Recently in my In-Box, I received an email from the American Banker offering a report that discusses how to use stress testing in this uncertain environment. It is something we have been talking about for some time. In fact, a few months ago I wrote an article that was published by CEIS Loan Review, Inc. where I discussed how to plan for reserving through the end of 2020 using stress testing as a component of the Qualitative Factor determination. I recommended using the Bank’s credit stress test as a reserve planning tool, focusing on the cash flow component of the stress test to identify an amount to reserve for Q2 and applying it as a Qualitative Factor. For either the Incurred Loss or Expected Loss models, there needed to be some way to reserve and support the reserve.
Heading for Q3 2020…
We are now heading for Q3 and the scenario where things are not getting better and in fact are getting worse has jumped to the forefront as the most likely outcome from this pandemic. For Q3 I indicated that property (collateral) values would start declining as renters became unable to pay, lessors were closing their business doors and debt availability became further constrained. And, of course we don’t know what, if anything, the government will intervene in. Because of this I recommended using your stress test and applying cash flow constraints as well as property value reductions in order to determine the credits that are likely to become non-performing as well as amounts to reserve against the credits. There is a need for scenario analysis speed and this is where it would benefit financial institutions to adopt a Tabletop Scenario Analysis process to the determination of the reserves.
Tabletops are not just for IT
A Tabletop exercise can sharpen and speed group analysis while the organization is under pressure and can elevate preparedness—provided you properly design, carefully conduct, fully evaluate, and actually use the results of your test. Although no tabletop exercise can convey a realistic picture of a pandemic, it helps executives and planners find the plan’s gaps and rapidly analyze changes as improvements, setbacks and intervention take place at a dizzying pace. For the reserve, it can help identify an amount that is supportable, which is a big challenge in these uncertain times.
The keys to a successful Tabletop process are defining the goal, creating and empowering the team, establishing the decision-making process, taking action and documenting the results. Following is a short case study that outlines the guidelines for a successful Tabletop exercise.
Tabletopping for the ALLL/ACL…
Bank P is a $600 million financial institution located in the suburbs of a larger metropolitan city. Its portfolio consists primarily of commercial loans, with the majority secured by real estate, and mortgages, most of which are non-conforming. Lately it has been growing its unsecured commercial loan portfolio, bit through origination and acquiring some loans from a Fintech. And of course it has booked quite a few PPP loans in the few weeks it had to originate them.
The Executive team is concerned about how much to reserve for the credit portfolio (as well as how to ramp up Special Assets). Historical losses have been practically nothing and the Q Factor supports almost all of the reserve of the Bank. They recognize that uncertainty is extremely high with respect to the economy and the loan portfolio and want to be prepared to conduct rapid analyses as the situation changes. To that end they have established a Tabletop analysis and decision making process that will review the changes and information as it becomes available and come up with a recommendation for the reserve. The CEO and CFO want to make the final decision and so it is agreed they will not be a part of the Tabletop team.
- Goal Identification – The goal for this is narrowly defined and focus on the amount of the reserve for Q3 and Q4 2020 that is to be dedicated to (formally) unrecognized criticized and classified credits.
- Team Formation – It is agreed that the team will be small but also have to ability to gather information from internal and third party resources. To that end the Chief Credit Officer, Controller, a Commercial lender, a commercial loan underwriter, the person who runs the ALM model and the person who runs the ALLL model are drafted. A chair will be selected as well as a minutes taker and documentation collection individual.
- Scenario Development – The initial scenario takes the current state and lays it out in a narrative. Something like, “In early 2020 the COVID 19 pandemic took root in the united States. In March, as the country was being shut down, Congress took a series of actions that enabled most borrowers to defer their credit payments for six months (through September 2020) without being identified as a troubled or defaulted credit. The Bank initially issued three-month forbearances to many borrowers which were recently extended in June. PPP loans were booked in June during a very short window. The virus appeared to be getting under control but an explosion of cases in June and July has now forced more business closures and more (and longer) unemployment. The initial measures enacted by Congress are expiring and, as of this date, nothing additional has been enacted. But there may be action soon”.
- Format of the Process – The team will initially meet and determine what information is needed to conduct the exercise. Information like credit stress tests, economic projections, the Q2 reserve and the analysis, the budget, types of commercial borrowers, etc.… is good to start with. In addition, the team will invite a representative from each of the following third parties; ALLL software firm, loan review and the ALM software firm. They will be invited to participate by phone to share their knowledge and provide ideas for additional information that will be helpful to the process. The team agrees that it will meet twice for each scenario to be explored. The first meeting will be to discuss the analysis and the second will be to establish the recommendation. As the situation changes, the team will consider those changes to be new scenarios and will repeat the process. So, for example, if the local economy is directed to be closed, this will be a new scenario. Meetings may have to take place via conference calls. The final recommendation will come from a meeting scheduled for the second week in October. This will complete the Q3 process and the team will begin the Q4 process.
Considering relevant information…
The Interagency Guidance relating to COVID 19 (June 2020) states the following in the ALLL/ACL section, “examiners will assess whether management has considered relevant available information about the collectability of the institution’s loan portfolio, along with any changes to the institution’s lending practices and economic conditions as a result of the pandemic”. Q1 and Q2 wound up being a bit of a “SWAG”. Q3 will be the test of how much information we have and how we use it to effectively stay in the game.
By the way, I’d be happy to discuss any of this with you. I can be reached at (816) 728-2912.