Written by Jay Lucas, Director
The pandemic threw a wrench into the financial world when it hit, creating havoc for business owners and lenders alike. Regulators encouraged lenders to work with their borrowers to help them maintain operations by providing a multitude of solutions to meet their clients’ immediate needs. Lenders provided solutions to address short- and long-term cash flow needs to assist business owners through this business disruption, which was beyond their control. In doing this, relationship managers may have waived traditional financial reporting and underwriting guidelines which was unquestionably the right course in the context of this unprecedented crisis, but these deviations from policy have created additional risk for lenders.
With the SBA rushing to get urgently needed cash to business owners through federal lending initiatives like the Paycheck Protection Program (PPP) and Economic Injury Disaster Loans (EIDL), financial institutions had to rewrite some policies and bypass others in an effort to expedite funds to customers in need. Disruptions to economic sectors such as restaurants, retail, and the hospitality industry created a domino effect in commercial real estate (CRE) portfolios. With significant deferral and rental concessions, owners of CRE flooded their financial institutions with extension and loan payment concession requests.
All of this economic chaos has impacted financial institutions and their portfolios, with criticized loans showing signs of increasing. Pandemic-driven payment deferrals have mitigated some economic losses to property and business owners, but the inevitable reckoning and its ultimate fallout is yet to be seen. Will the latest stimulus package approved by Congress be the end of the funding and SBA emergency relief? If so, what does this mean for financial institutions and their portfolios?
By necessity, many of the elements critical to a credit risk review have been relaxed during 2020 and the early months of 2021. Credit risk management for financial institutions now demands more urgent and rigorous attention.
- Loan portfolios – After a year of relaxed portfolio monitoring and government funding, loan portfolios represent significant risk for many financial institutions. While it is true that a large number of the recent loans are federally guaranteed, the abbreviated review process, greatly expanded loan volumes, and the ever-evolving regulations surrounding many of the temporary loan programs have lenders facing the possibility of far greater risk than management and governing boards may feel comfortable with – and for good reason.
- Unfunded loan commitments and lines of credit – From business owners to homeowners, few are immune from the financial ramifications of last year. Advances associated with existing lines of credit could exceed predictions by large margins. Is your institution prepared to meet these demands should they be realized? And if so, at what cost to the overall asset management strategy?
- Investing strategy – The unpredictability of the economy has unsettled financial markets to no small degree. Bubble? Impending correction? Runaway inflation? Predictions regarding economic instability are becoming more common than usual, and while it is easy to dismiss much of the drama, the fact remains that well-monitored loan portfolios will continue to be desired by investors. Responsible asset management requires a careful review of your current investment strategy and policies, given this broader context.
There is good news! Federally backed financial aid packages have assisted greatly with fully funding SBA 7(a) loans, however, the future of these portfolios is now dependent upon borrowers returning to traditional operations and payment terms. The principal and interest payments and increased guarantee percentages were just a few of the benefits included in the package of regulatory changes included in the last two stimulus bills.
Taken together, increased risk and rule changes only intensify the need for financial institutions to make a concerted effort to restore their traditional credit management practices. Now is the time for financial institutions to adopt a renewed focus on the basic risks of sound portfolio management.
Now that government assistance with SBA payments and other short-term programs designed to assist businesses is beginning to subside, we would expect to see an increase in loan downgrades over the next 12 to 18 months. There is a need to return to core lending best practices by increasing interactions with borrowers and assessing their long-term needs.
Should borrowers continue to request the need for short term extensions or modifications, be sure to take this time to document the file as follows:
- Require interim financials to properly document if the business has begun to return to normal operating levels.
- Clearly state what the sources and uses of funds will be used for.
- Require management to document how they plan to turn around the loss of sales and to return to viable operations.
- Review your collateral positions to document its condition and verify that liens are properly reflected.
- Evaluate borrower and guarantor contingent liabilities.
Self-identify and properly risk rate loans and any related modifications and be proactive in identifying risk. It should be expected that 2020 financials may not reflect the historical trends the business had pre-crisis, so underwriters will need to document any negative impacts on 2020 results in order to project cash flows going forward.
In addition to close internal scrutiny of loan portfolios and overall fiscal rigor, organizational leaders should consider their options for qualified third-party assistance to provide expert guidance in this process. The risk environment at this moment is both complex and multi-faceted. Independent third-party assistance can help in making sure that portfolio reviews are performed thoroughly and efficiently, allowing the institution to strategically focus its efforts on identified risks and ensure all other aspects of credit risk management are put back in line with established Board approved loan policies in a timely manner.
If your financial institution needs assistance in identifying the potential added risks generated by the events of the past year, reach out to the experienced advisors at Mauldin & Jenkins. We are here to assist you by helping identify and address any potential risks that may have evolved.