While we are still immersed in the economic fallout of the COVID-19 pandemic, banks must look ahead to a post-COVID-19 world and, in particular, the next 12-to-24-month regulatory exam cycle, when federal and state banking regulators will have the opportunity to take their first very close look at how banks have responded to the crisis. Financial institutions should review the ongoing guidance that has been provided by regulatory agencies and take the following steps to help focus the regulatory agencies on the institution’s percipient institutional decision making. This kind of demonstrative information can help prepare management to address regulatory concerns that may arise in the course of routine examinations.
1. Record precise and thorough documentation of loan modifications. While the regulatory agencies have been very clear in their guidance that modification of loan terms will not automatically result in troubled debt restructurings, such modifications must be made in good faith and in response to COVID-19 to borrowers who were otherwise current prior to the relief being granted. Banks must be scrupulous in documenting both the current nature of credits prior to the COVID-19 crisis and why their modifications are being made in good faith. Similarly, management should be closely reviewing their loan processes and procedures so that they can demonstrate to their examiners the “prudency” of their underwriting standards and how any loan accommodation programs are ultimately structured with a view toward loan repayment. Loan teams and loan committees should go the extra mile to review credit files and support their reasoning for loan modifications so that banks’ credit decisions are not second-guessed, which can result in unexpected and adverse accounting treatment for modified loans.
2. Practice close oversight by boards of directors. Boards of directors must be providing close oversight of management and setting a clear strategic direction for management to implement during this pandemic. Board minutes should be anything but a routine repetition of the same general discussion from prior months’ meetings with small modifications for different monthly financial reports. Rather, this is the time frame when boards and board committees should be meeting more frequently to assess the corporate health of their institutions and providing real documented leadership. Boards that only meet quarterly should take a very close look at whether the frequency of their meetings is truly adequate during this time, and should consider utilizing technology to increase the number of board meetings and adequately document discussions taken and decisions reached so regulators will be able to see active leadership. All boards should closely assess the composition of their committees and whether their members have the requisite skill set to meet the challenges posed by these unprecedented times. While the many bank interagency statements released on COVID-19 have encouraged all banks to work prudently with borrowers, prudence is not a substitute for “safe and sound.” We believe bank examiners will be closely focused on this area when assigning their first CAMEL rating for management after the brunt of this crisis has passed.
3. Be proactive. Spend the time and resources to review all credits in the portfolio and all material deposit relationships that may be adversely affected by COVID-19. Management teams and boards of directors should not be surprised by the effects of unexpected, adversely performing credits. As we previously have written, bank credit teams should be closely assessing the impact of the current business climate on borrowers’ ability to perform, and should request updated financial statements from their customers, and make sensible forecasts so that they are prepared to weather the storm. At the same time, banks should be very careful to avoid engaging in any actions that may give rise to lender liability claims from borrowers or fall outside the acceptable role of bank creditors.
Similarly, boards and management should be closely reviewing and assessing the performance of their employees during this difficult time and provide the resources necessary for their employees to succeed. Engage in frequent outreach. See what is and is not working and provide the requisite tools so employees can perform their jobs effectively. Banks are considered essential businesses in the various COVID-19 state and local orders, and, accordingly, many bank employees are working full time, if not overtime, to assist their customers and facilitate the implementation of the various federal- and state-sponsored economic programs. Boards and management should use this opportunity to increase the level of their visibility with their teams and be accessible to proactively identify areas needing focused attention.
4. Assess your capital adequacy and liquidity management. Banks generally spend a lot of time assessing their capital adequacy through various scenarios and adjusting for moderate and dramatic events. Following the 2008 financial crisis, banks have been adding to their capital cushions both in response to regulatory requirements and out of an abundance of caution. These capital cushions will be tested and, notwithstanding bank agencies’ efforts to provide, among other things, favorable risk-weighting for loan modifications that are made in a manner consistent with federal interagency statements, banks need to continue to model and test various scenarios in an effort to determine whether any capital will be needed in the future. The opportune time to access both the equity and debt capital markets is a question banks should review closely with their investment banking advisors, but it is incumbent on banks to be prepared now for that possibility. For public companies, this could mean filing a shelf registration statement with the Securities and Exchange Commission that would be ready to go in the second half of 2020 (and beyond) so that there is no delay over an SEC review. Similarly, smaller subordinated debt capital raises for institutions that are able to obtain a favorable rating from a nationally accepted bank rating agency may be an effective tool to pre-empt adverse capital impact resulting from COVID-19 and subsequent regulatory criticism. In addition, banks should closely review their liquidity resources and multiple avenues for achieving liquidity stability. As management of any institution knows, liquidity is closely followed by regulatory agencies in assessing an institution’s financial health.
5. Think about M&A possibilities even in this disjointed market. Perhaps the last item on the minds of members of boards of directors is a merger or strategic acquisition. And the only time you see regulators put M&A on the table for one of their supervised institutions is when that institution finds itself in dire circumstances and a merger or acquisition is a “Hail Mary” that regulators throw out as a last gasp before an impending takeover. Smart boards and management teams, however, may see the possibilities posed by this crisis as a unique opportunity for an equity acquisition or even a “merger of equals.” Stock currencies are down, but, with rare exceptions, they are down for everyone in the bank sector. Cost savings, however, are generally fixed for prudent strategic opportunities, and some institutions are better built than others to weather a longer-term recession. Boards of directors should closely assess what category they believe they fall in and whether they can use this crisis as the chance to put together institutions with a business model that makes sense. Although it may seem counterintuitive, finding the right strategic opportunity now may actually be considered dealing from a position of strength rather than responding to an M&A opportunity because regulatory agencies have forced your hand.