By Eugene Ludwig, Wayne Rushton, Tom Freeman and Jeff Glibert
The crisis triggered by the coronavirus pandemic is accelerating the financial industry towards an era of greatly increased debt adjustments and defaults. While Paycheck Protection Program loans should end up on the government’s books, most write-offs and write-downs will be the burden of banks and other lenders.
This whirlwind must be carefully managed by the banks. However, it also offers an opportunity to finally propel a much needed policy change into overly narrow and often misleading tagging methodologies that negatively affect regulation, banks, customers and the economy.
Important borrowing periods defaults are hard for banks and forcing unpleasant choices. To ensure the best loan modification, adjustment, and collection results – and regulatory response – there are practical steps bankers can take.
First, bankers should inventory credit divisions to ensure that policies, practices and procedures are up to date. Accounting, compliance and valuation requirements have changed a lot since the Great Recession. It is important to ensure that the infrastructure has kept pace and that responsibilities are clear on all lines of defense.
Second, bankers will undoubtedly need to take out many loans to welcome good clients. However, due to the recent favorable climate, many training teams have moved on.
This function must be put back to par. The will be a tension between those with the traditional “your first loss is your best loss” view; and those who want to prevent good customers from failing. The competence and circumspection of this team are essential. For community banks, it usually includes the general manager.
Third, credit talent should be examined on an individual and aggregate basis, focusing on experience and the ability to defend portfolios and processes. This review – and plans to address gaps – must be approved by the board of directors and presented to internal and external auditors, accountants and reviewers to ensure consistency with expectations.
The quality of banking processes and methodologies, and the skills of book advocacy officers can mitigate the severity of directed write-downs or regulatory criticism (and even enforcement action). It would also be wise to train and mentor less experienced staff in the effective presentation of this material.
Negotiating with other lenders (especially nonbanks) will require skill, as different lenders may have varying client goals in the short and long term. Experienced negotiators in each relevant industry will be of great value.
Fourth, portfolios should be reviewed taking into account prudent but realistic valuations. Cash flow and debt service capabilities and collateral valuations should be clear and well documented, and assets properly classified according to their performing or nonperforming status.
Be just as realistic in classifying loans. Highly leveraged transactions, commercial real estate, mortgage, oil and gas, and small business portfolios are particularly vulnerable to classification issues.
In addition, internal stress tests of portfolios, including investments, should be cautious. Be realistic in forecasting economic conditions, including a potential second phase of the virus requiring additional government intervention. The current performance of the credit portfolio may not match the pre-COVID credit risk appetite. Exceptions should be reported to the board to ensure good governance of aggregate levels and important individual cases.
Finally, for a certain number of banks, a new management information system will probably be necessary to follow up requests for modifications, exemptions and abstention from customers. Distressed borrowers can be expected to ask for new money. Each must be viewed in the context of available collateral, going concern, customer relationships, and structure (ie debtor-in-possession loans). Internal consistency of approach in scoring changes and customer demands across regions, branches and, where applicable, companies is essential.
Financial regulators are not overreacting to the current credit crunch, but they will rate loans as they see them. And they can be more conservative than a banker in their place.
With the intrusion of the Financial Accounting Standards Board into the appraisal process, loan scoring has become even more difficult.
A good subject matter expert should be prepared to review every troubled loan with reviewers and accountants. They should also have the ability to quickly put together highlights on individual loans and groups of loans and their guarantees.
It also requires understanding the standard classifications that examiners and accountants apply, including how those standards match the bank’s own internal ratings.
Consider whether the overall goal would be best achieved by outright selling certain loans. If the immediate sale value is acceptable, it can help avoid valuation haggling and provide a measure of liquidity.
Beyond that, a fundamental challenge is how to achieve realism in ratings. Particularly in crises like this which are motivated by temporary and non-financial influences, some accountants and regulators may not recognize the likely salvage values embedded in many assets.
The result is a misleading image detrimental to the regulatory process, banks, customers and the economy. Whether anchored in the allowance for loan and rental losses (ALLL) or in the current expected new credit losses (CECL), these rules hamper regulators and bankers trying to exercise good judgment.
Industry and government should do more to avoid surveillance and resolution practices that rely too heavily on clearance values from discount sales to the detriment of the bank and the borrower. In many cases, the borrower and / or its collateral have recovered in value, usually only benefiting unregulated players who buy collateral at bargain prices.
Today, regulators can temporarily assign “doubtful” rather than “loss” classifications to loans that are unlikely to be fully recovered pending resolution of certain unresolved factors. However, they don’t have the option to withhold write-offs when longer recovery periods are involved, and current accounting standards for loan losses would likely not support it.
This is an important area ripe for careful political scrutiny, as soon as possible. During this crisis, there could be a period of “cooling off” while this area is studied, and new rules are prescribed.
This is not to suggest total and senseless tolerance. Rather, regulators, bankers, and policymakers should apply sound judgment and methodologies rather than a narrow and ad hoc approach or stereotypical pseudoscience that does not take into account the experience, judgment and historical realities of the industry. Evaluation.
It’s time for bankers, business associations, Congress and regulators to work together on meaningful policy change on valuations. There would be huge benefits for the economy, businesses and workers at a time when America desperately needs it.
Gene Ludwig is Founder and CEO of Promontory Financial Group. He is also a former Comptroller of the Currency and a former Vice President and Senior Supervisor at Bankers Trust New York Corp.
Tom Freeman is a former Chief Risk Officer at SunTrust and former Head of Credit Analysis and Reporting at Fleet Financial. He is also a former member of the Board of Directors of the Risk Management Association (RMA).
Wayne Rushton is Senior Advisor at Promontory Financial Group. He is a former Senior Deputy Controller and Chief Examiner of National Banks in the Office of the Comptroller of the Currency.
Jeff Glibert is a member of the board of directors of Deutsche Bank USA. He is a former Managing Director of Promontory Financial Group and has held senior risk management positions at Lehman Brothers, Bank of America and Bankers Trust New York Corp.