Loan Grading in the Covid-19 Era
By: Steve H Powell & Company
Significant regulatory guidance exists concerning TDR status and identification relating to the effects of COVID-19. While broad leeway has been granted to allow for modifications without TDR identification, this issue should be considered separate and distinct from a loan’s assigned risk rating. Initial regulatory guidance indicated lenders should work with borrowers adversely affected by COVID-19 while maintaining appropriate safety and soundness standards. Unfortunately, with the pandemic recently passing its one-year anniversary, the long-term financial consequences are now becoming apparent for many borrowers.
In many cases, borrowers are experiencing significant financial stress that is no fault of their own and almost entirely linked to COVID-19. This financial stress is particularly evident in the Hospitality and Restaurant sectors, although many others have also been affected. When assessing loan grades, financial institutions are encouraged to be realistic in assessing the current financial situation of each borrower and adjust risk ratings where necessary and appropriate. Despite the financial stress being caused by COVID-19, loan grades should migrate over time to recognize the risk each transaction poses to the institution, especially in light of current economic conditions.
In a regulatory FAQ dated May 27, 2020, one question asked; “Do loans that receive payment accommodations have to be reported as nonaccrual, reflect appropriate ACL or ALLL, and be charged off?” and the following answer was provided:
Each financial institution should refer to the applicable regulatory reporting instructions, as well as its internal accounting policies, in determining whether to report loans with accommodations to customers affected by COVID-19 as nonaccrual assets in regulatory reports. (See also the response to questions 3 and 5). Each institution should maintain an appropriate allowance allocation for these loans, considering all information available prior to filing its reports about their collectability. As information becomes available that indicates a specific loan will not be repaid, institutions should preserve the integrity of their internal loan grading methodology and maintain appropriate accrual status on affected credits. Financial institutions should refer to the charge-off guidance in the instructions for the Consolidated Reports of Condition and Income.
Throughout 2020, examiners were understanding of the complications caused by COVID-19. However, increased regulatory scrutiny can reasonably be expected as the pandemic stretches into 2021. Proper loan grading and impairment identification will likely be a focal point. Despite best efforts by all parties involved, some borrowers will be unable to repay their debts. Financial institutions should continue to actively manage loan portfolios and adjust risk ratings as necessary.
In many cases, borrowers are experiencing significant financial stress that is no fault of their own and almost entirely linked to COVID-19. This financial stress is particularly evident in the Hospitality and Restaurant sectors, although many others have also been affected. When assessing loan grades, financial institutions are encouraged to be realistic in assessing the current financial situation of each borrower and adjust risk ratings where necessary and appropriate. Despite the financial stress being caused by COVID-19, loan grades should migrate over time to recognize the risk each transaction poses to the institution, especially in light of current economic conditions.
In a regulatory FAQ dated May 27, 2020, one question asked; “Do loans that receive payment accommodations have to be reported as nonaccrual, reflect appropriate ACL or ALLL, and be charged off?” and the following answer was provided:
Each financial institution should refer to the applicable regulatory reporting instructions, as well as its internal accounting policies, in determining whether to report loans with accommodations to customers affected by COVID-19 as nonaccrual assets in regulatory reports. (See also the response to questions 3 and 5). Each institution should maintain an appropriate allowance allocation for these loans, considering all information available prior to filing its reports about their collectability. As information becomes available that indicates a specific loan will not be repaid, institutions should preserve the integrity of their internal loan grading methodology and maintain appropriate accrual status on affected credits. Financial institutions should refer to the charge-off guidance in the instructions for the Consolidated Reports of Condition and Income.
Throughout 2020, examiners were understanding of the complications caused by COVID-19. However, increased regulatory scrutiny can reasonably be expected as the pandemic stretches into 2021. Proper loan grading and impairment identification will likely be a focal point. Despite best efforts by all parties involved, some borrowers will be unable to repay their debts. Financial institutions should continue to actively manage loan portfolios and adjust risk ratings as necessary.