Agility takes center stage as commercial lenders adapt to COVID-19 related risks

In January, financial institutions were focused on the LIBOR transition and the corporate bond market. By the end of March, the Covid-19 pandemic had shuttered businesses, upended markets, and introduced volatility on a new scale. Many traditional approaches to risk management went out the window as government stimulus programs introduced new scenarios and pandemic-related uncertainties brought forth new risks.

Now, several months into what is destined to be an economic journey, community banks and credit unions are beginning to realize the importance of agility as they try to balance risk and the need for continued profitability against the dual need to foster and grow community relationships.

We recently caught up with Jeb Beckwith of GreenPoint Financial to see what over thirty years of experience as a premier risk professional can tell us about the pandemic and the future of banking.

What to Expect Over the Short Term

When speaking about the current pandemic, Beckwith is quick to point out one thing: market shocks, as unexpected and impactful as they seem in the moment, do not last forever.

Medical science has already improved its knowledge on the Covid-19 virus, spawning emerging therapeutics and a possible vaccine on the horizon. However, extended stay-at-home orders and business closings continue to stress the economy, making it difficult to predict when the current economic turmoil will end.

For commercial lenders, the discussion must inevitably focus on risk. It becomes a matter of determining which companies will make it through the current downturn to the other side and how profitable they will be going forward.   

Beckwith says that we can look to the 1918 Spanish Influenza pandemic for clues on how the economy might react to the current health crisis.

The Spanish influenza killed an estimated 50 million people worldwide and had a devastating impact on the U.S. economy.ⁱ  According to research conducted by the Federal Reserve Bank of St. Louis, certain businesses were impacted more than others. Mines across eastern Tennessee and southern Kentucky, for example, were on the verge of closing down as the pandemic ravaged mining camps. Department stores saw a decline in revenue of 50 percent.ⁱⁱ 

However, during the Roaring 20s, the economy grew forty-two percent as the pandemic, and then World War I, came to an end.ⁱⁱⁱ  Beckwith anticipates a similar recovery is possible as 2021 rolls around.

“After the election and once we get some therapeutics going, it is easy to see the economy rebounding due to pent up demand,” said Beckwith.

However, risk is a funny thing, and as Beckwith points out, something banks can never completely eliminate. That is why managing risk is so important.

“You want to be able to manage risk so that losses that do occur are within acceptable norms and tolerances relative to your capital,” said Beckwith.

As banks and credit unions balance today’s risk against the anticipated recovery, they will need to protect the bottom line while also watching out for the businesses in their communities. Added agility to risk models and strategies will be particularly important as community financial institutions adapt to the CECL regime.

CECL Regime Comes of Age During Covid-19

“CECL is a poorly timed and fundamentally different way of looking at loan loss reserves,” said Beckwith.

Put in place January 1 of 2020, many banks began CECL reporting March 31, just as the pandemic took hold of the nation.  While the CARES Act offered banks and credit unions a partial reprieve from CECL regulatory standards, the delay in regulatory reporting was only extended until December 31 of this year or until the President declared an end to the Covid-19 crisis. Importantly, CECL is first and foremost an accounting change and financial reporting timelines were not delayed at all.  Having already invested in the new CECL framework, many financial institutions found that staying the course on CECL compliance was the less risky option.

CECL involves projecting expected future credit losses for the lifespan of a loan, while recording them at the time that financing is issued. Given that few experts in March were predicting such a lengthy impact from the pandemic, many financial institutions were not able to accurately determine the extent of default or to anticipate that they would have to grant deferrals on loans.

“We are seeing this now with JPMorgan’s results where they recently set aside an additional $10.5 billion in reserves to cover future, largely unanticipated loan losses,” said Beckwith. “And you are going to continue to see that kind of volatility going forward. It could even swing the other way in 2021 as the economy begins its recovery.”

While the Covid-19 pandemic introduced unprecedented volatility when it comes to forecasting loan losses or borrower credit worthiness, there are a few things community banks and credit unions can do to lessen their risk.

First, be sure to employ the right technology, including analytics that are CECL-friendly. Look for the ability to support the five loss methodologies mentioned by The Financial Accounting Standards Board. The ability to handle Q-Factors—manual adjustments to loss estimations based on unmodeled dynamics or one-time severe events—is particularly important in scenarios such as the Covid-19 pandemic.

Flexibility like this will be essential to community banks and credit union risk management as they progress through the Covid-19 crisis and into the recovery period. The added agility will make it possible to reduce the impact of losses while still supporting local businesses through times of financial hardship and prosperity alike.

_{ⁱ  “1918 Pandemic (H1N1 virus).’ Centers for Disease Control. Retrieved from: https://www.cdc.gov/flu/pandemic-resources/1918-pandemic-h1n1.html#:~:text=It%20is%20estimated%20that%20about,occurring%20in%20the%20United%20States.
ⁱⁱ  Thomas A. Garrett. “Economic Effects of the 1918 Influenza Pandemic.” Federal Reserve Bank of St. Louis, Nov. 2007. Web.
ⁱⁱⁱ  Kimberly Amadeo. “1920s Economy: What Made the Twenties Roar.” The Balance, Apr. 13, 2020. Web.}