Tag: credit risk analysis

6 key components of effective credit stress testing

Written by admin on August 25, 2023. Posted in Risk Management.

When your financial institution is conducting a credit risk stress test, it’s imperative that your test has several key components for effective testing. As your trusted financial guide, at Young & Associates, we’ll walk you through the process. In this blog post, we’ll explore the key components of effective credit stress testing.

1. Comprehensive scenario design

This is the single most important component in creating an effective credit stress test. They say that success is 90% planning and 10% perspiration. While the exact percentages may vary, the message still stands. Planning is important! When you’re designing your credit stress scenario, be sure that you have taken into account the following:

Interest rates

Economic growth

Industry-specific risks such as collateral value of special use property

2. High-quality data

The quality of a statistical model is only as good as the data it’s built upon. So, when you’re collecting your data, do your due diligence to ensure that it’s:

Complete and accurate: Missing data or incorrect data will create skewed outcomes that lead to inaccurate results.

Uniform: When you’re consolidating data from several sources, it’s important to ensure that the format and measurements are uniform over time. Be sure to test at least a few samples of the data for accuracy.

Timely: When you’re forecasting credit stress, it’s preferable to use data from within the past 3-6 months. The economy is affected by many things, so data that is more current will more accurately reflect the current situation.

Unique: If you’re combining data sets, it’s all too easy to get duplicates. Be sure to review the data sets to ensure that the data is not replicated elsewhere. Duplicate data can skew the results and lead to inaccurate assumptions. Examples would include property collateralizing multiple loans. It is best to consolidate these loans into one for collateral and NOI purposes.

Relevance: Is the data that is included in the credit stress test actually relevant to the test? You may be familiar with Karl Pearson’s famous phrase, “correlation does not imply causation.” It’s good to have a working knowledge of economics so that you can draw accurate conclusions from the data and the causes for the outcome.

3. Robust models and methodologies

If financial institutions want to test their credit stress with integrity, it’s important that they use robust models and methodologies to measure the risk under various circumstances. To achieve this, be sure the model you are using bases its testing on consistent data and data that is relevant to current or future economic outcomes.

4. Adequate portfolio selection

To obtain an accurate credit risk stress test for a specific loan portfolio (we recommend doing this), then it’s important to include a representative sample size for each segment of your portfolio (bottoms-up approach). However, if the sample size is small, Young & Associates will use call report data to back-fill the rest of the portfolio and use industry standards to stress the portfolio of loans not individually stressed (top-down approach). By including “the rest of the portfolio” Young & Associates can cover the entire portfolio without the financial institution having to gather all that data on smaller loans and accurately reflect the credit risk of your financial institution.

5. Credit stress scenario and sensitivity

By now, you are familiar with the preparation for a credit stress test, but another key component is the execution. What are the metrics that you’re measuring to indicate the credit risk of your bank or credit union? Credit stress tests measure several specific metrics, including credit losses, capital requirements and default rates and the sensitivity to those risks. This highlights the metrics that heavily influence the results and can indicate the robustness of the model.

6. Risk aggregation and reporting

Like any work, the communication of that data is just as important as the data itself. After the calculations are made, gather the outcomes and associated risks, while adding your insights for how to improve those risks. Young & Associates will go through the stress test report in detail with you and indicate issues in the report including specific borrowers that show greater risk. Young & Associates is also able to present the findings of the report to your board audit committee, and senior management if desired.

Connect with a consultant

Credit stress testing can sometimes feel overwhelming. We understand. Financial institutions exist to create stability for others, so when your bank or credit union is required to document the stress on your system, it can feel daunting. That’s where Young & Associates comes in. With unmatched expertise, you can trust us to guide your financial institution even when the future may seem unclear. Contact us today to learn more about our consulting and educational services.

Assess, plan, and effectively respond to today’s market challenges

Written by admin on July 18, 2023. Posted in Risk Management.

By: Jerry Sutherin, President & CEO

In today’s dynamic market, some of the biggest challenges faced by our clients include but are not limited to interest rate risk management, liquidity, capital adequacy, and commercial loan underwriting. These issues are magnified by the ability of our clients to locate, hire, and retain quality human capital to operate effectively and efficiently.

Interest rate risk management

Rising or fluctuating interest rates impact your financial institution’s growth prospects in both the short and long term. Not only do interest rates pose a risk to a financial institution’s balance sheet, but they also impede the ability to effectively produce reliable financial statement forecasts. A financial institution’s Net Interest Margin (NIM) is a key component of each income statement. Being able to adequately forecast interest income as well as internal cost of funds allows an institution to produce a reliable budget. To overcome this, financial institutions must identify, measure, monitor, and control interest rate risks to meet the requirements of the Joint Policy Statement on Interest Rate Risk (IRR) and the IRR regulatory guidance. Effective control of the interest rate risk will require conducting annual independent reviews of the asset liability management (ALM) function and validating your risk measurement systems to ensure their integrity, accuracy, and reasonableness. This will also involve internal controls of loan and deposit pricing. Establishing and maintaining these controls should begin at the board level and flow through management.

Credit risk management

Rising interest rates have also had a profound impact on credit quality of commercial lending. (One of the primary drivers of revenue for most financial institutions). The change in credit quality results in the tightening of credit standards throughout the industry and by the regulators. Being able to effectively underwrite loans and mitigate risks within a commercial loan portfolio is a function of having seasoned staff to manage these processes. Lack of quality credit talent exposes financial institutions to otherwise preventable credit risks. The dilemma for most financial institutions is finding, hiring, and maintaining experienced personnel. In some instances, this has resulted in inadequate credit presentations being prepared by unqualified individuals or loan officers underwriting their own credits for approval. The increasing burden of inflation and wages adds another layer of complexity to the mix. Many community-focused institutions are not willing or able to pay top rate for talent. This is understandable given the need and focus to remain competitive among the larger regional and national banks.

Liquidity risk management

Another impact of a higher interest rate environment and inflation is the disintermediation of funds or liquidity from financial institutions to other financial intermediaries. Sound liquidity management is crucial for controlling your organization’s liquidity risk and managing cash flow to meet expected and unexpected cash flow needs without adversely affecting daily operations. Your financial institution should assess the range of possible outcomes of contemplated business strategies, maintain contingency funding plans, position for new opportunities, and ensure regulatory compliance and the adequacy of your risk management practices.

Capital planning

Both interest rate risk management and liquidity management have a direct impact on the capital adequacy of all financial institutions. Capital contingency planning will ensure that your financial institution maintains the required level of capital through any realistic stress event. Periodic review of minimum capital requirements and stress tests can provide valuable insights. They will also maintain your standing with the regulators.

The importance of strategic planning

So far, this article has only discussed the challenges faced by the financial institution industry. These obstacles are not just management issues. They are also issues that boards of directors must navigate as well.

Are there solutions? Absolutely — yes there are. Boards of directors and management must be aligned on all strategic initiatives. These objectives need to be derived and adopted by the board and conveyed to management. The most common approach is through a focused strategic planning session involving the board and management. The outcome of such a retreat will enable the board to identify goals and risks faced by the organization. It also helps decide how to accomplish the goals and mitigate the risks. This could be through the utilization of qualified internal staff or engaging outside experts to assist with each objective. An effective strategic plan will incorporate all these pieces to help navigate the changing industry landscape.

More about Y&A

For 45 years, Young & Associates has partnered with banks and credit unions across the country. We provide consulting, outsourcing, and educational services to minimize their risk and maximize their success. Our services cover areas such as interest rate risk analysis, liquidity planning, assessment of capital adequacy strategic planning, regulatory assistance, internal audit, independent loan review, IT audits and penetration testing, and regulatory compliance assessment, outsourcing and training. Our team of consultants boasts an unmatched level of industry experience and is comprised of former banking executives, compliance regulators, and tenured finance professionals who have personally experienced many of the same issues you face at your organization.

More about Y&A Credit Services

For commercial credit needs, Y&A Credit Services is a full-service provider of outsourced underwriting services and credit analysis. An independent entity, Y&A Credit Services offers the same exceptional service, expertise, and integrity you’ve learned to expect from Young & Associates. Y&A Credit Services provides commercial credit underwriting and credit approval presentations, annual underwriting reviews, financial statement spreading and analysis, and approval and underwriting package reviews. We’ll work to improve the quality, speed, and accuracy of your lending with a focus on minimizing your credit risk. Our team members are experts in credit services and the financial industry. Our team includes former chief credit officers and senior credit analysts from both community and regional banks. We provide full outsourced credit department services to our clients, keeping their costs low. This helps these institutions remain competitive in their markets. Our seasoned credit professionals boast a combined more than 100 years of experience in credit administration. Our experts help mitigate risks while assisting our clients with safe and sound underwriting processes.

Partner with us for success

We look forward to assisting your bank or credit union in meeting these challenges head on. Contact us directly by emailing Jerry Sutherin, President & CEO, at jsutherin@younginc.com or calling him directly at 330.422.3474

The role of loan review in the credit risk management system

Written by admin on July 18, 2023. Posted in Risk Management.

By: David Reno, Director of Loan Review & Lending Services

Loans, especially non-consumer loans, typically represent the greatest level of risk on your balance sheet. Therefore, effective commercial loan portfolio management is crucial to control credit risk. It can serve as an early indicator of emerging credit risk related to lending to individual borrowers, aggregate credit exposure to related borrowers, and the overall credit risk associated with a loan portfolio. It serves as an integral part of an institution’s credit risk management system that is a continuum comprised of the following stages:

Well-formulated lending policies, procedures, and practices that are consistently applied, well-known to all credit and lending staff, and compliant with regulatory guidance
The collection and accurate credit analysis of financial and other underwriting information
Assignment of an accurate risk grade
Proper and qualified approval authorities and risk-based process
Correct and thorough documentation
Pre-closing preparation and loan closing
Post-closing credit administration
Internal annual loan review
External/independent loan review
Timely problem loan identification and management
Proper calculation of the ALLL
Collection and loss mitigation

Effective and efficient loan reviews can help an institution better understand its loan portfolio and identify potential risk exposures to contribute to the formulation of a risk-based lending and loan administration strategy.

Regulatory background

The OCC, FRB, FDIC, and NCUA issued the Interagency Guidance on Credit Risk Review Systems in FIL-55-2020 dated May 8, 2020, which aligns with Interagency Guidelines Establishing Standards for Safety and Soundness. This guidance is relevant to all institutions supervised by the agencies and replaces Attachment 1 of the 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. The final guidance details the objectives of an effective credit risk review system and discusses such topics as sound management of credit risk, a system of independent, ongoing credit review, and appropriate communication regarding the performance of the institution’s loan portfolio to its management and board of directors.

Credit risk rating (or grading) framework

The foundation for any effective credit risk review system is accurate and timely risk ratings. These risk ratings are used to assess credit quality and identify or confirm problem loans. The system generally places primary reliance on the lending staff to assign accurate, timely risk ratings and identify emerging loan problems. However, the lending personnel’s assignment of risk ratings is typically subject to review by qualified and independent peers, managers, loan committee(s), internal credit review departments, or external credit review consultants that provide a more objective assessment of credit quality.

Elements of an effective credit risk review system

The starting point is a written credit risk review policy that is updated and approved at least annually by the institution’s board of directors or board committee to evidence its support of and commitment to maintaining an effective system. Effective policies include a description of the overall risk rating framework and responsibilities for loan review.

An effective credit risk review policy addresses the following elements:

Qualifications of credit risk review personnel. The level of experience and expertise for credit risk review personnel is expected to be commensurate with the nature of the risk and complexity of the loan portfolio, and they should possess a proper level of education, experience, and credit training, together with knowledge of generally sound lending practices, the institution’s lending guidelines, and relevant laws, regulations, and supervisory guidance.

Independence of credit risk review personnel. Because of their frequent contact with borrowers, loan officers, risk officers, and line staff are primarily responsible for continuous portfolio analysis and prompt identification and reporting of problem loans to proactively identify potential problems. While larger institutions may establish a separate credit review department, smaller institutions may use an independent committee of outside directors or other qualified institution staff. These individuals should not be involved in originating or approving the specific credits being assessed, and their compensation should not be influenced by the assigned risk ratings. Regardless of the approach taken, it is prudent for the credit risk review function to report directly to the institution’s board of directors or a committee thereof. Senior management should be responsible for administrative functions.

The institution’s board of directors may outsource the role to a third-party vendor; however, the board is ultimately responsible for maintaining a sound credit risk review system.

Scope of reviews

Comprehensive and effective reviews cover all segments of the loan portfolio that pose significant credit risk or concentrations. The review process should consider industry standards for credit risk review coverage, which should be consistent with the institution’s size, complexity, loan types, risk profile, and risk management practices. This consideration helps to verify whether the review scope is appropriate.

An effective scope of review is risk-based and typically includes:

Loans over a predetermined size along with a sample of smaller loans
Loans with higher risk indicators, such as low credit scores or approved as exceptions to policy
Segments of loan portfolios, including retail, with similar risk characteristics, such as those related to borrower risk (e.g., credit history), transaction risk (e.g., product and/or collateral type), etc.
Segments of the loan portfolio experiencing rapid growth
Past due, nonaccrual, renewed, and restructured loans
Loans previously criticized or adversely classified
Loans to insiders, affiliates, or related parties
Loans constituting concentrations of credit risk and other loans affected by common repayment factors

Review of findings and follow-up

A discussion of credit risk review findings should be held with management, credit, and lending staff and should include noted deficiencies, identified weaknesses, and any existing or planned corrective actions and associated timelines.

Communication and distribution of results

The results of a credit risk review are presented in a summary analysis with detailed supporting information that substantiates the concluded risk ratings assigned to the loans reviewed. The summary analysis is then periodically presented to the board of directors or board committee to maintain accountability and drive results. Comprehensive reporting includes trend analysis regarding the overall quality of the loan portfolio, the adequacy of and adherence to internal policies and procedures, the quality of underwriting and risk identification, compliance with laws and regulations, and management’s response to substantive criticisms or recommendations.

Summary insights

The back-testing that is performed by the loan review process is necessary to ensure that an institution has in place a comprehensive and effective credit risk management system and that an institution acknowledges and practically applies the established framework of its unique but compliant credit culture.

An effective external loan review process is not so much a traditional audit exercise as it is an advisory process that produces meaningful dialogue between the review firm and the institution that seeks to identify and interpret various aspects of credit risk to minimize risk of loss by implementing industry best practices, maintaining regulatory compliance, and supporting the institution’s long-term viability in continuing to serve the needs of its customers and community.

For more information on the role of loan review in the credit risk management system, contact David Reno. Reno is the director of loan review & lending services, at dreno@younginc.com or 330.422.3455.

Ensure you’re ready for the upcoming current expected credit loss (CECL) implementation deadline in January 2023

Written by admin on December 5, 2022. Posted in Risk Management.

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Key elements of effective credit underwriting

Written by admin on July 27, 2022. Posted in Lending & Loan Review.

By Ollie Sutherin, chief financial officer, Young & Associates

The focus of this article is to provide an overview of what Y&A Credit Services views as key elements during the underwriting process. While there are many variables needed to effectively underwrite credits, below are the primary focal points of any quality credit presentation that we underwrite or review.

Cash is king

“Cash is king” is a saying that we use often as it translates to, “if you don’t have the cash to repay, you shouldn’t have the loan.” So often we are presented with transactions that aren’t the strongest, don’t show cash flow, and the underlying organization has no business being lent money. Lenders often try to form complex explanations regarding the guarantor’s wherewithal, global cash flow, etc., and they lose sight of the actual company, its financial condition, and its ability to service the debt on a stand-alone basis.

Every analysis should begin with the subject company and its ability to service debt. If it is a real estate holding company and the note is secured by a specific property, what is the cash flow of that property? If the most recent tax return statement, compiled, audited, etc., does not evidence the ability to service debt, what is the trend of the company? What are they doing to improve from the previous year and what is the YTD revenue/expenses compared to the prior year?

Eventually, we take into consideration the guarantor’s wherewithal and how it impacts the cash flow; however, the primary focus should always be on the company itself (the primary repayment source). If a transaction is being presented where repayment is heavily reliant on the guarantor, then the following questions must be asked: What is their character like? Have all of the assets and liabilities been verified on their personal financial statement(s)? Are other contingent liabilities factored in as well? So often, mistakes are caught when analysts simply say, “John Doe has $1,000,000 in cash and is clearly able to service the subject note should it be needed” without doing the proper due diligence verifying the source of the cash.

Quality of information

If the cash flow of the company is the backbone of the transaction, then the quality of information is the legs, providing the necessary base for everything. We are always looking at the reliability of this information as it minimizes the risks of inaccuracy and subsequently the risk of default. For example, if borrowers only give internal statements that are hastily prepared and communicate lease details in one-two sentences in an email, this poses a much greater risk than detailed property information in the actual tax return and actual signed lease agreements provided for review. Furthermore, as it pertains to C&I transactions, internally prepared statements rarely reconcile, which makes performing a UCA Cash Flow analysis much more difficult. Tax returns and audited or compiled statements always reconcile, providing an accurate analysis.

Collateral values

As it relates to the property or equipment securing an obligation, an appraisal is always going to be the safest way to measure the value. Too often, internal evaluations or estimates are utilized to justify a request during underwriting. To meet regulatory standards, the collateral securing an obligation must support the amount being considered and obtaining the appraisal during the underwriting phase can potentially save a significant amount of work if the value is insufficient to support the debt. For existing credits that are being refinanced, another important aspect of collateral valuations includes site visits by the account officers. Having photos and notes from the site visit will provide added support to the collateral pledged for the transactions.

Stress testing

Stress testing individual loans during underwriting is becoming increasingly necessary, especially in today’s rising rate environment. This was a regulatory focus back in the late 2010s as there was a rising interest rate environment. Variable rate notes, property values, vacancy rates and ultimately cash flow for debt service were adversely impacted. At the beginning of the pandemic in March 2020, rates dropped markedly and remained flat until just recently. To curb inflation, the Federal Reserve began increasing rates and the extent of the impact on variable rate loans has yet to be determined.

Stressing individual loans at origination provides the institution with a tool to better understand the impact of rate increases on cash flow, property values, and vacancy rates in different scenarios. The result is a more informed credit decision during the underwriting phase. Ultimately, these variables help determine the breakeven point of a business’s cash flow and provide great insight to the actual strength of the primary borrower.

Projections / proformas

These are something that all lenders should request from a borrower/potential borrower to justify the strength of a transaction. However, often these projections will paint an excellent picture of the company and a stellar cash flow that is more than adequate to service the underlying transaction. The intent of requesting and analyzing projections is to compare them to historical results, in many instances where the projected cash flow is higher than historical results. This is typically due to the borrower understating expenses which leads to overstated cash flow and debt service coverage. Given all of this, it is still important to obtain projections and to compare them to actual statements when available. Should they vary significantly, it will open the door to questions and force a deeper look into smaller details such as management of the company.

Y&A Credit Services

Over the past few years, a defined need has developed in the community financial institution industry. Specifically, it has been difficult for financial institutions to hire and retain quality credit professionals, especially in rural areas, to underwrite loans and perform other necessary tasks necessary for adequate credit administration. This need has led Young & Associates, Inc. to create a wholly-owned subsidiary (Y&A Credit Services) to meet the needs of these organizations. Y&A Credit Services has the mission of filling the voids of clients who have limited or even no credit staff to perform these necessary tasks. If your organization has a need for credit underwriting services, please feel free to contact us at 330.422.3482. Our services include spread sheet analyses, annual reviews, full credit underwriting and review of prepared presentations along with a full complement of other credit-related services through Young & Associates, Inc.

Young & Associates introduces Y&A Credit Services, LLC

Written by admin on June 1, 2022. Posted in Announcements, News.

We are proud to introduce a new line of business through an affiliated organization of Young & Associates, Inc.: Y&A Credit Services, LLC.

Y&A Credit Services is a full-service provider of outsourced underwriting and credit services and offers various commercial underwriting and credit services such as:

Commercial credit underwriting and credit approval presentations
Annual underwriting reviews
Financial statement spreading and analysis
Approval and underwriting package reviews

“Y&A Credit Services understands the challenges that financial institutions nationwide face with locating and retaining skilled credit department staff who can efficiently produce trustworthy credit risk management results while supporting an increasing volume of workflow,” said Jerry Sutherin, President & CEO of Young & Associates. “We offer an effective solution to this dilemma by employing our experienced staff, technology, and proven processes to enhance your credit administration process, mitigate credit risk, and ensure continued profitable loan portfolio growth and performance.”

Completely independent from Young & Associates, Inc. and with a name you trust, Y&A Credit Services can help large and small financial institutions increase the quality, accuracy and speed of their lending while mitigating risks in a highly regulated industry. “We are an independent entity, but we offer the same exceptional service, expertise, and integrity you’ve learn to expect from Young & Associates,” says Ollie Sutherin, Principal of Y&A Credit Services.

Visit yacreditservices.com to learn more about the new company and explore the website. And if our services sound like a viable solution to your current challenges, contact Ollie Sutherin by email at osutherin@younginc.com or phone at (330) 422-3453. We would be happy to discuss how we can help your credit department and institution achieve its objectives.

Testing Your Balance Sheet’s Capacity to Weather the Pandemic and Embrace New Opportunities

Written by admin on October 5, 2020. Posted in Management & Planning.

By Martina Dowidchuk, Senior Consultant and Director of Management Services

As we adjust to the new reality and navigate through the immediate operational challenges, long-term planning comes back into focus. What is the bank’s balance sheet capacity to weather the economic downturn, absorb the potential losses, and leverage the existing resources to support households and businesses affected by the pandemic?

Community banks, with their relationship-based business models, are uniquely positioned to support their markets by using their in-depth knowledge of the local economies and the borrowers’ unique situations to provide timely and individualized assistance for impacted customers. This is an opportunity to facilitate a return to economic stability and be the source of information and communication, but also to enhance customer relationships and trust over the long term.

Unlike during the 2008 financial crisis, most banks have stronger risk infrastructure, larger capital buffers, and higher liquidity reserves. How long the existing safeguards will last depends on the length and severity of the downturn. As we continue to work surrounded by an array of unknowns, there are planning steps that can be taken now to get in front of problems and position the bank to leverage its strengths to support the local communities and shareholders.

Capital Plan Review – How much capital can be deployed into new credits? How much stress can we absorb?

Considering the abrupt economic changes, the bank’s risk-specific minimum capital level requirements should be revised to reflect the likely changes in the levels and direction of credit risk, interest rate risk, liquidity risk, and others. The recently issued regulatory statement relaxing capital requirements includes modifications related to the amount of retained income available for distribution, allowing banking organizations to dip into their capital buffers and to continue lending without facing abrupt regulatory restrictions. Institution-specific capital adequacy calculations can also provide a basis for the decision whether or not to opt in to using the community bank leverage ratio, which has been temporarily reduced from 9 percent to an 8 percent minimum threshold.

Stress testing the capital against credit losses, adverse interest rate environment, and other earnings challenges can help identify potential vulnerabilities and allow management to proactively prepare and protect the bank from losing its well-capitalized status should the simulated stress scenarios unfold. The sooner the problems are identified, the more flexibility you have in developing a solution. Every bank should have an up-to-date capital contingency plan to be implemented if the capital levels approach the minimums needed for a well-capitalized bank designation.

The review of the minimum capital requirements and the stress tests can provide valuable insights regarding not only the bank’s ability to survive a recession, but also to estimate the amount of “excess” capital that can be used to support additional lending. Many banks can justify lower capital requirements once they customize the capital adequacy calculations to their specific risk profiles. If additional asset growth can be supported from the capital perspective, the plan should be further evaluated from the liquidity standpoint.

Liquidity Plan Review – Are the existing liquidity reserves sufficient to support additional loan growth and the potential funding pressures?

Liquidity plan review needs to go hand in hand with capital planning. While most community banks have strong liquidity positions, the scale and speed of the coronavirus shock have raised concerns that credit drawdowns, sudden declines in revenues, and a higher potential for credit issues will strain bank balance sheets. Funding pressures may be building because of uncertainty about the amount of damage that the coronavirus might cause. Banks may be experiencing deposit drains from customers experiencing financial hardship or seeing withdrawals driven by fear. On the other hand, the volatility of the stock market and the uncertainty may drive the “flight to safety” and increases in bank deposits.

Changes in the business strategies and the results of the capital stress tests should be incorporated in the liquidity plan and the projected cash flows should be stress tested. Banks need to plan for ways to meet their funding needs under stressed conditions. The simulations should cover both short-term and prolonged stress events using a combination of stress constraints that are severe enough to highlight potential vulnerabilities of the bank from the liquidity perspective. The analysis should show the impact on both the on-balance sheet liquidity and the contingent liquidity, while taking into consideration changes in the available collateral, collateral requirements, limitations on access to unsecured funds or brokered deposits, policy limits on the use of wholesale funding, and other relevant stress factors.

Credit Risk Assessments – What is the loan loss potential?

Credit risk has the highest weight among the risk factors affecting capital and it is the biggest unknown in today’s environment. The assessments will need to shift to be more forward looking rather than solely relying on past performance. The stress tests will be most useful when customized to reflect the characteristics particular to the institution and its market area. Banks need to understand which segments of their portfolio will be the most affected and perform targeted assessments of the potential fallout, along with the review of other segments that may have had weaker risk profiles before the pandemic, higher concentrations of credit, or those segments that are significant to the overall business strategy.

The estimates might be a moving target in the foreseeable future; however, once the framework is set up, the analyses can be regularly repeated to determine the current impact. The results of these credit risk assessments will provide a valuable input for fine-tuning the capital plan and assessing adequacy of liquidity reserves, as well as for formulating strategies for working with the affected borrowers and extending new credit.

Measuring Impact of Plans

As we face abrupt changes in the strategic focus, taking the time to diagnose strengths and weaknesses, to understand the range of possible outcomes of the new business strategies, and to line up contingency plans ready to be invoked as the picture get clearer is a worthwhile exercise. Young & Associates, Inc. remains committed to assist you in every step of the plan review process. Our modeling and stress testing tools will allow you to generate valuable support information for your decision making, ensure regulatory compliance, and be proactive in addressing potential problems and positioning for new opportunities. For more information, contact Martina Dowidchuk at mdowidchuk@younginc.com or 330.422.3449.

Loan Modifications: A Proactive Approach for Working with Borrowers Impacted by Coronavirus (COVID-19), Guided by Recently Issued Interagency Statement

Written by admin on April 1, 2020. Posted in Lending & Loan Review.

By Bob Viering, Director of Lending, and Aaron Lewis, Director of Lending Education, Young & Associates, Inc., March 25, 2020

On March 22, 2020, the federal banking regulators issued an interagency statement on loan modifications for customers affected by the Coronavirus Disease 2019 (also referred to as COVID-19). In a number of ways, it resembled historical statements issued in the wake of natural disasters. In keeping with previously issued statements following natural disasters the federal regulators recognize that there can be an impact on borrowers and encourages banks “to work prudently” with those borrowers. However, given the sudden and significant impact of the rapidly spreading coronavirus pandemic that has had a nationwide impact, the breadth of the statement was far more reaching than previous statements issued following natural disasters which historically have been isolated to specific geographic regions. In the statement the federal regulators included the following provisions:

1. The federal regulators confirmed with the Financial Accounting Standards Board (FASB) that “…short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings (TDRs).”

2. “…short term (e.g., six months)…”modifications can include: payment deferrals, fee waivers, extension of payment terms or other delays in payments that are “insignificant.”

3.“Current” is defined as less than 30 days past due. If the credit is current at the time of the modification the borrower is deemed to not be experiencing financial difficulties.

4. Banks can choose to work with individual borrowers or as “part of a program.”

5. Borrowers granted a modification will not be “automatically adversely risk rated” by agencies’ examiners. In fact, it is stated that agency examiners will use judgment in reviewing credits modified and “regardless of whether modifications result in loans that are considered TDRs or are adversely classified, agency examiners will not criticize prudent efforts to modify the terms on existing loans to affected customers.”

6. Loans granted modifications will not be classified as past due if modified, unless they become past due per the terms of the modification.

7.During the temporary short-term arrangements (as provided in the Interagency Statement), loans should not be reported as “non-accrual.”

8. As information is gathered, if an adverse classification, non-accrual, or charge-off is warranted, bank actions should follow existing guidance on the topics.

The best way to interpret the Interagency Statement is to consider it as providing banks breathing room while more information is developed that allows the bank to accurately assess the borrower’s financial strength. It is clear throughout the statement that any modifications must be temporary and short-term to not be classified as TDR. This guidance is in keeping with previous statements regarding TDR and relative impact to the credit. While there is no specific definition of what constitutes short-term or temporary, the mention of six months in the Interagency Statement should be a reasonable maximum to consider.

The statement mentions that working with either individual borrowers or as part of a program is acceptable. The term “individual borrowers” is fairly self-explanatory. A “program” for working with borrowers will require a bank to determine criteria to allow for a more automatic deferral decision. This would need to include checking that the borrower was not past due for reasons other than the impact of COVID-19, that the deferral meets the criteria as outlined in the Interagency Statement, and that the bank believes the borrower has been impacted by the Coronavirus. In the case of a program, the decision on granting deferrals may be made by a lender or manager close to the front lines.

Once the deferral decision has been made, the real work begins. As mentioned above, this statement really provides banks with a near-term way to deal with an unknown impact while providing time to fully assess the actual impact on the borrower. Here are the steps we would recommend that banks take in response to the impact of COVID-19:

1. Make a list of borrowers most likely impacted by COVID-19. Hotels, restaurants, non-essential retailers, ‘Main Street business,’ some manufacturers, distributors, and especially non-owner occupied commercial real estate owners with tenants impacted by COVID-19 are examples of customers that are most vulnerable to the current health crisis.

2. Reach out to those borrowers to see how they are doing, how they have been impacted, and what they see as next steps for their business. Let your borrowers know you are here to work with them as they navigate through the downturn, including taking pro-active steps to ensure the viability of their business. Let them know what you are doing in the community to help. This is the most important time to keep up communications with your customers. They may well be concerned about what might happen to them and a few kind words of support from their bank can go a long way to letting them know they are not alone.

3. Based on your initial analysis and conversations with potentially impacted borrowers, you should derive a shorter list of borrowers for which deeper analysis is warranted. As you develop a forward-looking analysis the following considerations should be made:

4. It is imperative that a pro-active approach is taken by the institution in response to the impact of COVID-19. Sufficient human resources should be dedicated to the bank’s response and outreach to impacted customers. If human resources are limited at the institution, the aforementioned list of borrowers should be prioritized based on factors developed by management, i.e., size of credit, borrower sensitivity to the impact of a downturn, and those businesses considered critical to the well-being of the community (large employers).

In addition to the bottom-up (customer level) analysis discussed above, we would recommend that the bank perform a comprehensive stress test of its loan portfolio to determine the level of impact, if any, on capital which should be addressed by the board and senior management. (This is a great time to update your capital plan as well.)

The next few months are likely to be a difficult period for many banks and their borrowers. As of today, we don’t really know the actual impact on the economy from COVID-19. But, we can be sure it won’t just be a quick blip and a return to normal for all borrowers. Take the time allowed by this unprecedented Interagency Statement and be proactive.

IRR and Liquidity Risk Review – Model Back-Testing / Validation of Measurements

Written by admin on March 6, 2020. Posted in Lending & Loan Review, Management & Planning, Risk Management.

Effective risk control requires conducting periodic independent reviews of the risk management process and validation of the risk measurement systems. This helps to ensure their integrity, accuracy, and reasonableness. To meet the requirements of the Joint Policy Statement on Interest Rate Risk (IRR), as well as the Interagency Guidance on Funding and Liquidity Risk Management and the subsequent regulatory guidance, Young & Associates, Inc. can assist you in assessing the following:

The adequacy of the bank’s internal control system
Personnel’s compliance with the bank’s internal control system
The appropriateness of the bank’s risk measurement system
The accuracy and completeness of the data inputs
The reasonableness and validity of scenarios used in the risk measurement system
The reasonableness and validity of assumptions
The validity of the risk measurement calculations within the risk measurement system, including back-testing of the actual results versus forecasted results and an analysis of various variance sources

Our detailed interest rate risk review reports and liquidity risk review reports assess each of the above, describe the findings, provide suggestions for any corrective actions, and include recommendations for improving the quality of the bank’s risk management systems, and their compliance with the regulatory guidance. We are happy to customize the review scope to your bank’s specific needs.

For more information, contact Martina Dowidchuk at mdowidchuk@younginc.com or 330-422-3449.

Liquidity Risk Management

Written by admin on March 6, 2020. Posted in Compliance & Regulations, Management & Planning.

By Martina Dowidchuk, Director of Management Services and Senior Consultant

Does your liquidity management meet the standards of increased regulatory scrutiny? Regulators are gradually reviewing what they once deemed acceptable more rigidly, and financial institutions need to be prepared to show that their liquidity risk oversight complies with both supervisory guidance and sound industry practices.

Community banks may not view liquidity risk as an immediate concern given the abundance of liquidity in the banking industry today. However, the history shows that liquidity reserves can change quickly and the changes may occur outside of management’s control. A bank’s liquidity position may be adequate under certain operating environments, yet be insufficient under adverse environments. Adequate liquidity governance is considered as important as the bank’s liquidity position. While the sophistication of the liquidity measurement tools varies with the bank’s complexity and risk profiles, all institutions are expected to have a formal liquidity policy and contingency funding plan that are supported by liquidity cash flow forecast, projected liquidity position analysis, stress testing, and dynamic liquidity metrics customized to match the bank’s balance sheets.

Some of the common liquidity risk management pitfalls found during annual independent reviews include:

Cash Flow Plan:

Lack of projected cash flow analysis
Inconsistencies between liquidity cash flow assumptions and the strategic plan/budget
Lack of documentation supporting liquidity plan assumptions
Overdependence on outdated, static liquidity ratios and lack of forward-looking metrics
Lack of back-testing of the model

Stress Scenarios:

Stress-testing of projected cash flows not performed
Stress tests focusing on a single stress event rather than a combination of stress factors
Stress tests lacking the assessment of a liquidity crisis impact on contingent funding sources
Insufficient severity of stress tests

Contingency Funding Plan Document:

Contingency funding plan failing to address certain key components, such as the identification of early warning indicators, alternative funding sources, crisis management team, and action plan details
Lack of metrics defined to assess the adequacy of primary and contingent funding sources in the baseline and stressed scenarios

Liquidity Policy:

Inadequate risk limits or lack of acceptable levels of funding concentrations defined in the liquidity policy
Liquidity policy failing to address responsibilities for maintenance of the cash flow model, model documentation, periodic assumption review, and model validation

Management Oversight:

ALCO discussions related to liquidity management not containing sufficient detail and not reflected appropriately in the ALCO meeting minutes
Lack of periodic testing of the stand-by funding lines
Lack of liquidity model assumption review or documentation of such review
Lack of periodic independent reviews of the liquidity risk management process

If you want an independent review of your existing liquidity program and a model validation, or need assistance developing a contingency funding plan, liquidity cash flow plan, and liquidity stress testing, please contact me at 330.422.3449 or mdowidchuk@younginc.com. Young & Associates, Inc. offers an array of liquidity products and services that can help you to ensure compliance with the latest regulatory expectations.

A Current Perspective on Concentrations of Credit

Written by admin on February 28, 2018. Posted in Lending & Loan Review.

By: Tommy Troyer, Executive Vice President

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

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

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

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

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

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

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

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

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

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

Where is the UCA/FAS 95 Analysis?

Written by admin on August 24, 2017. Posted in Lending & Loan Review.

By: David Dalessandro, Senior Consultant

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

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

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

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

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

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

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