied real estate loans as calculated under the 2006 CRE Guidance.  Additionally, the Bank’s three-year growth rate in this category was 72.7%, which is greater than the 50% reference level that constitutes the second part of the two-part regulatory test for a heightened concentration in this category.

Impact of loan acquisitions

It should also be noted that regulatory guidance does not differentiate between organic growth and commercial real estate growth via acquisition. Therefore, all such loans acquired does impact the ratios noted in the concentration chart above.

Loss estimation in bank stress testing

The basic premise for any stress test modeling is to identify moderate / high loss estimates. Then look at the impact to capital on a loan-level basis as well as portfolio-wide. While some community banks provide some stress testing on a transactional basis at origination, the output is typically limited to scenarios that focus primarily on future interest rate fluctuations.

CRE stress test modeling, on the other hand, allows for an organization to gauge potential losses of the CRE portfolio using internal core loan-level data as well as call report data while factoring in other variables that could influence the ultimate collectability of commercial real estate loans.

Loan-level or bottom-up stress testing

The bottom-up or loan-level portion of the stress test estimates losses under the stress scenarios on a loan-by-loan basis. The loan selection is typically a function of the desired penetration identified by the organization. It’s comprised mostly of larger transactions with a sampling of newer originations and adversely risk rated transactions.

In this portion of the analysis, various stress factors are applied to the NOI, collateral value, and interest rate for each loan identified by the Bank. This information, coupled with the transaction’s debt service coverage, liquidation costs and Cap Rates help form a possible loan-level loss for each loan in moderate and in moderate and high-risk scenarios.

Top-down stress testing

To ensure that the entire CRE portfolio is stressed, a useful model would use a top-down loss estimation method to “fill in” losses on the remaining portfolio for which loan-level information was not provided. This is accomplished by comparing the total balances for which loan-level data was provided in each of the various categories (construction and land development, multifamily, and all other non-owner occupied CRE) to the Bank’s call report. Losses are estimated on the amount of exposure for which loan-level information was not provided by applying a top-down loss rate.

The Moderate and High Stress Scenarios below are determined by applying the loss rates included in the stress test example in the 2012 OCC guidance on community bank stress testing. These loss rates represent two-year loss rates, consistent with the OCC’s stress testing guidance.

Top-Down Loss Rates Chart

Enhancing portfolio oversight and credit risk management

Collectively, the “bottom-up (loan level)” and “top-down” moderate and high stress scenarios provide a global overview of a bank’s CRE portfolio and its potential impact to capital. Knowing that this is not a replacement for an enterprise-wide stress test. However, it allows a bank to provide its management, board of directors and regulators with some context of the estimated losses in this segment of their loan portfolio. It also serves as an effective supplement to their internal or third-party loan review.

Historically speaking, any situation in which significant weakness is experienced in critical market and economic factors will result in credit losses that are elevated above those that a bank experiences in “normal” times if unprepared. There is no replacement for appropriate credit administration, however all banks should always utilize tools such as stress testing to enhance their oversight of the metrics behind their CRE portfolio.

Financial institution performance and ultimately their ongoing safety and soundness are dependent on the performance of the Bank’s CRE portfolio. It is critical that management and the board of directors ensure that the bank emphasizes effective implementation of the risk management elements discussed in the 2006 CRE Guidance. These elements include:

  • Continued effective board and management oversight,
  • Effective portfolio management,
  • Ensuring that management information systems are able to provide the information necessary for effective risk management,
  • Performing periodic market analysis and stress testing,
  • Regularly evaluating the appropriateness of credit underwriting standards, and
  • Maintaining an effective credit risk review function

If a financial institution is successful in these endeavors, their CRE loan portfolio should continue to contribute positively to their performance. Accordingly, I am a proponent of all community financial institutions having a stress test performed regularly. This helps to ensure the performance of that segment of their loan portfolio as well as the entire organization.

Partner with Young & Associates for expert CRE stress testing

Navigating the complexities of commercial real estate stress testing can be challenging, especially with evolving regulatory expectations and economic uncertainties. At Young & Associates, we offer specialized CRE and Ag portfolio stress testing services designed to address these very challenges. With over 45 years of experience, our team understands the intricacies of regulatory guidance. We can provide your community bank with the insights needed to enhance strategic and capital planning.

Our proven stress testing model assesses the potential impacts of adverse economic conditions. This helps you manage risk effectively and comply with regulatory expectations. We provide actionable insights to guide your loan product design and underwriting standards. This eases the burden of stress testing and supporting your institution’s resilience.

Choose Young & Associates for a partnership that combines deep industry knowledge with a commitment to excellence. Let us help you stay ahead of regulatory demands and strengthen your CRE portfolio management. Reach out to us now to schedule a consultation.

 

[1]              FDIC, PR 54-2012, “Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks.” May 14, 2012.

[2]              OCC Bulletin 2012-33, “Community Bank Stress Testing: Supervisory Guidance.” October 18, 2012.

[3]              FDIC “Supervisory Insights, 9(1).” Summer 2012.

[4]              FDIC FIL-104-2006, OCC Bulletin 2006-46, FRB SR 07-1, “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.“ December 12, 2006.

[5]              FDIC FIL-62-2015, OCC Bulletin 2015-51, FRB SR 15-17, “Statement on Prudent Risk Management for Commercial Real Estate Lending.“ December 18, 2015.

 

Internal Audit: Your Third Line of Defense in Third-Party Risk Management

Written by admin on . Posted in Advice, Blog, Compliance & Regulations, Consultation, Cybersecurity & Information Security, Information Technology, Internal Audit, Management & Planning, Risk Management.

By Jeanette McKeever, CCBIA, Director of Internal Audit, Young & Associates

In today’s financial landscape, banks and credit unions increasingly rely on third-party vendors to meet regulatory demands, leverage technological advancements, and maintain competitive edges. However, these relationships introduce various types of risks in internal audit, from compliance and operational risks to reputational and strategic risks. Amidst economic uncertainty, increased digitalization, and growing supervisory attention, many financial institutions are reviewing their third-party risk management (TPRM) frameworks to ensure they are robust and comprehensive.

Here, the role of internal audit becomes indispensable. Internal audit’s role in TPRM goes beyond mere compliance. By leveraging their unique skills and perspectives, internal auditors can help institutions identify, monitor, and control risks while achieving strategic goals.

Understanding Third-Party Risk in Banking

Third-party relationships and their associated risks require careful management. Ineffective oversight of the complex operational, financial, technological, and legal agreements governing these extended business relationships can lead to brand or reputation damage, data security breaches, and significant financial losses. Additionally, such oversight failures can result in errors in financial reporting, compounding the challenges and potential impacts on the institution.

Financial institutions are entrusting an increasing percentage of their operations to third parties, prompting regulators to scrutinize these relationships more closely. The updated interagency guidance from the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board (FRB), and the Office of the Comptroller of the Currency (OCC) outlines the regulatory expectations for managing third-party risks throughout the relationship lifecycle: planning, due diligence, selection, contract negotiation, ongoing monitoring, and termination.

Monitoring vendor performance is also a regulatory requirement for credit unions. The National Credit Union Administration (NCUA) specifies the criteria for assessing vendor performance in their 2007 supervisory letter SL No. 07-01, “Evaluating Third-Party Relationships.” This guidance emphasizes key areas for third-party relationship management, including risk assessment and planning, due diligence, risk management, monitoring, and control.

The Role of Internal Audit in Third-Party Risk Management

Though Chief Risk Officers are typically responsible for managing third-party risks, internal audit plays a crucial role as the third line of defense. Internal auditors bring essential skills, capabilities, and perspectives to thoroughly examine TPRM programs, identifying gaps or areas for improvement that might have been missed by the second line of defense. The board relies on internal auditors as an extra layer of security to ensure that third-party risks are properly identified and assessed, appropriate internal controls are in place, and timely risk intelligence is generated to inform decision-making.

Leveraging Internal Audit to Improve Third-Party Risk Controls

Internal audit can contribute significantly to managing third-party risks through various areas:

  • Pinpointing Critical Contracts: Internal auditors can assist in identifying high-risk third parties and ensure they receive more frequent scrutiny. This can help with prioritizing risk management efforts.
  • Assessing Risk Management Programs: They can evaluate the effectiveness of third-party due diligence processes and controls, conducting research to gauge the risk level and reputation of third parties.
  • Reviewing Compliance with Governance Standards: Internal auditors can verify if the financial institution’s processes for selecting and managing third parties adhere to governance requirements and include necessary risk and compliance clauses in contracts.
  • Evaluating and Improving Risk Controls: They can assess the effectiveness of risk management controls, ensure regulatory compliance, and check for “right to audit” clauses in third-party agreements.
  • Facilitating Informed Decision-Making: Auditors offer valuable insights into third-party risks. They also evaluate decision-making and contract management processes. This ensures that these processes align with the bank or credit union’s strategic objectives. Additionally, auditors verify that the processes provide sufficient risk protection.
  • Assessing Performance and Identifying Opportunities: They review global third-party performance, detect inconsistencies, and recommend best practices for effective risk and performance management.

Integrating Internal Audit into Third-Party Risk Management Strategies

1. Independent Vendor Risk Assessment and Identification

Conducting a risk assessment is essential for the initial decision-making process regarding whether to establish a third-party relationship. Internal auditors bring an independent perspective to the assessment and identification of third-party risks. They can perform thorough risk assessments to identify all third-party relationships and associated risks. This independent evaluation helps ensure no significant risk is overlooked, and it provides a holistic view of the financial institution’s third-party risk landscape.

2. Vendor Due Diligence and Selection Oversight

The due diligence process equips management with the necessary information to evaluate both the qualitative and quantitative aspects of potential third parties, determining whether a relationship will support the financial institution’s strategic and financial goals while mitigating identified risks.

If your financial institution has its own internal audit team, involving them in the due diligence process for vetting potential third-party relationships can be highly beneficial. Though not prevalent practice in community banks and credit unions yet, leveraging your institution’s third line of defense can enhance third-party risk management processes and provide an extra layer of protection.

Internal audit teams can provide oversight during the due diligence and selection phases of third-party relationships. They can assess the processes used for selecting third parties to confirm that the institution has effective policies and procedures in place. By ensuring thorough due diligence, internal auditors help identify potential risks early on. Their oversight includes evaluating the third party’s operational quality, compliance capabilities, risk profile, and long-term viability.

3. Contract Management and Compliance

Financial institution management should ensure that the specific expectations and obligations of both the financial institution and the third party are clearly defined in a written contract before finalizing the arrangement. Board or committee approval is required for many material third-party relationships, and significant contracts should be reviewed by appropriate legal counsel before finalization. The level of detail in contract provisions will depend on the scope and risks associated with the third-party relationship. Effective contract management is crucial for mitigating third-party risks. This involves not just due diligence but also thorough processes in agreement formation, publication, activation, compliance with service delivery, analysis, optimization, and offboarding.

The internal audit function can engage in contract management in two key areas:

  1. Auditing the overall contract management process.
  2. Reviewing active contracts with critical vendors.

Auditing the Contract Management Process

An effective contract management process is crucial for maintaining strong performance across your institution. Even minor inefficiencies can lead to significant issues, particularly when your financial institution aims to grow and scale. A robust contract management system contributes to a thriving institution.

Regular audits of your contract management lifecycle can reveal hidden costs and growth opportunities. These audits should assess process deficiencies, compliance issues, and historical management practices. Start by identifying key stages in your process and setting benchmarks for measurement. Key stages often include planning, due diligence, selection, contract negotiation, ongoing monitoring, and termination, as outlined in regulatory guidance.

Evaluate your management practices within each stage. Is the contract management process clearly defined? Are roles and responsibilities assigned? Who ensures compliance with service-level agreements (SLAs)? Addressing these questions through a contract management audit can help identify risks and gaps, ensuring a more effective and efficient process.

Reviewing Active Contracts with Critical Vendors

Begin by inventorying and segmenting critical vendors based on risk levels to identify those most critical to audit. Incorporate audits of high-risk and important service provider contracts into your annual audit plan. Gain an understanding of the key risks associated with each service provider and thoroughly review their contracts.

Internal auditors can review critical third-party contracts to ensure they include comprehensive risk and compliance clauses. This includes verifying that contracts have “right to audit” provisions, which allow the institution to monitor third-party compliance continuously. Once you’ve established your audit rights, you can start the contract audit by assessing key legal and business risks. Look for deficiencies and compliance issues in the contract, and consider conducting on-site reviews if your audit rights permit. An efficiency audit may also be warranted to ensure services are delivered as per the contract and service level agreements.

After completing the audit, validate the results, identify root causes, and propose solutions. Finally, communicate the results to the contract owner and key stakeholders, ensuring they are informed of the findings and recommended actions.

4. Ongoing Monitoring and Reporting

Once a third-party relationship is established, continuous monitoring is essential to manage evolving risks. Internal audit can play a vital role in developing and implementing monitoring frameworks that track third-party performance, compliance, and risk exposure. Regular audits and reviews can provide senior management with timely risk intelligence, enabling informed decision-making and ensuring that effective internal controls are in place.

5. Internal Audit Collaboration with Risk Management Functions

Internal audit of third-party risk management becomes more effective when auditors and risk managers collaborate and share information, leveraging each other’s abilities and tools. By working closely with risk, compliance, and other departments, internal auditors can ensure that third-party governance policies and procedures are consistently applied across the bank or credit union.

By integrating third-party risk assessments with audit plans, both auditors and risk management teams can eliminate redundancies in the risk evaluation processes. This approach also helps standardize the risk language used and offers management teams and boards a comprehensive view of the financial institution’s third-party risk profile. This collaboration integrates TPRM into the overall risk management strategy, enhancing the institution’s ability to manage third-party risks.

Building a Robust Third-Party Risk Management Framework

To effectively manage third-party risks, financial institutions should establish a comprehensive TPRM framework. TPRM necessitates a framework that holds the board of directors and senior management accountable, requiring them to adjust the principles based on the size, scope, and criticality of the products or services provided by third parties. This framework should be consistently applied across the institution and integrated into its operational, risk, and compliance management activities. As discussed, key components of a robust TPRM framework include:

  • Defining and Inventorying Third-Party Vendors: Internal audit can assist in identifying and inventorying all third-party relationships, categorizing them by risk level and criticality.
  • Risk Appetite Assessment: Assessing the bank or credit union’s risk appetite concerning third-party relationships, particularly those in high-risk locations or industries.
  • Enhanced Vendor Due Diligence: Conducting enhanced due diligence for critical third-party relationships, ensuring alignment with the institution’s risk profile and regulatory requirements.
  • Ongoing Monitoring and Performance Standards: Establishing and maintaining rigorous monitoring and performance standards for third-party relationships, ensuring continuous compliance and risk management.
  • Training and Awareness: Providing training for stakeholders on TPRM processes and the importance of effective third-party risk management.

Risk-Based Internal Audit for Financial Institutions

With regulatory bodies calling for enhanced third-party oversight, the imperative for thorough risk and assurance functions has never been greater. These functions must delve deeply into the third-party network to ensure that critical risks and compliance requirements are diligently managed and monitored. Internal auditors are pivotal in this endeavor and should seek to broaden their role in fortifying third-party risk management.

At Young & Associates, we understand the critical importance of robust TPRM processes and offer expert consulting services to help banks and credit unions strengthen their internal audit functions, risk management, and more. By leveraging our expertise, financial institutions can enhance their third-party risk management frameworks, ensuring compliance, mitigating risks, and achieving strategic objectives. Ultimately, effective TPRM is not just about regulatory compliance; it’s about creating a resilient and thriving financial institution.

For more information on how Young & Associates can support your internal audit needs, click here.

Upcoming Nacha Rule Changes in 2026: What You Need to Know

Written by admin on . Posted in ACH, Advice, Blog, Compliance & Regulations, Consultation, News.

By Mindy Shadoin, Consultant, Young & Associates

On March 15, 2024, Nacha announced significant updates to ACH (Automated Clearing House) Rules, aimed at enhancing fraud management and improving the recovery of funds. These updates are set to roll out in phases, with some changes effective as early as June 2024 and others beginning March 20, 2026. This article summarizes the key changes that will take effect in 2026, providing a concise overview of what community financial institutions need to know.

Key Changes Effective March 2026

The changes effective March 20, 2026, are designed to address fraud more effectively and enhance the recovery of funds when fraud occurs. Institutions must adapt to these new rules to comply with regulatory requirements and improve their fraud detection and management practices.

Fraud Monitoring (Phase 1)

Who’s Affected: Originating Deposit Financial Institutions (ODFIs) and each Non-Consumer Originator, Third-Party Service Provider, and Third-Party Senders with annual ACH origination volume of six million or greater in 2023.

Requirements: Institutions must implement risk-based processes for ACH entry fraud detection and review these processes annually. The final rule emphasizes specific process requirements over the previous “commercially reasonable” standard.

Reason: The amendment is designed to cut down on fraud. By regularly monitoring for fraud, institutions can create a baseline of normal activity, which makes it easier to spot unusual or suspicious behavior.

RDFI ACH Credit Monitoring

Who’s Affected: Receiving Depository Financial Institutions (RDFIs) with annual ACH receipt volumes of 10 million or more in 2023.

Requirements: RDFIs must develop fraud detection systems for incoming credit entries, using a risk-based approach to monitor transaction patterns and account anomalies.

Reason: The rule aims to decrease successful fraud and improve the recovery of funds in case of fraud. It supports an institution’s regulatory duty to monitor suspicious transactions. Additionally, it promotes better communication between compliance, operations, product management, and relationship staff.

New Definitions and Descriptions

False Pretenses

The updated rules introduce the term “False Pretenses,” which refers to fraud involving misrepresentations of identity, authority, or account ownership. This definition aims to cover common fraud scenarios like Business Email Compromise (BEC) and vendor impersonation, enhancing clarity in handling such cases.

Standard Company Entry Description: Payroll

Effective March 20, 2026, regardless of ACH volume, all Prearranged Payment and Deposit Entry (PPD) Credits for wages and similar compensation must include the description “PAYROLL” in the Company Entry Description field. This standardization will help RDFIs better identify payroll-related transactions and prevent fraud associated with payroll redirections.

Standard Company Entry Description: Purchase

Effective March 20, 2026, regardless of ACH volume, this amendment requires that e-commerce purchases use the description “PURCHASE” in the Company Entry Description field. This change will help differentiate e-commerce transactions and prevent misclassification of transactions.

Changes Effective June 2026

Fraud Monitoring (Phase 2)

Starting June 22, 2026, the rules from Phase 1 will apply to all RDFIs not previously covered. These Phase 2 changes will further enhance fraud detection and fund recovery processes, ensuring comprehensive coverage across the industry.

Preparing for the Nacha Rule Changes

The upcoming changes to the Nacha Operating Rules represent a significant step forward in managing ACH fraud and improving fund recovery. Financial institutions will need to prepare by refining their fraud monitoring processes and adapting to the new definitions and descriptions outlined in these rules. For detailed information, you can find the Nacha Operating Rules and Guidelines on Nacha’s website.

Staying informed and compliant with these rules will be crucial for maintaining effective fraud management and regulatory adherence. This article provides a simplified overview of these updates, focusing on key changes and their implications. For a more comprehensive understanding, inquire about the in-depth article featured in the August edition of our Compliance Update newsletter, including details on the final rule changes, adjustments from the original proposal issued in May 2023, and specific actions required.

Each month, our Compliance Update newsletter offers in-depth analysis and insights on regulatory updates and amendments impacting the banking industry. Our compliance experts review new developments and provide valuable guidance to help you maintain regulatory compliance and navigate the evolving landscape. To receive timely and detailed compliance information, we encourage you to subscribe. Click here to learn more about our Compliance Update newsletter and purchase a subscription.

Additionally, Young & Associates provides a full suite of regulatory compliance consulting services tailored to meet the unique needs of your institution. Our offerings include ACH self-assessment reviews, compliance outsourcing, our Virtual Compliance Consultant Program, and more, designed to simplify complex regulatory requirements and allow you to focus on strategic goals. For more information on how we can support your institution, please contact us.

CDs Maturing in Q2: Impact on Interest Rate Risk Management

Written by admin on . Posted in Advice, Blog, Consultation, Contingency Planning, CRE & AG Stress Testing, Interest Rate Review, Interest Rate Risk, Lending & Loan Review, Liquidity Management, Liquidity Review, Management & Planning, Regulatory Enforcement, Risk Management.

By: Michael Gerbick, President at Young & Associates

Interest rate risk (IRR) is the exposure of a bank or credit union’s current or future earnings and capital to adverse changes in market rates. Management of that risk is critical to community financial institutions and since the pandemic and rates went to zero, due to the rapid pace of change, effective management of that risk has been difficult due to the rapid increase in interest rates.

Navigating Market Volatility: The Role of ALM Models 

Most banks and credit unions utilize asset liability management (ALM) models to assist in the modeling of interest rate increases and decreases, typically +/- 400 bp shock scenarios. Similar to the parallel rate shock scenarios of the ALM models designed to identify risk exposure in a rapidly changing rate environment, the Fed raised rates between March 2022 and July 2023 from 0% to 5.25–5.50%.  

The yield curve shape changed significantly, putting additional stress on the Asset Liability Committees (ALCO) responsible for managing the ALM function of financial institutions, and has not let up. Yes, the inverted yield curve has flattened from 12 months ago, however in March this year, the Treasury yield curve for the two-year and ten-year yields hit a consecutive day record for being inverted 625 days, besting the previous record set in 1978.  

The chart shown below1 illustrates the difference between the higher yield 2-year and the lower yield 10-year. 

Strategies Amidst Rising Rates: Insights for Community Banks and Credit Unions 

Amongst many of the strategies employed during the rising rate environment of 2022 and 2023 was offering certificates of deposit (CDs) to maintain and grow deposits on the balance sheet. However, the funding mix began to shift as consumers migrated towards the higher interest-bearing accounts or the Bank increased Federal Home Loan borrowing which caused the cost of funds to increase.  

Industry research for the last two years shows interest-bearing deposits up 5.1% and non-interest-bearing deposits down 28%2. Rates have not risen since July 2023, however many of the CDs offered in 2023 are due to mature in 2024 in a different rate environment than when they were issued. Financial institutions are monitoring this closely.  

Strategic Considerations for ALCOs: Addressing Interest Rate Risk 

ALCOs are tasked with predicting the interest rate exposure in the elevated rate environment. Currently, we are in a unique environment and banks and credit unions should be cautious about using historical data only to predict future activity. In addition to non-bank competitors competing for deposits, community financial institutions need to continue improving their approach to cost of funds, net interest margin compression, and how the institution will effectively manage their exposure to interest rate risk. A few strategies and actions financial institutions can employ related to deposits are: 

Optimizing Interest Rate Exposure

Increase the frequency in which ALCO meets to review the interest rate environment. This may currently be semi-annual or quarterly at your institution. The financial institution may consider meeting monthly to stay abreast of any changes in the environment or new products the Bank is releasing. 

Policy Revision

Review your policy limits approved by the Board. Your policy may only have -100 bp or -200 bp scenarios listed given the previous low-rate environment. Not only review the existing policy limits with the Board but increase the stress range to account for -300 bp and -400 bp. 

Trigger Points

In addition to the policy limits, consider thresholds for the rate of change of the risk measures that consider risks associated with liquidity, interest rate risk, and capital. These rate of change thresholds are designed to commence action or additional investigation into the source of the significant movement ahead of falling outside of policy limits. 

Stress Your Assumptions

ALM models have built-in assumptions and are likely based on historical industry averages supplemented by data supplied by your institution. Common key assumptions outlined by the FDIC3: 

  • Asset Prepayment – represents the change in cash flows from an asset’s contractual repayment schedule. The severity of prepayments fluctuates with various interest rate scenarios. Mortgage loans are a prime example of assets subject to prepayment fluctuations.
  • Non-Maturity Deposits
    • Sensitivity or Beta Factor – describes the magnitude of change in deposit rates compared to a driver rate.
    • Decay Rate – estimates the amount of existing non-maturity deposits that will run off over time.
    • Weighted Average Life – estimates the average effective maturity of the deposits.
  • Driver Rate – represents the rate, or rates, which drive the re-pricing characteristics of assets and liabilities. Examples include Fed funds rate, LIBOR, U.S. Treasury yields, and the WSJ Prime rate.

Have discussions with your team and understand what is going on broadly in the economic environment as well as items specific to your bank or credit union. Address changes or concerns in your modeling assumptions or at the very least, be aware of their potential impact. Spend time to learn the assumptions. Do not accept the defaults as correct, make sure your team understands them.

In addition to your base case, stress the assumptions – double or triple the decay rates, assume a high sensitivity to driver rates in the change in deposit rates, and cut the prepayment speeds in half. The alternate scenarios with severe assumptions will assist ALCO in understanding potential value creation and risks.  

Interest Rate Risk Review

Regulatory guidance indicates that every bank should have an annual third-party assessment of the interest rate risk system. Similar to other audits, this review should be delivered to the Board of Directors or the Board’s audit committee and is a critical component of the Board’s responsibility for bank oversight. 

Educate the Board on Interest Rate Risk

There are educational videos available through the FDIC website. In addition, there are IRR modeling vendors that will attend meetings to provide perspective to your institution on the current economic environment and your modeling results. Leverage them. 

Managing Interest Rate Risk in 2024 and Beyond 

There is always an opportunity for significant value creation in any environment. The rapidly increasing rate environment experienced in 2022-2023 brought forth significant risks and opportunities. The 2024 environment possesses new challenges, and I am excited to see our community banks and credit unions adjust their balance sheets, act on the highest value opportunities, and limit their interest rate exposure.  

Assess Your Interest Rate Risk 

Ready to proactively manage your institution’s interest rate risk? Young & Associates offers comprehensive interest rate risk reviews tailored to your needs. Ensure your bank or credit union is prepared to navigate market volatility with confidence. Reach out to us now to schedule your consultation!

 

 

1Federal Reserve Economic Data (FRED) 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
2S&P Global US Bank Market Report 2024
3FDIC Developing Key Assumptions for Analysis of Interest Rate Risk

2024 Housing Market Outlook: Implications for Mortgage Lenders

Written by admin on . Posted in Advice, Consultation, Mortgage Quality Control.

By: Donald Stimpert, Manager of Secondary Market QC Services

Fannie Mae’s recent revised forecast for 2024 and beyond unveils a nuanced projection that holds significance for community banks and credit unions navigating the intricate landscape of the housing market. The insights presented by Fannie Mae’s Economic and Strategic Research (ESR) Group encapsulate essential indicators and predictions that will influence the housing and mortgage sectors in the forthcoming year.

Economic Deceleration and Housing Recovery

The December report anticipates a potential economic slowdown in 2024, aligned with a gradual recuperation in both home sales and mortgage originations. Although initially forecasting a modest recession for 2023, the economic resilience has surprised many market analysts. Fannie Mae now perceives the possibility of a softer landing due to disinflation and low unemployment rates. However, the housing sector faced challenges in 2023, witnessing record-low affordability, lock-in effects, and a severe deficit in available for-sale housing, leading to the lowest existing home sales since the Great Financial Crisis.

Factors Impacting Home Sales in 2024

Fannie Mae’s analysis points to a challenging landscape ahead. 2023 set a record low for existing home sales since 2010, setting the stage for a gradual recovery in 2024. Yet, obstacles like unaffordability, lock-in effects, and constrained inventory persist, likely causing a marginal impact on 2024’s total home sales compared to the previous year.

Despite glimpses of potential relief, these hurdles are expected to persist. Although the decline in the 10-year Treasury rate offers a glimmer of hope for better sales and mortgage originations, persistently high mortgage rates forecast subdued home sales at around 4.8 million in 2024, with a modest increase to 5.4 million by 2025.

October’s rock-bottom existing sales at 3.79 million could signal a turning point. Recent shifts in purchase mortgage applications, fueled by notable drops in mortgage rates, hint at a possible sales uptick. This trajectory depends on further rate moderation, potentially leading to increased sales.

Moreover, Fannie Mae’s projection of a slight dip in new home sales contrasts with unexpected buyer resilience amidst rising rates. This unexpected stability, boosted by concessions from builders, hints at sustained sales consistency.

This sales resilience, coupled with an unforeseen home price rebound, shapes Fannie Mae’s view on mortgage originations. Despite fluctuations, the forecast indicates a subtle upward trend, aligning with current origination levels.

Upgraded Projections for Single-Family Mortgage Originations

Amidst these challenges, Fannie Mae projects a positive trajectory in total single-family mortgage originations:

  • $1.5 trillion in 2023
  • $1.9 trillion in 2024
  • $2.3 trillion in 2025

This upgrade stems from a positive outlook on purchase mortgage origination volumes. Forecasts indicate a substantial increase to $1.4 trillion in 2024, a noteworthy leap from the anticipated $1.3 trillion in 2023. Looking ahead, the trajectory continues its upward trend, projecting $1.6 trillion in purchase origination volumes by 2025. Simultaneously, refinance origination volumes are on an upward trajectory, poised to surge to $451 billion in 2024 and further escalate to $686 billion in 2025.

Dynamics of Mortgage Rates and Home Sales

The report reflects on the impact of declining interest rates, projecting a shift to an average FRM30 rate of 6.7% in 2024 and 6.2% in 2025, down from the current 7.4% in Q4 2023. However, the transition in monetary policy might introduce volatility in mortgage rates, presenting a potential risk factor for these projections.

New vs. Existing Home Sales, Housing Starts, and Price Growth

The resilience of new home sales, unexpected amidst economic uncertainties, and the lower-than-expected impact of high mortgage rates on sales showcase a trend where buyers seem less affected by increased rates compared to previous years. Homebuilders’ concessions, including mortgage rate buydowns, aim to stimulate sales amidst these challenges.

Implications for Community Banks and Credit Unions

Understanding Fannie Mae’s 2024 outlook is crucial for community banks and credit unions to tailor their strategies. The projected increase in mortgage originations presents both opportunities and challenges, urging these institutions to adapt swiftly to evolving market dynamics and consumer behaviors.

In conclusion, Fannie Mae’s revised outlook for 2024 emphasizes the need for adaptive strategies by community banks and credit unions to harness opportunities amid the projected housing market landscape. Staying informed about these forecasts will empower these financial institutions to navigate potential challenges while capitalizing on growth prospects effectively.

Secondary Market Quality Control

Young & Associates stands as a trusted ally for financial institutions amid Fannie Mae’s housing market projections. Specializing in secondary mortgage quality control, our QC services serve as a shield against risks, meeting federal and private investor requirements, including those of Fannie Mae. As Fannie Mae anticipates a gradual housing market recovery and increased mortgage activities, partnering with Y&A can fortify your institutions’ risk management strategies. Our meticulous evaluations ensure compliance readiness and accuracy, aligning financial entities with market shifts highlighted by Fannie Mae, securing robust mortgage operations for the future. Visit our website for more information or contact us here.

Managing CRE Credit Risk Amid Market Shifts

Written by admin on . Posted in Advice, Consultation, CRE & AG Stress Testing, Lending & Loan Review, Liquidity Review, Management & Planning, Regulatory Enforcement.

By: Jerry Sutherin, President & CEO of Young & Associates

The landscape of commercial real estate (CRE) lending is shifting due to current economic events, presenting both challenges and opportunities for community financial institutions deeply entrenched in this sector. The challenges range from the profound impact of remote work trends and the uncertain future of office spaces to growing concerns about inflation and higher interest rates bringing CRE risk into the spotlight. This volatility has garnered increased attention from internal and external stakeholders, as well as regulatory authorities. Consequently, identifying the most pressing threats among these challenges and proactively mitigating risk has become a top priority for financial institutions with CRE exposure.

In the face of rising interest rates and delinquencies, many financial institutions are preparing to confront these economic stressors. In fact, some were already scaling back lending before the recent collapses of Silicon Valley Bank and Signature Bank. We have all witnessed the tightening of lending standards resulting from that event, and many analysts anticipate further tightening among all community financial institutions. This constriction is also impacted by limited deposits and liquidity forcing financial institutions to be selective in how they deploy their capital. These facts leave many analysts predicting when credit problems will emerge in the CRE sector.

The evidence speaks for itself. According to S&P Global Market Intelligence, the delinquency rate for all CRE loans held in U.S. banks has increased by five basis points year over year. Moreover, within a single quarter earlier this year, the delinquency rate for nonowner-occupied nonresidential property loans spiked by a significant 24 basis points. This has led to tighter lending standards at origination, reflecting the concerns of institutions. Further, financial institutions are taking proactive measures to mitigate CRE risk after origination. Some have set aside high-single-digit percentage allowances for office loans. Others have reduced exposure through portfolio sales. Overall, loan originations have fallen, CRE sales have slumped, and forecasts indicate a drop in CRE prices.

The tightening of lending standards, the slowdown in the growth of CRE loans, and the impact on loan originations have emerged as central concerns in the financial sector. What unifies these factors is their inherent risk and whether they act as warning signals or responses. Managing CRE credit risk is undeniably intricate, but leveraging available strategies and tools empowers community banks, credit unions, and financial institutions to effectively navigate the ever-changing CRE lending sector. This enables them to proactively assess and plan for risk mitigation, rather than merely react to these changes.

Understanding Commercial Real Estate Risk

As CRE loans represent a substantial part of many banks’ loan portfolios and higher yielding assets, especially within community financial institutions, understanding the significance of CRE credit risk is paramount. Community banks and credit unions often operate in areas experiencing job and population growth, leading to a high demand for CRE lending and, in turn, a high concentration of CRE loans. This growth and its corresponding effects on loan portfolio concentration pose new challenges for banks in terms of risk monitoring and control.

While larger financial institutions commonly maintain experienced staff and even entire departments to manage these risks, it is generally not cost effective for smaller financial institutions to hire and maintain qualified resources to help mitigate the inherent risks. In the absence of an internal CRE risk management team, it is imperative for financial institutions to rely on independent third-party resources to assist in this crucial process.

Historical Context and Lessons from Past Experiences

A retrospective examination underscores the importance of proactive risk management. Many significant historical banking failures were largely attributed to overinvestment in CRE loans and the lack of an effective risk management process. Weak underwriting standards and poor portfolio management led to an oversupply of CRE properties and borrower defaults. Over time, regulatory improvements, such as stricter underwriting and risk management requirements, have been implemented. Nevertheless, predicting the future remains uncertain. We can only analyze past patterns and the shortcomings to properly assess future risks.

In 2023, community and regional financial institutions comprise approximately 72% of the CRE loan market, taking on an above-average amount of CRE credit exposure. Recognizing such circumstances is vital, as you should be alert to potential red flags. Identifying and managing CRE credit risk is critical.

Identifying Emerging CRE Risk

A comprehensive understanding of CRE credit risk highlights the increasing complexity of its landscape. CRE credit risk is multifaceted, with numerous risk categories affecting CRE lending, including market risk, asset risk, liquidity risk, and credit risk, among others. To construct a robust risk management strategy, all these variables must be explored and considered.

To assess your financial institution’s CRE loan segment’s health, a systematic approach is needed. When determining if your CRE portfolio exceeds your institution’s risk appetite and how to quantify that risk and respond effectively, the answers lie in developing a comprehensive, tailored framework for assessing and analyzing your CRE loan market. The most recent regulatory interagency Statement on Prudent Risk Management for Commercial Real Estate Lending notes that institutions that successfully monitored risk have:

  • Established appropriate loan policies, underwriting standards, and concentration limits.
  • Conducted cash flow analyses based on realistic rates and expenses to ensure repayment ability and assessed borrowers’ ability to repay during interest rate fluctuations and loan structure changes.
  • Analyzed the impact of economic changes on the loan portfolio’s quality, earnings, and capital.
  • Provided boards and management with information to adapt lending strategies in changing market conditions.
  • Maintained information systems to manage concentration risk effectively.
  • Implemented appropriate appraisal review and collateral valuation processes.

With the many challenges faced by community financial institutions, the need to effectively identify, measure, and manage these risks has become paramount. While established best practices exist to address these risks, financial institutions must transition from assessing each risk in isolation to recognizing the interconnectedness and synergy between them. A more holistic approach to risk management is required, allowing institutions to confidently inform their capital planning, risk tolerance, and overarching strategy.

Strengthening CRE Risk Management in Community Financial Institutions

A comprehensive risk management strategy empowers financial institutions to adapt to market dynamics, instilling confidence among stakeholders and regulators. Alongside the factors discussed in the previous section, regulatory guidelines highlight two critical facets of CRE risk management: stress testing and portfolio reviews. While community financial institutions can execute these internally, outsourcing can offer efficiency and effectiveness.

CRE Portfolio Stress Testing

Stress testing and sensitivity analyses are indispensable tools for evaluating CRE risk and gauging the impact of economic fluctuations on asset quality, earnings, and capital. These assessments should align with the portfolio’s size and risk profile. CRE stress tests inform strategic and capital planning, credit concentration limits, policy, and underwriting. Integrating stress testing into risk management and strategic planning is essential to anticipate and mitigate risks, especially given current market uncertainties.

Although loan-level stress testing serves a purpose on a transactional level at origination, financial institutions should also regularly perform portfolio-level stress testing that encompasses a bottoms-up and a top-down approach. The bottom-up approach allows financial institutions to gauge the risks of individual, seasoned loans by stressing each transaction through interest rate changes, collateral values, and other market factors. Implying moderate and high stress scenarios to each transaction allows for early identification of potential losses and their impact on the capital of your organization. The top-down approach takes the remaining portfolio not identified on a loan-level analysis and uses the same stressors to further identify any possible impact to capital.

Independent Loan Reviews for CRE Risk Mitigation

Thorough loan reviews are pivotal for identifying and mitigating potential CRE portfolio risks. They enable banks to assess loan quality, maintain compliance with regulations, and make necessary adjustments on a loan and portfolio level. An effective loan review function is crucial for assessing asset quality, evaluating underwriting and ongoing monitoring, and identifying exceptions to policies. Proactive issue resolution ensures risk mitigation before regulatory scrutiny or asset quality deterioration.

To further safeguard against future losses, it is critical that a loan review be independent. If maintained internally at the organization, it should report directly to the audit committee of the board of directors or the full board of directors. If a third-party firm is contracted to perform this work, it too should report all findings to the board of directors or a committee thereof.

Tactical Approaches to Limit CRE Risk in an Unpredictable Market

To minimize exposure to CRE credit risk, institutions should enhance communication with borrowers, allocate additional resources for portfolio management, understand collateral, and manage interest rate risk. Effective market area monitoring, adaptable to the institution’s unique risk exposure and appetite, is essential. Clear communication of risk tolerance from the board down to lending staff fosters alignment and clarity.

Community financial institutions must not become complacent in their approach to risk management. It is critical to remain agile and continually adapt to changing environments and emerging risks, especially in the currently volatile realm of CRE lending. By staying proactive and employing a comprehensive risk assessment and management approach, banks and credit unions can successfully address CRE credit risk, safeguard their portfolios, and maintain their success.

Optimize Your Risk Management Strategies with Young & Associates

With over four decades of experience, Y&A specializes in helping community financial institutions manage risk. Our enduring presence in the industry reflects our ability to adapt to evolving financial landscapes. Our seasoned consultants, who have backgrounds in banking, bring firsthand experience of market fluctuations.

Outsourcing CRE Stress Testing

Young & Associates offers a CRE portfolio stress testing service that efficiently and insightfully assesses your portfolio. Using data specific to your bank, we stress your CRE portfolio across various factors. Our report quantifies potential impacts on earnings and capital resulting from collateral value decreases, changes in property net operating incomes, or increases in interest rates. What sets us apart is our ability to handle the stress testing process efficiently, allowing your institution’s management to focus on other important initiatives.

Outsourcing Loan Review

For most community financial institutions, outsourced loan review is the best choice due to size and the need for an independent party. Our loan review service, applied to your CRE portfolio, not only uncovers individual credit assessments but also evaluates the alignment of your credit standards, analysis, and continuous credit monitoring with the specific characteristics of your CRE portfolio. Our findings not only inform you about existing portfolio risks but also provide recommendations for effective risk management.

Contact us to explore how we can support your journey in addressing CRE credit risk effectively.

The Art of Safe Lending: How to Mitigate Commercial Loan Underwriting Risks

Written by admin on . Posted in Advice, Commercial Underwriting, Consultation, Lending & Loan Review.

By: Ollie Sutherin, Principal of Y&A Credit Services

Community financial institutions have long been known for their agility and personalized service, excelling at creating unique lending solutions and facilitating distinct transactions. However, the very attributes that have set them apart may now present fresh challenges as they seek to expand. Community banks and credit unions find themselves navigating a delicate equilibrium: effectively managing underwriting risk, diversifying their loan portfolios, and growing to better serve their communities. 

Additionally, the world of commercial loan underwriting presents its own distinctive challenges that further complicate finding this equilibrium. Commercial loan underwriting standards, in particular, are designed to foster relationship banking rather than transactional interactions. Loans are underwritten based on the borrower’s anticipated ability to operate their business profitably and service the debt being requested. However, the actual cash flows of borrowers can often deviate from expectations, and the value of collateral securing these loans may fluctuate. Most commercial loans are secured by the assets they finance, along with other business assets such as accounts receivable or inventory, and sometimes entail personal guarantees. Loans secured by accounts receivable heavily rely on the borrower’s ability to collect due amounts from customers. These complexities create a web of considerations for underwriters. 

Effective management of a community financial institution’s loan portfolio necessitates a strategic approach guided by skilled underwriters who play a pivotal role in mitigating underwriting risks in commercial lending. 

The After Effects of the SVB Collapse 

A little over six months have passed since the financial world experienced a seismic shift when a prominent regional bank collapsed. This event sent shockwaves throughout the banking sector, triggering a chain reaction that affected numerous other financial institutions, both regional and local. These far-reaching consequences have also left their mark on various aspects of community bank and credit union operations. 

Risk management has always held a pivotal role in credit underwriting, and its significance has become more pronounced in today’s ever-volatile environment. As we navigate an era of monetary tightening, global inflationary pressures, and increasing interest rates, underwriters find themselves under increased scrutiny. In the past, cheap funding was abundant, but now, risk-appropriate pricing is paramount for funding new deals. Underwriters must balance a new interest rate environment with the heightened lending and refinancing risks, necessitating increased diligence in risk assessments when extending credit and negotiating terms. 

To shed light on this matter, we will explore effective strategies for community financial institutions to limit underwriting risk in commercial lending, ensuring they can thrive while maintaining a prudent approach to lending.  

Comprehensive Credit Analysis 

The cornerstone of any sound underwriting process is conducting a comprehensive credit analysis. This involves digging deep into the current financial health of the borrower, their business, and the industry they operate in. By meticulously assessing factors like cash flow, collateral, and credit history, you can gain a clearer picture of the borrower’s ability to repay the loan. 

Moreover, consider working with an experienced outsourced credit underwriting service like Y&A Credit Services to ensure you have access to the latest data, analytical tools, and expertise in evaluating commercial loans. Our team of experts can assist from reviewing your analysis to completely underwriting the transaction, ensuring you have all the information to help you make informed lending decisions. 

Diversification of Loan Portfolios 

Diversification is a risk management principle that rings true in commercial lending as well. By diversifying your loan portfolios across various industries and business types, you can reduce your exposure to sector-specific risks. A balanced mix of loans in manufacturing, real estate, healthcare, and other sectors can help buffer your institution against economic downturns that may affect a particular industry. 

Loan Covenants and Monitoring 

Establishing clear and enforceable loan covenants is another key step in limiting underwriting risk. These covenants set out the terms and conditions under which the borrower must operate and repay the loan. Regularly monitoring the borrower’s compliance with these covenants and requesting the most current information from your borrower is equally important. It allows you to detect early warning signs of financial distress and take corrective action sooner when you have more options for a successful outcome for both your borrower and your institution. 

Loan Portfolio Stress Testing 

In an ever-changing economic landscape, stress testing is an invaluable tool for gauging how your loan portfolio would perform under adverse conditions. By modeling various scenarios against your portfolio, you can assess your institution’s vulnerability to economic shocks and make proactive adjustments to your lending practices. 

Ongoing Training and Education 

Staying up to date with the latest industry trends, regulations, and best practices is essential. Encourage your staff to engage in ongoing training and education programs related to commercial lending and underwriting. This ensures that your institution’s underwriting processes remain current and effective. 

Regular Commercial Loan Underwriting Reviews 

To maintain the health of your loan portfolio, it’s crucial to conduct regular reviews of your commercial loan underwriting practices. This ensures that your institution’s standards and processes align with the evolving landscape of commercial lending. It also allows you to make necessary adjustments and refinements to minimize underwriting risks continuously. 

Outsourcing Commercial Credit Underwriting 

Third party assistance for commercial credit underwriting can be a strategic move to ensure the accuracy and effectiveness of your underwriting processes and relieve your institution of the need to maintain an up-to-date full-time staff.   Professional outsourced services, like Y&A Credit Services, offer expertise, access to advanced analytical tools, and an impartial perspective, helping your institution make sound lending decisions and maintain high underwriting standards.  These services can be implemented from fully outsourced to fractional, helping assist during peaks in volume.  

Y&A Credit Services’ Guidance in Commercial Underwriting 

Mitigating underwriting risk in commercial lending stands as a pivotal cornerstone for upholding the financial health and stability of community banks and credit unions, especially in the wake of the industry upheaval earlier this year. By implementing comprehensive credit analysis, diversifying loan portfolios, enforcing loan covenants, conducting stress tests, and investing in ongoing training, regular reviews, and outsourcing, you can confidently navigate the complexities of commercial lending while minimizing risks and enhance your institution’s lending capabilities. 

At Y&A Credit Services, we understand the importance of risk management in commercial lending, and we’re here to guide you through the process. Our outsourced credit underwriting services are designed to provide community banks and credit unions with the expertise and resources needed to make sound lending decisions. Together, we can build a more secure lending future for your institution, helping our communities one loan at a time. 

Contact us today to learn how we can help. 

Considerations for AI Adoption at Community Financial Institutions

Written by admin on . Posted in Advice, Consultation, Information Technology.

By: Mike Detrow, CISSP 

You have probably seen the headlines claiming that artificial intelligence (AI) models such as ChatGPT will soon replace many human jobs. Marketing campaigns are also touting the use of AI by vendors to improve the effectiveness of their data analysis tools. If you have not already started to think about the application of AI for banking operations, you will likely be evaluating it soon. Just as with any other risk management practice, it is best to evaluate new technologies proactively rather than waiting until your vendors force you to use them or your employees begin using them without your knowledge. 

The purpose of this article is to identify the risks associated with machine learning and generative AI that you should consider as you are evaluating use cases for AI at your financial institution. Machine learning is the use of training data and algorithms that allow computers to imitate intelligent human behavior more realistically. Generative AI uses machine learning to allow a computer to generate new content such as text, images, video, or sounds based on specific input provided by a user.  

The Role of AI in Financial Institutions: A Look at Practical Applications 

First, let’s explore potential use cases for AI in community financial institutions. Some of the applications that we have seen so far include: 

  • Document development, such as job descriptions, policies, and marketing materials 

Risk Factors for AI Implementation in Community Financial Institutions 

Next, let’s examine some of the potential risks associated with the use of AI in community banks and credit unions. One of the biggest concerns with the use of AI is the security of non-public information. Entering such data into an AI model that is not under the complete control of the financial institution or one of the institution’s vendors introduces the risk of this information being disclosed, resulting in the potential misuse of this sensitive data. 

In addition to security concerns, there are other risks which should be considered. Results provided by AI-driven decision-making models could be biased based on the data that was used to train the model. Also, the information provided by AI models may be inaccurate or misleading, which could inadvertently result in an employee disseminating such incorrect information if not thoroughly vetted.  

Building a Strong Foundation for AI Risk Management within Your Financial Institution 

Now that you are aware of the risks associated with AI, what should you do to evaluate its potential within your bank or credit union? To safeguard your financial institution in the era of rapid AI adoption, it’s imperative to set guidelines early. The first step is to establish a group within your institution that will provide oversight for AI. If you already have an IT Steering Committee, this role will likely be assigned to this committee as it should already include the appropriate employees for this task. If you do not have an IT Steering Committee, you should consider establishing a cross-functional group of employees drawn from various areas of the institution to handle AI oversight. 

The first initiative for your AI oversight group should include a discovery process to identify any existing use of AI at the financial institution. It is possible that employees are already using ChatGPT to help develop marketing materials, for writing scripts or macros, or they may be using web browser plugins to improve productivity. Some of your vendors may also be using AI for various tasks associated with delivering services to your financial institution or customers, such as AML models, loan underwriting, and website virtual assistants or chatbots.  

This group should develop a plan to identify any employee use of AI, whether it be through engaging in conversations with employees or potentially through employing the use of web traffic analysis. Keep in mind that your IT staff may not be the only employees that are potentially using AI within your financial institution.  

Additionally, your AI oversight group should review vendor documentation and, if deemed necessary, reach out to vendors to determine how they may be using AI. The purpose of this discovery process is to determine whether any non-public data has been put at risk based on any current or prior use of AI by employees or vendors so that appropriate actions can be taken to address any potential data misuse and prevent any further inappropriate AI usage.  

Once the AI oversight group has identified existing utilization of AI by employees and vendors and addressed any potential security concerns, the next step is to formally establish the institution’s risk appetite related to AI. This is achieved by documenting it within a policy that will be approved by the board and provided to employees for their acknowledgement. You should consider the following criteria within your policy: 

  • Definition of AI and the associated risks 
  • Authorization Process: Clearly defined IT Steering Committee approval requirements for new use cases. 
  • Vendor Risk Management: Due diligence practices for new vendors and ongoing monitoring of existing vendors to understand their AI usage and the potential risks involved. 
  • Acceptable Use: Employee guidelines for the usage of AI models such as ChatGPT and browser plugins, data security, output verification process, etc. 
  • Ethical and Legal Requirements: Guidelines for nondiscrimination, regulatory compliance, and adherence to other institution policies. 
  • Intellectual Property Protection: Measures to safeguard intellectual property rights and copyrighted material. 
  • Incident Response: Procedures to detect and report any suspected security incidents. 

It is important to note that it is likely not feasible to implement an outright ban of AI at the financial institution within your policy, especially as some of your vendors are likely already using AI or will be using it in the near future. 

With the use of AI expected to increase very rapidly over the next few years, it is imperative for management to establish guidelines for its use as early as possible to limit the potential for its misuse at your institution. 

Y&A’s Solution for Secure AI Adoption and Risk Preparedness within Financial Institutions 

In the rapidly evolving landscape of AI integration within the financial sector, striking a balance between reaping the potential benefits of this technology and practicing effective risk management can be challenging. It’s crucial to adopt a risk-ready approach to scaling AI integration in order to safeguard the future of your institution. The proliferation of AI applications shows no signs of slowing, making it wise to proactively address risks before regulatory measures come into effect. 

To streamline the process of addressing AI risk, Young & Associates offers a customizable AI policy that you can tailor to your financial institution’s specific needs. Click here to learn more about this product. 

Should you have any questions about this article, please reach out to Mike Detrow, Director of Information Technology, at mdetrow@younginc.com or contact us on our website. 

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