I had the opportunity last week to participate in a webinar hosted by the Los Angeles Chapter of The Risk Management Association (RMA), titled “Ongoing Risk Implications of Government Lending Programs.” Joined by my Protiviti colleagues Ariste Reno and Rhonda Gallion, we discussed the current bank regulatory environment, credit risk issues, and fraud and compliance issues related to government grant and lending programs, specifically the Paycheck Protection Program (PPP). The following summarizes some of the key takeaways from the webinar.
Bank Regulatory Response
We are all – the regulators included – dealing with an extraordinary situation for which there is no playbook. Regulators must draw from lessons learned from a variety of other crises, including credit crises, operational risk events and natural disasters to determine how to guide the industry through the pandemic and its aftermath. They must do this while balancing two, potentially conflicting priorities: their organizational mandate to protect the safety and soundness of the banking system and their desire to be supportive of government initiatives to aid consumers and companies that have been adversely impacted. Regulatory releases, including the June 23, 2020 Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Financial Institutions, recognize that individual institutions may face distinct and unique risks and make clear that the regulators will look closely at how management identifies and addresses these risks.
Credit Risk Issues
Banking organizations face an evolving set of credit-related risks, including:
- Increase in forbearance requests
- Declining credit quality of C&I loans, particularly in the hard-hit sectors such as travel and leisure and energy
- Expected increase in commercial real estate default rate
- Shifting customer payment priorities
- Need for increased loan loss reserves
Like the bank regulators, banking organizations are also trying to balance two priorities: supporting distressed borrowers and managing credit quality. To meet these two objectives, banking organizations will need to take specific actions to identify borrowers at risk and appropriately risk rate; evaluate how they engage with these borrowers; improve data collection, reporting and monitoring of credit portfolio risk indicators; recalibrate credit models and reassess their own debt collection and work-out capabilities.
Particularly challenging for banks is how to appropriately risk-rate and reserve for loans to borrowers that are experiencing difficulty. Loss reserving models were not built to consider the extremes in model variables (i.e., record-high unemployment, GDP contraction, permanent market shifts, and gaps in/expiry of government stimulus programs to provide income replacement) that are being experienced in this pandemic period. As such, banks have developed quantitative model overlays, qualitative adjustments and sensitivity analysis to estimate the increased risk of loss, while working to redevelop loss reserving models that can better predict losses in the current environment.
While these approaches are necessary and helpful to offset existing model limitations, they are challenging to document and support in terms of the management judgment, assumptions and measurement methods used. Regulators will be looking for well documented management rationale for these adjustments, linkage to specific portfolio risks and model limitations, and detailed support on how the adjustments were derived. (See Protiviti’s April edition of Credit Pulse for additional information on the impacts of COVID-19 on financial institution lending.)
Fraud and Compliance Risks
Fraud is a risk for all lending programs. The speed at which the PPP was rolled out and the program’s evolving rules and guidelines exacerbated that risk. Instances of PPP fraud and prosecutions are now becoming more and more frequent in the news. The cases prosecuted by the Department of Justice so far have been the low-hanging fruit – outright deceptions fueled by greed with proceeds of the PPP loans used for everything from buying Lamborghinis to yachts. Given how quickly the Justice Department has identified these frauds – with the help of Suspicious Activity Reports filed by the lenders and whistleblower tip-offs – we can expect that what we have seen so far is only the tip of the iceberg and that far more cases will emerge over time, some fueled by desperation but fraud nonetheless. The PPP loan forgiveness phase is likely to expose more fraud, and the delayed release of forgiveness guidance is compressing the 24-week timeline and potentially exposing lenders to increased operational risk to process the forgiveness applications during Q4 as they deal with usual year-end obligations.
Lenders that self-discover frauds will fare much better with the regulators and law enforcement than those who learn about them from law enforcement. Therefore, lenders should take proactive steps to:
- Ensure that all components of the lender’s PPP program are documented
- Re-examine the Know Your Customer information collected on borrowers
- Analyze their incentive programs and payouts for any signs of potential insider wrongdoing
- Ensure that PPP loans have been incorporated into their BSA/AML transaction monitoring programs
- Be prepared to assess eligibility for forgiveness based on a comparison of information provided at the time of an application and that included with the forgiveness application
(For additional information on red flags for fraud in government lending programs, see our blog Suspicious Activity Reporting: Government Aid Programs in the Spotlight.)
It’s not just fraud risk that is concerning to regulators and law enforcement, though. The PPP has also been plagued with claims of discrimination, including preferences for existing and/or larger borrowers to the detriment of minority-owned businesses. Program documentation, therefore, should also be clear on if and how applicants were prioritized, and a portfolio review should be performed to identify and address any potential instances of discrimination.
Much uncertainty remains. What we all first thought would be a challenge for a few months has turned into a lengthy disruption with no clear end in sight. The banking industry has demonstrated its resilience and adaptability thus far and will need to remain vigilant as the situation and attendant risks continue to evolve.