From Carr, Riggs & Ingram, this is, It Figures: The CRI podcast, an accounting, advisory and industry focused podcast for business and organization leaders, entrepreneurs, and anyone who is looking to go beyond the status quo.
Good morning, I’m Rob Demonbreun with CRI, I’m out the Nashville office and focused in the banking area. And I’m joined today by one of my partners, Chris Cain. I’ll let him introduce himself.
Yeah, thanks, Rob. So good day everyone. I’m Chris Cain, I’m a financial institution partner out of the Birmingham office and been working with financial institutions over 23 years. And I like to say time flies when you’re having fun, because I really enjoy what I do and enjoy working with Rob and talking about financial institutions.
So along those lines, we thought what we would do today is we wanted to talk about a relevant topic. And I think as Chris and I work with our clients in the industry, a hot topic today is credit risk management. We’re in a time of complete economic uncertainty where we’ve had high inflation, we’ve had rates being increased higher than ever. And so now we’re saying what’s going to be the impact of all this on our loan portfolios and what do we as bankers and accountants and auditors, what do we need to be thinking about to be ready for what could happen to our loan portfolios? So we’re going to start off with this question. And so Chris, what I want to know right now, what challenges are we seeing right now, just generally, in the financial institution industry that relate to the economic uncertainty that we currently have?
Yeah, absolutely, Rob. Bankers are facing unprecedented challenges with this economic uncertainty. And if we’re to take a step back, what is banking fundamentally? And fundamentally banking is managing risk, effectively managing risk to be successful. And there’s so many different risks that a financial institution faces, such as liquidity risk and interest rate risk in an environment of raising interest rates. And then obviously credit risk, something of really utmost importance given all this economic uncertainty, and I know I have a lot of clients that are really thinking about looking at credit risk management more proactively.
And I know right now it’s really such an interesting time because we’re dealing with so many different risk within the industry, like you said, with interest rate risk and liquidity risk, they’re all concerns. But I think today what we want to focus on specifically is credit risk because we definitely can see that there’s some challenges potentially coming down the road related to that. So talk specifically about what you’re hearing from your clients right now, what are some concerns that are out there right now that maybe we’re not feeling them directly in our portfolios yet, but are on the horizon potentially?
Yeah, absolutely. So I think when I talk to my bank clients, many of those bankers are really thinking about ’08 and ’09, the last economic downturn, the last crisis that they faced. And really thinking about what were the lessons that they learned from that crisis and how can they proactively take those lessons and apply that for credit risk management. And I think the first important topic that they’re really considering within that is loan portfolio monitoring. So really looking at what’s driving loan policy exceptions, looking at loan to value or LTV, looking at debt service coverage ratios, looking at credit bureau scores and trends within those and really saying, “Hey, is there migration within those credit scores?” And we have some banks that are doing soft credit pulls and updating those credit scores for their borrowers and really seeing has there been deterioration in those credit scores.
And then of course DTI or debt to income, looking at payment extensions and deferrals. And then past dues, obviously bankers really look at past dues, 30 days, 60 days, 90 days. Also looking for an upturn in loan extensions. And then as part of that whole process is really getting some interim financial statements, some internally generated by management financial statements to really get the financial picture for that bar and really understand what’s going on on an interim basis instead, of waiting till year-end financial statements. Because at that point, if the bar is having a difficult year, it may be too late in the process to really proactively manage that credit.
I think it’s interesting what you mentioned about the monitoring aspect of it because I know with both of our experience with clients and what we’ve seen, is a lot of times the focus on monitoring is an after the fact monitoring, so it’s a lagging indicator. So we’re looking at non accruals, we’re looking at charge offs, we’re looking at things that it’s already bad at that point in time. And I think the things you’re talking about, which I think are interesting and things that banks need to be thinking about, is how can we look at trends of things that are the leading indicators, changes in LTVs, the past dues you mentioned, the 30, 60 and 90 days, looking at how are the trends in your under 30-day past dues, are they increasing? Is that an indicator of what’s coming down the road?
Same thing with migration of grades, you mentioned that in the past rating area. So are they migrating to where they’re getting worse within that grading area? So it’s very important to try to find those metrics that we can look at to predict possibly where the portfolio is headed. So I think you make a valid point. And with that, what are some other things outside of monitoring, that banks need to be looking at right now and considering they, for lack of a better word, project what their portfolio portfolio’s going to look like should the economy continue to deteriorate? What are some other things they can be looking at?
Yeah, absolutely. So I think some practical takeaways particularly for this podcast, is for banks to really monitor loan customers for overdrafts and really looking at deposit overdrafts can be an early indicator of cash flow problems. So I have a bank client that has a report of loan customer overdrafts on a daily basis that is monitored by credit administration for review and further analysis. Because again, leading indicators, being proactive and managing credit risk is really saying, “Hey, does this deposit overdraft signal that this borrower is potentially having cash flow problems, and is this something that we need to follow up on?” And again, getting interim financial information, have a conversation with a borrower, really understand what’s driving that business and is there any potential weakness there?
So let’s think about this too, so as we’re looking at other strategies or other techniques or other methods we need to do in monitoring as a bank and considering what our portfolios are looking at, some things that come to my mind and that we’ve talked about are concentration analysis, loan review strategy, stress testing some other methods of monitoring that can be used by banks to proactively look at their portfolios right now. Because as we know and we’re both seeing, loan volumes are slowing down right now, so pipelines are not as full as they were. And so we can really take a deep dive as a bank now into some of these other areas that have been, I won’t say they’ve been put by the wayside, but maybe not as important because we’re trying to make loans, now let’s take some time and look at some of these other things. What do you think about that in those areas?
Yeah, I think all those are excellent points. And really let’s look at maybe concentration of analysis a bit further. So when you look at concentrations by loan category, particularly focused on commercial real estate, CRE and that commercial industrial portfolio, and within that CNI portfolio, the bank would likely want to further segment that by industry. Because certain industries may present additional risk to the institution and may need some additional monitoring, to some of my earlier points, and may need credit administration to be more involved with that, looking at that industry segment. And then also you may want to further break out that commercial real estate, that CRE by property type and look at are there potential property types that have weakness in your geographic market or in the economy overall. And then also within concentrations, I think it’s important to look at interest only loans because what we learned from the last economic downturn is that interest only loans present additional risk and should have further monitoring.
And I always tell my clients, really look at that concentration, look at what makes up that segment of the portfolio and do a deep dive and understand the risk within that segment. So something else to think about as we look back to lessons learned from ’08, and ’09 is concentrations on loans outside the banks target market. Most of my community bank clients and most of them had issues with at least some loans that were outside their geographic market. And really understanding those loans, the bars situation and doing some careful analysis and regular updates with those is vitally important within that concentration bucket. So those are the things within concentration that I think are important and practical steps for bankers to really consider in that process.
So let’s talk about the loan review strategy because all of our clients and all banks have some type of loan review function in place, whether it’s internal, whether it’s a third party that assists. And when times are good, that’s an easy process because everybody’s paying, the trends are all going in the right direction, and usually there’s some type of set scoping parameter of what’s reviewed. And so as we get into a period where we feel a transition could be taking place, how should a loan review function be? How can it be changed to reflect where we are today and not just the same thing we’ve always done?
Yeah, so absolutely. So when times are good, I think bankers have a tendency to do SALY, or same as last year approach with regard to loan review. But now because of this economic uncertainty, I think it’s a good time to step back and analyze what is the bank’s loan review strategy given the risk. So in order to do that, we really help our clients by saying, “Hey, let’s meet loan officers, executive management, credit administration, and let’s discuss risk and potential risk in that bank’s loan portfolio, and let’s make a list of those risk, and let’s look at stats with regard to concentration analysis and let’s develop what we think is a plan that is direct linkage between the risk within the portfolio and the loan review strategy.” And I think oftentimes bankers get focused on, as part of a loan review strategy, “Hey, let’s just focus on the really, really large credits because that’s what we’ve historically done.”
And then there’s less focus on smaller loans or segments of smaller loans that when aggregated together, present a lot of additional risk. And I know regulators in ’08 and ’09 commonly refer to that as the soft underbelly within the institution and would say, “Hey, the soft underbelly presents additional risk. What are you doing with regard to review for that soft underbelly?” So what I think is really proactively looking at the risk and having direct linkage between the loan review strategy and those risks and then putting that in writing. And when you formulate that plan, discuss it further with executive management, and then as always, discuss it with the bank’s audit committee. Get the audit committee involved and looking at, “Hey, have we considered all those risks and are those appropriate for the analysis and the monitoring and really putting all the pieces together.” And then really being able to share that memo with the bank’s regulators, because clearly you can see all the thought that’s been put into that, the monitoring, the concentration analysis, and really bring it all together as part of a loan review memo.
Those are great points and things that we should be considering right now. So let’s talk about this. I know when I mention this word, it’s going to make bankers get nervous, community bankers in particular, when I talk about stress testing, because there’s requirements for larger banks to have stress tests and banks are stress testing a lot of things already regardless of size. But I know as community banks and what we serve and we talk about stress tests and they start thinking about models and complicated techniques to stress test things, particularly as we’re talking about credit risk today. But I think it’s important as we’re looking at our portfolios and what could potentially happen with this time of economic uncertainty, it’s a good time to consider stress testing and there’s a lot of different ways to do this. So why don’t you talk for a second about specifically as it would relate to a community bank that doesn’t have modeling, doesn’t want to get into technical monitoring, but wants to keep it relatively simple, what are some ways that community banks can stress test now?
Yeah, absolutely, Rob. So I think all those are really excellent points and factors for bankers to consider when you think about stress testing. And I think the number one thing with stress testing is if you’re not doing it, you need to get started, because if you have a starting point, it’s easier to further enhance it, develop it more based off an initial model. And we like to say is look at the complexity of the institution, and a lot of banks may not be that complex, so therefore they do not need complex stress testing. So in this case, I think a spreadsheet can be your friend and using a spreadsheet with some thought out assumptions, stressing loss factors within various segments of the portfolio that present a risk, and see how that impacts the allowance for loan losses. And really just starting simple. So my advice there from a practical standpoint would be start simple and develop the model further.
You could look at cap rates for real estate and you could do all kinds of different scenarios, but I think starting small here and really kind of walking through, “Hey, if we had additional losses in certain segments of the portfolio that we deem risky based on monitoring and concentration analysis, how would that impact the bank’s allowance?” And then I’m a big believer in document, document, document. So document the thought process, document the assumptions within the stress testing, and then really have again, a memo that kind of outlines the thought process, discuss it with executive management, chief risk officer as part of that process, obviously the chief credit officer. And then really kind of sit down and then do it on a quarterly basis and then enhance it going forward. I think too, this is a place where supervisory insights can provide a lot of help and guidance there. And I know there’s a good one on stress testing for community banks and something for others to consider as part of that process.
I think that is a great point you make because typically in the supervisory insights that the FDI puts out twice a year, usually in the fall or in the winter and in the summer, that they always have a credit risk management piece. And keeping track of those, they’re usually talking about things that are their supervisory insights and things financial institutions need to be working on. And a lot of times they’re geared towards smaller banks and they can be very helpful. And I think those points on stress testing are important to keep in mind because you can make it as simple or as complex as you want it to be. And ultimately what you’re trying to figure out and the bank’s trying to figure out is what’s going to impact my capital because capital is king, and if you have it, great, but if you’re losing it’s not so great. So being able to project what these assumptions, changes in assumptions would have on your capital is important.
So let’s pivot just a little bit and as we start wrapping up, just briefly talk to me about what kind of dialogue in a period of time this should management have within each other, within different lines of the bank, with governance bodies, how should that look right now?
Yeah, so I think step one is opening the lines of communication among all the stakeholders within the bank. And that’s really starting from the audit committee as part of a review of a loan strategy memo, to folks within credit administration and then ultimately, loan officers, having routine regular meetings among various stakeholders in the institution. The clients in ’08 and ’09 that really were successful in navigating that uncertainty, they had regular meetings among those various stakeholders, among the chief credit officer, among credit administration, among loan officers, and really saying, “Hey, what are our risks? What is credit administration seeing as risk?” Doing all this monitoring, doing the concentration analysis, and then talking to loan officers and saying, “These are the customers that we see are trending potentially downward. What’s really going on with that business? Have we obtained interim financial statements and do we understand the business? And are there things that the bank can do early to really help that borrower?”
And then discussing it as a group, because I think so many times having experience from more senior level executives and some of the things that maybe they saw in ’08 and ’09 and applying those because as we both know, early identification of problem credits is vital because the outcome is generally so much better and the losses are less for the institution. And again, that’s what we’re trying to focus on, and that’s the ultimate solution in this process and the best outcome for the institution and for our clients.
Absolutely, and I think to tag along to what you’re just saying, I think transparency’s important. I mean, we need to admit if it’s a problem, it’s a problem, and then figure out how to resolve that problem because nobody’s perfect, everybody’s going to make a bad decision in a lending decision. And it may not have been a bad decision when it started, but now it is, and let’s admit it and deal with it. And I think being able to communicate at all varying levels of management, and from a corporate reporting or board standpoint, governance standpoint is important for that transparency of figuring out the problems, actively identifying and moving on.
Yeah. As part of that process one thing I would like to mention further is looking at loans and downgrading them when appropriately. It’s oftentimes that loans need to be downgraded and aren’t done so by credit administration or loan officers for whatever reason. And then loan review comes in and says, “Hey, what’s going on with this credit? There’s deterioration and it needs to downgrade.” So I’m a big fan of … loan risk ratings are a fluid process, it’s a fluid process depending on the risk that that credit presents to the institution. And the whole reason why risk ratings are in place is that lower risk rated credits can have additional monitoring by credit administration to understand what’s going on with that. So I agree, transparency is vitally important as part of that process.
All right, so we’re coming close to the end now. So we’ve talked a lot about a lot of different things and some strategies, some monitoring, some metrics to consider during a period of economic uncertainty. So now as we’re starting to conclude, what are some, let’s do a little recap of what we’ve talked about just very briefly, and then some practical takeaways that our clients and banks can implement, use to navigate this successfully during this period of time.
Yeah, for sure. So I think on the monitoring side, the takeaway that I would want to point out is really having that full customer relationship. And what I mean by having the full customer relationship is if you have a loan customer, you need that deposit relationship as well. And then as part of that deposit relationship, you can look at past dues and overdrafts and look at that more as part of that process. So the takeaway from monitoring is looking at overdrafts as an early indicator of cash flow problems for borrowers.
So in the concentration analysis section, I would say the big takeaway there is looking at interest only credits as a group, as a potential concentration, and then also looking at loans that may be out of the bank’s target geographic market and analyzing those further. And then in the loan review section, I would say is developing a strategy memo as part of that process, getting feedback from executive management, as well as the audit committee. And then the stress testing I would say is don’t think that you have to have some sophisticated, very complex software because oftentimes that is not needed and too complicated for smaller community banks. So I would just say there, get started, do it on a quarterly basis because there’s economic uncertainty, look at the trends and further enhance that as time passes.
Excellent points and great takeaways that we can use in going forward. So as we wrap up, CRI works with a lot of banks. You and I work with a lot of banks and we see a lot of different things. And so how can CRI be an asset during a time of economic uncertainty for financial institutions as we’re talking about credit risk, what can we do to help if they’re reaching out to third parties, if they’re already clients, what’s CRI ready to do for them?
Yeah, so absolutely. So first off, I want to just say to all the clients out there, thank you so much for your business. We really value our relationship and really appreciate them. And then for the ones that aren’t, we would love to be a helper. I like to say CRI helps financial institutions manage all those risk really and manage credit risk. So some things to consider on that topic would be using us as a sounding board for looking at some monitoring, doing an internal audit of credit administration, and then doing loan review. We do a lot of outsourced loan review and really help institutions identify problem credits early in that process so they can have a better outcome. So in the end, I think what we want to do is help community banks help their communities be better.
Chris, that’s well said, and that’s a great way to end it. I want to thank you for being here today and helping with this podcast. Thank you for the information you’ve provided. It’s definitely valuable and something that our clients and potential clients can put to use. And we want to thank you for your time for being here today, and thank you for listening to us today. We appreciate it and take care.
Thanks so much.
If you want more CRI insights, or are interested in learning about our firm, please visit our website at cricpa.com. Thanks for listening to this episode of It Figures: The CRI Podcast. You can subscribe to It Figures on iTunes, Spotify, or wherever you prefer to listen to your podcasts. If you liked what you heard today, please leave us a review.
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