Because of the pandemic, experts say stress testing loan portfolios is more important than ever. But COVID-19 has changed risk management, and regulators are making accommodations amid the crisis.
By Katie Kuehner-Hebert
Stress testing loan portfolios during the COVID-19 pandemic can be challenging, to say the least.
With the ups and downs of lockdowns, partial or even complete reopenings, and then surges in coronavirus cases shutting down some businesses again, the traditional models used to stress test books “are out the window,” says Daniel Bockhorst of South State Bank.
“There’s certainly value in the models, and for many credits we’re using them, but for certain types like restaurants, lodging and retail that have had significant impact, it’s more of a bottoms-up approach—evaluating them on a loan-by-loan basis,” says the chief credit officer at the $37.7 billion-asset community bank in Winter Haven, Fla.
“The pandemic has really shown the importance of stress testing.”
—Daniel Bockhorst, South State Bank
But even within industry types, there are significant differences in how commercial customers have been affected, and so community banks should drill down further into those categories when stress testing, Bockhorst says. For example, among South State Bank’s lodging customers, hotels near airports that cater to business travelers are still struggling, while hotels near beaches “are having a very good summer.”
“The pandemic has really shown the importance of stress testing,” he says. “However, banks should not get caught up on the protocols around validating the model and focus more on the reasonableness of the output given the current circumstances.”
Stress testing of individual loan transactions and segments of the portfolio at greatest risk may prove more predictive than using analytical models says Cynthia C. Brzeski, a certified public accountant at Wipfli LLP in Milwaukee.
“Community bankers can address the new risk profile by applying historical loss rates—those from the Great Recession years, for example—to their current portfolios,” she says. “They can assess the likely impact on earnings and on capital for at least two years and implement appropriate defensive and recovery capital planning strategies.”
In addition to stress test guidance from regulators, firms like Wipfli are providing web-based seminars and roundtable discussions to share ideas and best practices with bankers, she says.
Further risk considerations
Stress testing mortgages that have been sold to Freddie Mac, Fannie Mae and other government agencies need to take into account a provision under the Coronavirus Aid, Relief, and Economic Security (CARES) Act that enables borrowers affected by COVID-19 to have automatic forbearance for up to 12 months if requested, says Ron Haynie, ICBA’s senior vice president of mortgage finance policy.
“For stress testing, banks may have to make some assumptions on what percentage of their portfolio of loans sold to agencies will go into forbearance after the initial period,” he says. “For loans that haven’t been sold and are not subject to the automatic right of forbearance, banks are trying to be consistent to prevent any issues from a fair lending perspective.”
For forbearances and other hardship assistance on any type of loan, enhanced quality control and testing measures may be needed to validate that all incoming requests are being processed consistently and fairly, says Britt Faircloth, consulting manager for fair and responsible banking at Wolters Kluwer Compliance Solutions in Waltham, Mass. “In addition, fair lending analysis is critical and should include analysis of disparities in denial rates, disparities in average pricing and some form of benchmark overlap or comparative file review testing where applicable,” Faircloth adds.
Banks should also consider fair lending monitoring related to Paycheck Protection Program (PPP) loans they made, she says. Geographic analysis can help determine fair and equitable levels of service for both underwriting and servicing mortgage and PPP loans across all demographics.
So far, regulators have been “very accommodating” to banks and have allowed them to grant forbearance on all sorts of loans. Under the CARES Act, banks do not have to classify them as troubled debt restructurings, if the accommodations are COVID-19 related, says Christopher Cole, ICBA’s executive vice president and senior regulatory counsel. “That’s been helpful to a lot of our community banks,” he says. “The regulators have indicated this accommodation will continue until the end of the pandemic, which could go into 2021.”
The impact on underwriting
Underwriting practices have also been affected by the pandemic, according to Suzanne Konstance, vice president of product management and marketing at Houston-based Wolters Kluwer Lien Solutions.
“Much of the information lenders had to rely on in the past—debtor’s past behavior, modeling outcomes—has changed and is unpredictable in the COVID-19 environment,” says Konstance, who is based in Greenwich, Conn. “While originating new loans, lenders are becoming extra cautious and looking for ways to minimize the losses on the portfolio.”
Due to these factors, Konstance and her team expect that banks will apply liens to more loans than they did before to mitigate the higher level of risk and uncertainty in lending.
“In the past, UCC filings were sometimes overlooked for certain loans, whether because, traditionally, liens weren’t applied at that loan type or value, or due to a lack of understanding of the benefits,” she says. “In times of crisis, the benefits of UCC filing become more pronounced and help minimize risk and improve recoveries.”
But with higher levels of risk, more oversight should also take place, Konstance says. Best practices require that lenders monitor their debtors for changes or new activity, that they understand their order to collect on the collateral, and that they are alerted if a competitor files a lien on a debtor.
Banks should also consider vendors that can provide automation and integration capabilities to facilitate their work with borrowers, government agencies and other stakeholders, she says. “As we have seen recently with the impact of stay-at-home orders and remote workforces, automating transactions so that a human touch is not needed can be critical,” Konstance says. “Automation doesn’t just add efficiency; it can actually keep business flowing.”
Katie Kuehner-Hebert is a writer in California.