Many financial institutions have moved quickly to operationalize changes needed to address the near-term and longer-term impacts of the COVID-19 global pandemic. In a recent webinar conducted by Protiviti, credit risk management and mitigation techniques were explored in depth. More than 1,100 people attended, and many of them shared their most pressing concerns and views through polling questions focused on understanding how they are managing through the current crisis environment and beyond.
For lenders, the operational priorities include updating loan monitoring processes, loan systems flags and fields, reporting, technology infrastructure and staffing to keep up with requests for loan modifications as well as new originations under various special government programs intended to soften the financial impact of the COVID-19 crisis. At the same time, lenders must keep their eyes on a host of emerging risk issues that could arise as crisis conditions evolve. For instance, loan modifications that are being made due to the COVID-19 hardship need to be clearly identified and flagged in bank systems so that they can be tracked, monitored and followed up on, both as the crisis evolves and once the crisis period is over. This is important as these modifications can lower loss forecasting on portfolios in the short term and impact the accounting for Troubled Debt Restructurings (TDR) as well as the credit loss estimation under the Current Expected Credit Losses (CECL). Stress-testing and CECL models developed and calibrated before the pandemic need to be recalibrated to reflect actual portfolio conditions and a range of expected downside scenarios over the forecast horizon.
Government lending programs, such as the Main Street Lending Program and the Paycheck Protection Program (PPP), pose numerous risks for lenders. As an example, the two-year amortization schedule on Main Street loans, which come with a higher rate than some other government programs and no forgiveness, could increase borrower payments and make it difficult for some to meet their obligations down the line. Conditions for loan forgiveness under the PPP and making sure the full Small Business Administration (SBA) guarantee is locked down are among the concerns and potential risk issues that banks need to address.
Meanwhile, an unprecedented rush of credit-line drawdowns to shore up personal and corporate liquidity needs has increased concerns that a wave of loan defaults is on the horizon. In the commercial real estate space, for example, research firm Trepp projects that the default rate could rise from less than 1% prior to the pandemic to 8% or higher, depending on how long the crisis goes on. Leveraged loans, already a high-risk debt class, are raising red flags given that many are covenant-lite and do not allow lenders to proactively manage the loans and/or move quickly as borrower capacity for repayment decreases. Underscoring this concern is the fact that Moody’s has about 20% of collateralized loan obligations, or CLOs, which are packed with leveraged loans, on watch for potential downgrade.
Recordkeeping and Documentation
Echoing the concerns cited above, in polling conducted during the webinar, a majority of the responding financial institution attendees indicated that government lending programs, increased utilization of lines of credit and the volume of borrower deferral requests have created the greatest challenges for their organizations during this crisis.
Regarding government lending programs, lenders can take several practical steps now to mitigate downstream risks. For instance, while institutions await further guidance on the terms of loan forgiveness, they should establish processes to enable borrowers to calculate forgiveness during the applicable period after loan funding, and develop the infrastructure and processes to capture the required documentation to make a determination on forgiveness. Creating a secure site where customers can post underlying support materials for forgiveness determination and to track expenditures and metrics needed to calculate loan forgiveness is highly recommended. Taking these practical steps would also help lenders mitigate potential liability related to how they are servicing applications. Already, lawsuits have been filed against certain lenders alleging disparate treatment in the application roll-out and against prospective fraudulent borrowers. The U.S. Treasury Department also has announced that the SBA intends to perform a full audit on all loans over $2 million, and at least one major bank has disclosed that federal and state authorities are investigating its PPP lending practices. These actions all underscore the importance for lenders to ensure all processes are monitored and documents are captured going forward.
Managing Portfolio Quality
There are several actions lenders should be taking now to manage portfolio quality and mitigate losses. During the webinar, Protiviti’s experts covered many of these actions, including recalibrating credit risk rating models, identifying at-risk borrowers for closer monitoring, reassessing concentration analysis based on geographies and industry segments, staying attuned to increased fraud risk, and considering the potential for an extended economic shutdown or prolonged disruption to normal operations.
Given the many uncertainties, existing monitoring tools, such as flag reports or exception/watch reports, should be adapted to focus attention on the greatest areas of risk at the day-to-day operational level. Senior management and the board should be provided with the reports daily so that all areas of the bank are well informed on the credit quality and risk of loss in the bank’s portfolios.
Additionally, lenders should think through how they utilize traditional metrics and reporting to assess COVID-19-related delinquencies. For instance, FICO scores may not be as relevant in the current environment and should not be wholly relied upon to accurately predict default. Rather, lenders should look to those traditional metrics as a starting point, and focus on assessing borrowers more broadly on metrics such as current liquidity or deposit balance (or changes therein), as well as debt-to-income and debt coverage ratios, and how all those are changing in the current environment.
It is important to note that many planning and forecasting models were not built to accommodate the extreme scenarios being experienced in the current environment, such as over 20 million unemployment claims in the first four weeks of the crisis. Before the pandemic hit the market, banks were well on their way in preparing to report their credit losses under the new CECL accounting rules. First-quarter CECL implementation impact and reporting through 8-K filings and earnings announcements is already being released, with the additional need to adjust loss forecasts to account for changes to economic scenarios, the reasonable and supportable period, and other variables embedded in the CECL forecast. The bottom line here is that COVID-19 will impact credit losses, and financial institutions should monitor their model output and reassess the different scenarios impacting portfolio quality as they estimate their loss reserves.
The path forward will no doubt be fraught with further challenges, as governments take unprecedented steps to stem the tide of the pandemic and the resulting economic challenges. However, by continuing to take action to understand borrowers’ current conditions, supporting them where possible, and keeping abreast of changes impacting their own financial condition, institutions can mitigate the effects of this crisis today and beyond.
Todd Pleune and Benjamin Shiu from Protiviti’s Model Risk Management practice contributed to this content.