Regulatory agencies recently issued joint examination guidance regarding the impact of the COVID-19 pandemic on examiners’ supervisory principles and the examination process. The joint guidance outlines regulatory considerations for governance and risk management practices related to COVID-19, including how examiners will complete their overall assessment of an institutions’ financial condition and the effectiveness of the institutions’ risk management programs. In addition to the overall assessment of financial condition and risk management, the guidance discusses considerations across the CAMELS spectrum for upcoming examinations.
On June 23, 2020, the Federal Deposit Insurance Corporation (FDIC) issued FIL-64-2020, “Interagency Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Financial Institutions.” The guidance outlines supervisory expectations by CAMELS topic — capital, asset quality, management, earnings, and liquidity — and provides insight into areas of examiner focus. Themes throughout the guidance relate to the use of existing composite and components ratings and a reasonable approach to understanding management’s response to the pandemic. Risk varies given the institution’s size and complexity, and the guidance gives credit to the varying examination considerations by risk level . However, the guidance also notes that composite and component rating downgrades and formal or informal enforcement actions may occur if management hasn’t properly assessed the institutions’ risk as a result of the pandemic and responded accordingly.
A summary of considerations by CAMELS topic as outlined in the guidance follows. Please read on to understand our interpretation of potential responses given the recently issued guidance.
Capital
The guidance acknowledges the many factors which could or will impact capital levels, such as loan or deposit growth due to government programs, losses due to credit quality concerns, or unforeseen expenses due to the pandemic, for example. Each of these factors has a current or future impact on capital. Additionally, the regulatory agencies have encouraged institutions to use their capital buffers to support lending activities.
What does this mean to your institution?
Robust capital planning and capital monitoring activities will be expected. Depending on the size, risk, and profile of your institution, capital stress testing should be considered. Contingent plans should be in place to forecast results in insufficient capital levels, including documented plans to build or preserve capital, as needed.
Asset quality
Most of the guidance focuses on this category and the potential pandemic-related impact to credit. Many institutions have modified a significant number of loans to allow borrowers loan payment deferrals. Completing current credit risk reviews is also a challenge, given the full impact of the pandemic is still uncertain for many borrowers. However, new loan underwriting standards may have eased as a result of the pandemic. The regulatory guidance speaks to each of these topics, as well as considerations for collateral appraisals and the potential impact on underlying real estate values.
Many of the points expressed in the guidance align with the recently issued guidance regarding credit risk review systems and the allowance for credit losses.
What does this mean to your institution?
The institutions’ existing credit management systems should be revisited to ensure monitoring programs exist to recognize potential problems sooner than later. Loan and portfolio-level stress testing of cash flows could be considered, and recency of borrower and guarantor financial statements and verification of liquidity should be completed. For additional considerations for an institution’s credit review function, see our article on credit quality during COVID-19.
Management
The pandemic is burdening every aspect of the financial institutions industry. Risk is elevated across all functions due to credit quality concerns, remote working environments, and many other external factors beyond the institutions’ control. Examiners will expect robust documentation to support the actions taken to adapt operational and cybersecurity controls given elevated risks. They’ll also consider vendor management programs and how the institution has managed and monitored vendor risk when significant systems and operations are managed by third parties. For each change enacted as a result of the pandemic, management should take appropriate steps to analyze the effectiveness of new and modified controls and processes. That said, the guidance acknowledges examiners will distinguish “between problems caused by the institution’s management and those caused by external factors beyond management’s control.”
What does this mean to your institution?
Management should evaluate the impact of the pandemic on all aspects of the institution. Risk assessments should be revisited to address elevated risk, and any areas with elevated risk should have an appropriate, documented response. Risk management and internal audit activities should be reviewed for potential modification. Frequent reporting to the Board of Directors/Audit Committee/Risk Committee should summarize each of these matters.
Earnings
Uncertainty exists around future core earnings given the items discussed throughout this article. Examiners acknowledge the unknowns around loan modifications/deferrals and the impact on interest income, as well as the unknown impact on loan loss provisions and operational activities.
What does this mean to your institution?
Institutions should quantify the impact of loan payment modifications/deferrals within earnings forecasts. Considerations should be given to stressed credit scenarios and additional loan loss reserves, including the impact to earnings and ultimately capital. Continued monitoring and reporting of monthly financial results to senior management and the Board of Directors will be crucial.
Liquidity
Liquidity risk varies significantly by institution and uncertainty exists for most institutions. Many are flush with deposits given Economic Assistance Payments and customers’ flight to safety; others are liquidity-strained due to loan growth or payment deferrals. The long-term impact on liquidity of these programs or behaviors is currently unknown. The guidance addresses this uncertainty and communicates that examiners will not scrutinize institutions for tapping various liquidity programs to help manage liquidity risk.
What does this mean to your institution?
Liquidity forecasting and refreshing contingency funding programs is crucial. Daily, weekly, and monthly forecasting of liquidity positions and constant monitoring of the balance sheet will assist the institution in clarifying uncertainty in this area.
Sensitivity to market risk
Balance sheets have been transformed due to government lending programs, deposit growth, and many other factors. These structural changes to the balance sheet, combined with the current and projected interest rate environment, have a potential multiplier effect on the institutions’ interest rate risk profile. Examiners will evaluate the temporary or permanent changes to the institutions’ balance sheet as a result of these items.
What does this mean to your institution?
Existing interest rate risk policies and reporting should be reviewed to determine if policy thresholds and reporting practices are sufficient to identify and communicate interest rate risk concerns throughout the institution. Models and assumptions should be reviewed for any significant changes on the institutions’ balance sheet.
What’s next?
In summary, regulatory expectations have been established, and we expect examiners to follow through on this guidance in upcoming examinations. Management and the Board of Directors should read and understand the guidance to determine the appropriateness of your institution’s response. If risk management programs haven’t been adapted and responses not documented, now is the time to step back and assess your institution’s risk profile as a result of the COVID-19 pandemic.
Please don’t hesitate to reach out to your Plante Moran advisor to discuss our thoughts in additional detail.
