Fed to assess banks’ management during Covid-19

US supervisors are set to resume their full supervisory regime with a focus on how banks’ managers have adapted to the Covid-19 pandemic, the Fed announced on June 23.

The Federal Reserve and other federal and state supervisors will examine whether management appropriately assessed the risks posed by the pandemic, and their effectiveness in responding to changes in the market.

They will also assess whether the evolving business and market situation has been addressed in banks’ long-term strategies. Operational adjustments to the working-at-home environment and the fraud and cyber protections associated with it will also be under the microscope.

Supervisors will consider the “unique, evolving, and potentially long-term nature” of the issues facing banks and will assess the “reasonableness of management’s actions” in response, the statement said. It was issued jointly by the Fed, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency and state regulators.

Observers have noted that banks are well positioned to be a key part of the solution to the current crisis – in contrast to 2008, when they were a major driver of the financial crisis. Following actions taken by fiscal, monetary and regulatory authorities to support lending, banks have provided new loans and restructured existing debt to ease strains.

The supervisors will test whether banks, which were thought to be resilient heading into the crisis, have fulfilled this responsibility and avoided exacerbating the problems. A particular risk is that some businesses may struggle to recover from the economic shock, potentially raising the rate of non-performing loans.

The added focus on the crisis measures is a shift from the supervisory practices exhibited during normal times, where examinations tend to be more generic.

Supervisors temporarily eased their examination regime on March 24, so that banks were able to focus on the market and operational challenges created by the pandemic.

The examinations will be based on the two existing rating frameworks: the Uniform Financial Institutions Rating System, more commonly known as “Camels” ratings, and the Rating System for US Branches and Agencies of Foreign Banking Organizations, often referred to as “Roca” ratings.

The ratings cover two broad areas – an overall assessment of management actions and the effectives of the bank’s assessment of risk. 

Management assessment

In assessing the actions of managers, supervisors will focus on the operational risk practices being deployed and banks’ business strategies – both in response to immediate changes in the market and the longer-term implications of the pandemic. Supervisors will also examine how prepared managers were heading into the crisis in areas of financial resilience, contingency planning and resolution practices.

In response to the pandemic and lockdown measures, many banks have had to quickly adapt processes and technology to continue servicing customers. “Rapid changes in operational processes and increasing fraud and cyber threats may result in a heightened operational risk environment,” supervisors say.

The steps taken will be judged against banks’ ability to adapt fraud and cyber security controls to manage heightened risks related to the new operating environment. Supervisors will also examine the impact of banks’ decisions relating to cost-cutting measures – such as reduced staffing, delayed hiring or technological updates – on their operational resilience.

“Management may have changed the institution’s business strategy to focus on new lines of business or expand into new markets,” the guidance says. “If the institution’s business strategy changed, examiners should consider whether the institution has sufficient controls and expertise for the new or expanded activities.”

The examinations will also focus on management’s understanding of the pandemic’s impacts on earnings and capital, as well as funding, liquidity operations and sensitivity to market risks.

The earnings assessment will look at how banks have been accounting for the range of impacts and regulatory forbearance measures.

If a bank’s risk profiles are not reflected appropriately in their capital levels, examiners will judge whether the management has developed a satisfactory plan to maintain capital adequacy or, if needed, build capital, the guidance says.

“The risks associated with the Covid-19 pandemic, as well as impacts of policy responses, can be challenging to assess in real time,” the guidance says. Banks will be judged on their ability to identify risks in real time, given the limited information currently available.

Credit and market risk assessment

In the second area, which is closer to normal supervisory examinations, banks will be judged on their assessment of risk given the strains and volatility in the business and market environment. For example, their ability to conduct loan reviews and prudently underwrite new loans. But the current limitations to operational capacity have required a slightly different approach, the guidance says.

Loan modifications will face a more lenient assessment, in that supervisors will “exercise judgement” and not automatically assign adverse risk ratings to a loan that was modified, the guidance says. Supervisors will be looking at whether prudent and realistic measures have been taken.

For real estate loans, judgements will be made on whether banks have been making “best efforts to obtain a credible valuation of real property collateral before the loan closing”, the guidance says. How any loan appraisal backlogs – in part due to regulatory forbearance – are being addressed will also be examined.

Supervisors recognise that cashflow disruptions may cause temporary shifts in banks’ interest rate risk profiles. As a result, banks may need time to distinguish short-term and long-term disruptions. Supervisors will assess the procedures banks have in place to review and update their “asset and liability management models” in light of these risks.