Read Between the Lines July 2020

What Community Banks Need to Know about Regulatory Actions

Regulators Want Stress Tests to Account for Changing Conditions

If your bank isn’t adjusting its stress tests to reflect for the changing COVID-19 environment, expect to come under increased regulatory scrutiny.

The Office of the Comptroller of the Currency made the mandate clear in its Spring 2020 Semiannual Risk Perspective: “Banks should update their portfolio management practices regarding stress tests to incorporate both the direct and indirect impacts of changing economic and market conditions,” it wrote.

And it reiterated the need for stress testing in a June 16 safety and soundness enforcement action against an Iowa bank, demanding the bank board “develop procedures and adherence to significant individual loan stress testing and/or sensitivity analysis to quantify the impact of changing economic conditions on asset quality, earnings, and capital.”

The reference to the need for stress testing is significant. Regulators had already warned in interagency supervisory guidance that examiners would be focusing on bank capital planning and risk management processes in the wake of the pandemic. The only tool that can sufficiently satisfy regulatory demands is a stress test designed specifically for the coronavirus economy. It can not only help banks understand their capital margin of safety, but it also can accurately forecast the level of ALLL. (For a primer on this type of stress testing.  please read our June special Bank Insights report.)

The OCC said in its risk perspective that “the allowance for credit losses should continue to appropriately reflect the risks in the loan portfolio with qualitative factors considering current environmental issues.”

With low interest rates, increasing loan loss reserves and troubled borrowers, the OCC warned that bank profitability “will be challenged” throughout 2020.

“The broad themes facing the federal banking system are weak financial performance, elevated credit, and operational risks,” the OCC noted in its risk overview. “The onset of the pandemic created an uncertain credit environment testing the resiliency of both commercial and retail loan portfolios. Credit risk management practices need to be flexible and proactive to meet the challenges of the current environment.”

Consent Orders Shows Importance of Valid Strategic Plans

The coronavirus has virtually wiped out every bank’s strategic plan, and regulators know it.  If your bank hasn’t yet reworked its plan to adapt for the current environment, you’re operating in the dark.

Regulators have made it clear that management must consider the pandemic environment in strategic planning.  They have told examiners to look at how a bank works with its troubled borrowers, as well as how it is accounting for changing local conditions, and to make sure the bank is factoring “the results of these efforts into its longer-term business strategy. Strategies could evolve throughout the local and national recovery. Institutions may be compelled to reconsider branching, mergers, or other expansions.”

Regulators often telegraph problems in the industry when issuing consent orders. We saw this after the 2008 financial crisis, when order after order began mandating increased capital for community banks. Two Federal Deposit Insurance Corp. consent orders, issued in May to Kansas banks, call for the banks to submit written three-year strategic plans. (The OCC’s June order, described above, also called for a new three-year strategic plan).

The FDIC told each plan that its long-term plans must “provide specific objectives for asset growth, balance sheet composition, loan portfolio mix, market focus, earnings projections, capital needs, and liquidity position.” Each bank must include “a description of the operating assumptions” that back up the projected income and expense components of the plan.

These new enforcement orders may be a sign of tougher exams in the future. Community banks should make sure their risk management processes have been adapted for the pandemic before examiners are at their doors.

Worth watching: the number of banks on the FDIC’s troubled bank list. There were 54 banks on the list as of the first quarter of 2020. The total number of banks has declined to 5,116, including 57 that were absorbed by mergers and one failure in the first quarter. But M&A activity has slowed during the pandemic, so the number of problem banks may be increasing in the quarters ahead.

Make Sure the BHC Remains a Source of Strength

Community banks should get reacquainted with 2009 Federal Reserve guidance on dividend payments, capital redemptions and capital repurchases by holding companies, advises Jim Nolan,  executive vice president for supervision, regulation, and credit at the Federal Reserve Bank of Boston, in a Community Banking Connections article about supervision during the pandemic.

The Fed has already suspended stock repurchases and limited the amount of dividends the largest banks can pay in the second quarter, a move that may have implications for community banks.

“Capital planning is always an essential element of balance sheet management, but it becomes even more important during times of uncertainty or stress,” Nolan writes. To assess capital adequacy, bank holding companies must assess the quality and level of earnings under different economic scenarios, as well as balance sheet risk, cash flow and liquidity and potential losses. Nolan encourages boards to consider other risks that may affect the holding company’s ability to serve as “an ongoing source of financial and managerial strength.”

Supreme Court Rules CFPB is Here to Stay

The Consumer Financial Protection Bureau, established by Congress in the Dodd-Frank Act, is here to stay, the Supreme Court ruled on June 29. But the original structure, which provided for a director with a 5-year term who could be removed only for misconduct, “violates the separation of powers,” the court ruled. That means the president can remove a director at will. “There is nothing in the text or history of the Dodd-Frank Act that demonstrates Congress would have preferred no CFPB to a CFPB supervised by the President. Quite the opposite,” Chief Justice John Roberts wrote.

The case began when a California-based law firm, under investigation by the CFPB for violating telemarketing sales rules, challenged the agency’s constitutionality.  While the CFPB was known for tough enforcement under President Obama, it has grown much weaker in the Trump era.

Example: The CFPB overturned underwriting requirements on payday lenders earlier this month, rescinding a 2017 rule that would have required lenders to verify whether borrowers had enough income to afford the loans, angering Democrats who have asked for an investigation.