By: Mark A. Mangano
Commercial lending during times of economic stress involves managing enhanced risks. Managing those risks may require setting new lending goals, reviewing processes, and increasing training.
The emergence of the Coronavirus Disease 2019 (COVID-19) is rapidly disrupting economic activity across the country. These disruptions are reducing economic activity for many industries. These reductions will inevitably create financial stress for many businesses and individuals.
Lending in an expanding economy is significantly different from lending in an uncertain and potentially contracting economy. Community banks are built on the promise of supporting customers through good times and bad. However, support must be provided in a manner consistent with safe and sound banking practices.
Regulatory Encouragement
On March 13, 2020 the FDIC issued “FDIC Statement on Financial Institutions Working with Customers Affected by the Coronavirus and Regulatory and Supervisory Assistance” FIL-17-2020. The FDIC suggests:
“Financial institutions should work constructively with borrowers in communities and industries affected by COVID-19. The FDIC encourages financial institutions to engage in prudent and proactive actions, which are in the best interests of the financial institutions, the borrowers, and the economy…Prudent efforts to modify the terms on existing loans for affected customers of FDIC-supervised banks will not be subject to examiner criticism”
While the statement suggests examiner flexibility in determining whether modified loans are considered impaired, the statement specifically reminds bankers that the existing accounting standards for classifying modified loans remain applicable.
Enhanced Risks
Modifying loans due to financial stress present five enhanced risks that must be managed. Those risks include default risk, reporting risk, collateral risk, regulatory risk, and procedural risk.
Default Risk
It is every lender’s hope that his or her customers will weather economic downturns. Each commercial borrower will experience unique circumstances driving its choice to approach the bank for a loan modification or accommodation.
Working with commercial customers under financial stress presents risks and opportunities. The primary risk is that the economic stress will exceed the customer’s capacity to continue. This risk presents the opportunity for bankers to help the customer pursue the most realistic paths to preserve the economic value of the business. In times of economic stress, business owners need a trusted and thoughtful advisor to help evaluate options.
Reporting Risk
The form and documentation of loan modifications can have significant impact on financial reporting. Modified loans may require specialized reporting and accounting. The reporting of a modified loan as an exception, trouble debt restructuring, non-accrual, or adverse classification depends upon the circumstances, credit enhancements, or collateral enhancements associated with the modification. Managing the negotiation of modifications can limit the adverse impact of those modifications on the income statement and balance sheet in the future.
It is prudent to train commercial loan officers and workout specialists on the reporting impact of various modification solutions. In many cases it may be possible to assist the customer, while limiting the reporting risks associated with that assistance.
Collateral Risk
Modifications can take many forms. It is imperative that assisting the customer does not impair the bank’s collateral position.
A request for modification should trigger a review of the nature, quality and perfection of the bank’s collateral interests. If the review reveals deficiencies in the bank’s collateral position, correction of those deficiencies should be a requirement of any modification or accommodation. Finally, the bank should ensure that all modifications and accommodations ensure the status of the bank’s lien position in collateral.
Regulatory Risk
Despite regulator encouragement of banks aiding stressed businesses, banks remain accountable for the safe and sound nature of their lending portfolios. Taking advantage of the stated regulatory flexibility in classifying loans modified in response to stresses associated with COVID-19 will require documentation.
When examiners review modified loans, they should easily understand how the modification related to COVID-19. They should also be able to follow the bank’s rationale in crafting the modification. Modification documentation should always indicate how the modification benefitted both the bank and the borrower.
Procedural Risk
Banks perform best when personnel follow well considered and communicated policies and procedures. The sudden increased activity in the discipline of negotiating and documenting loan modifications presents the risk of pursuing solutions that do not adhere to the bank’s expected standard.
Banks can decrease risk and improve consistency by adopting specialized policies and procedures to govern how bankers address modification requests. Education and monitoring procedures will be critical to ensuring that the new risks are mitigated and managed.
The COVID-19 crisis is an opportunity for bankers to again prove their value to their customers in times of stress. Applying consistent and well considered procedures to working through modification requests will improve the bank’s future performance.
Mark Mangano is counsel with Jackson Kelly PLLC. Mark is an attorney focusing on strategic planning, corporate governance, and bank regulatory issues. He has 26 years of experience as the CEO and owner of a community bank.
Mark Mangano
Mark.Mangano@JacksonKelly.com
304-284-4104