Tough Exams During COVID-19: One Bank’s Saga of Loan Downgrades and Stress Tests

Tough Exams During COVID-19: One Bank’s Saga of Loan Downgrades and Stress Tests

Kelly Barclay, President and CEO of Ozona National Bank in Texas, wasn’t expecting an aggressive safety and soundness exam last month in relation to COVID-19 economic issues. As a member of the Dallas Federal Reserve Bank board and a director of the Independent Bankers of Texas, she had heard from colleagues that examiners would be flexible with pandemic-related credits.

But she was in for an unpleasant surprise. The OCC examiners, acting on new supervisory guidance, immediately began pushing for downgrades on many of the $305-million asset-sized bank’s pandemic-affected loans. They were also critical of management for not taking action before the exam started.

“This did not sit very well with us,” acknowledged Barclay. After all, the bank had done everything it thought it should do: It helped struggling borrowers by putting loans on 90-day deferrals, and was obtaining up-to-date financials for review from borrowers requesting a second round of deferrals, which happened to coincide with the start of the exam.

But the examiners said, “it was important for banks to recognize credit quality issues now, rather than later.” They began reviewing the bank’s deferred loans, particularly in industries most affected by COVID-19, such as hospitality, entertainment, and commercial real estate.

“Though we were early on in the loan grading process, once management understood the OCC’s expectation, we took prompt action and downgraded many loans based on the present condition of the borrowers. Our criticized assets tripled at the end of the exam,” Barclay said.

And if conditions do not improve by year’s end, Barclay said some loans could be downgraded further.

The June interagency guidance from the regulators noted that “when assessing asset quality, examiners should consider whether management has been able to identify loans and investments substantially affected by the pandemic and recognize any deterioration in a timely manner, including any potential loss exposure.”

Despite the downgrades, the exam went well, thanks to an updated COVID-19 stress test from the Invictus Group, which Ozona received mid-way through the exam.

“Fortunately, we have a 7-year relationship with Invictus, and we felt it was more important, now more than ever, for us to have a holistic approach in determining the associated risk within the loan portfolio so we could determine what impact a severe economic downturn would have on the bank’s capital,” Barclay said.

She asked Invictus to stress the loans being marked down during the examination as if they were special mention, and then as if they were substandard. In all cases, the tests showed that the bank remained well-capitalized.

“Once management reviewed the results from the Invictus stress test with the examiners, they were very impressed with the overall results and very complimentary that the bank’s loan portfolio was stressed with a higher probability of default and incorporating a significant decline in property values,” Barclay said.

Typically, banks with her level of criticized assets experience would be expected to receive a supervisory notice called “Matters Requiring Attention.” But the Invictus COVID-19 stress test satisfied the examiners and “confirmed this bank has sufficient capital and can withstand this economic downturn for two years or more,” Barclay said.

Cautionary Tale

Ozona’s recent exam should be a red flag for other community banks. The guidance that the OCC examiners used was signed off by every regulator, which typically means that they all will follow suit. Tough exams may soon be the norm, like what happened after the 2008 crisis.

“I feel that a lot of bankers, because they don’t have the regulatory pressure, have their heads in the sand,” Barclay said. “Based on my conversations with other bankers, most have not yet recognized the downgrades in credit quality or fully considered the potential negative impact on capital. No fault of the borrowers or the bankers, I feel the next several years will be challenging for financial institutions as we cope with operating in a zero-rate environment, coupled with increases to the reserve allowance for loan losses. That’s very concerning to me.”

She tells anyone who will listen that they need an Invictus COVID-19 stress test, which provides a “hard dollar per loan” for how much the bank can afford to lose. She says it is especially important for banks with high CRE concentrations. “For me, it is an awesome tool.”

She says the Invictus stress test provides “a defensive plan on how you can protect the capital that’s at risk.” It also gives her an overall view of the entire portfolio, highlighting risk to capital that she would not otherwise see because those problem loans might not yet be on the bank’s radar.

The board also embraces the tests because they provide understanding and comfort that the bank can survive a downturn based on the assumptions in the model. The Invictus tests are customized for each bank, based on its exposure to industries affected by the pandemic or any other unplanned, adverse occurrence.

Satisfying Regulatory Requirements

The Invictus stress test results satisfy examiner requirements that banks’ capital planning processes incorporate the impact of the pandemic. “Examiners will evaluate the institution’s capital projections and whether institution management appropriately assesses the institution’s capital needs and vulnerabilities related to the pandemic and consistent with the institution’s risks,” the June guidance noted.

“Even though community banks all know their customers, they will have a hard time conveying their story to examiners without a COVID-19 stress test,” Barclay said.

OCC examiners praised the Invictus test in their exit interview. “To have this COVID-19 stress test, that line item by line item shows each loan and its impact to capital and also delivers key insights for the bank to monitor as our economy gradually recovers from this pandemic, provides me a peace of mind!” Barclay said.