Preparing for Bank Examinations in a Challenging Environment
By: BEAU J. HURTIG
June 2009
Many issues confront the banking industry today, including a poor economy, decreasing real estate values, and an increasing number of loan defaults. To make matters worse, partially as a result of the vast sums parceled out to support financial institutions deemed too big to fail, regulators are under mounting public pressure to mitigate damage to the Deposit Insurance Fund and restore financial institutions to health. Additionally, the number of enforcement actions is on the rise. A bank examination under the currently adverse economic and political environment can be a source of anxiety for bank management. Adding to this anxiety is the fact that most of the factors mentioned above are beyond the control of bank management. However, taking a neutral and proactive approach to preparing for a bank examination will allow the best possible examination result.
Performing an Impartial Review of the Bank’s Position
One of the most important actions for bank management in these uncertain times is to evaluate the bank’s position from an impartial and extremely conservative perspective. Actions, risks, and financial positions that were deemed acceptable during past exams may be subject to increased scrutiny today. Therefore, bank officials should not simply rely on past practices but should reevaluate such practices. Identifying weaknesses and correcting them prior to the exam will not only gain credibility with your examiner, but may also lead to higher management CAMELS ratings.
Reviewing Asset Quality
Begin to apply this impartial and conservative approach by evaluating asset quality. Examiners have increasingly questioned bank loan portfolios as the economy has softened. Specific red flags include excessive loan concentrations and the holding of loan participations under certain circumstances, especially where a high rate of interest indicates high risk or where a multitude of participants exist, providing the bank with little influence in the collection and resolution process. Naturally, real estate loans are often the subject of intense scrutiny. Finally, examiners are increasingly skeptical of guarantors as a source of repayment. Therefore, bank management should reassess their asset quality, fully support the assessments through proper documentation and GAAP-compliant analysis, and increase the allowance for loan and lease losses, if necessary. The goal should be to identify all problem loans before the exam so management can develop a strategy to timely mitigate losses. This proactive reassessment can be a difficult process, but doing so can be very helpful in avoiding a downgrade in the management rating.
Responding to Reduced Asset Quality
After identifying problem assets, bank management should develop plans to reduce risks associated with those loans. These plans should address portfolio problem areas identified during the evaluation. The plan should also specify actions to be taken to reduce the risks associated with problem assets and assign responsibility for the completion of those actions. Additionally, the plan should include target dollar levels to which adversely classified loans should be reduced over a given period of time. Management should also review collateral (including appraisals), the borrower’s current financial position, and other potential alternative sources of repayment. Although the current circumstances make it difficult for management instantly to remove problem loans from the bank’s books, a thoughtful analysis and plan with respect to such assets can help improve the examination process. Bank management should also review and update, if necessary, policies with respect to loan participations and loan concentrations, especially if a real estate loan concentration exists.
Assessing the Bank’s Capital Position
The risk identification process may result in a greater number of adversely classified loans and an increase in the bank’s allowance for loan and lease losses. This, in turn, may reduce the bank’s capital position. For this reason, among others, bank management should also conduct an impartial review of the bank’s capital position prior to the examination. The bank’s strategic plan should document this analysis and any updates to the bank’s capital position and future plans, including support for any planned dividends. Additionally, bank management should identify potential options for addressing future capital issues, such as seeking additional equity investment through a securities offering or shrinking the bank’s balance sheet. Such actions may not be ideal in the current environment as it may be difficult to find investors and willing asset purchasers, but proactively identifying such risk and developing a contingency plan can greatly reduce unpleasant surprises associated with issues the examiner may identify.
Assessing Liquidity
Bank management must also consider the bank’s liquidity position. Management should be prepared for the fact that a reduced CAMELS rating or capital position may hinder the institution’s ability to maintain adequate liquidity. For instance, failure to maintain an adequately capitalized position for prompt corrective action purposes may result in restrictions on the use of brokered deposits, and a 4 or 5 CAMELS rating may result in reduced ability to obtain Federal Home Loan Bank financing. A number of traditionally 1 or 2 rated banks have been significantly downgraded during the past year. Therefore, even when expecting the best, management should prepare for the worst by developing contingency plans prior to the exam to ensure adequate liquidity in the event of an unfavorable exam result. Bank management will have much greater flexibility in developing contingencies before experiencing an exam with negative results.
Other Action Items
Management should also review traditional points of exam emphasis, in addition to the issues bank examiners currently emphasize relating to weakening loan portfolios, increasing allowances for loan and lease losses, declining capital positions, and decreasing liquidity. Management should reevaluate the institution’s overall risk management process and be sure the process addresses identified risks and is properly documented and reviewed by the board. Further, management should review and monitor third-party vendor relationships and information security procedures. Finally, management should review past exam reports and ensure identified problem areas have been addressed.
Takeaway
Preparing for a bank examination in this extraordinarily adverse economic and political environment can be a source of anxiety for bank management. However, even under the current circumstances, adopting an impartial analysis and proactive response prior to the exam can mitigate unpleasant surprises in examination findings, improve the overall experience for the parties involved, maximize the bank’s rating, and strengthen the bank’s position after the examination.