Credit risk and LIBOR regulatory compliance challenges

Regulatory pressures

Adoption of CECL. Increasing delinquencies and elevated credit losses will continue to dominate the landscape in 2021 and a focus on CECL will remain top of mind as regulators assess institution’s ability to estimate losses from an accounting perspective as well as their effectiveness in identifying and managing the increased risk profile to mitigate losses. The adoption of CECL has created a disconnect where some organizations have lowered their focus on traditional credit risk practices, such as credit review, as they focus more on the lifetime loan loss estimates. However, make no mistake, from a safety and soundness perspective, regulators will continue to be focused on credit risk management practices.

Supervisory priorities. As indicated in the OCC’s 2021 Bank Supervision Fiscal Operating Plan, “the OCC will adjust supervisory strategies, as appropriate, during the fiscal year in response to emerging risks and supervisory priorities.” The OCC highlights that credit risk management will be a focus area given weaker economic conditions, emphasizing that examiners should focus on: “commercial and retail credit risk control functions, including portfolio administration and risk management, timely risk identification, independent loan review, risk rating accuracy, policy exception tracking, collateral valuation, stress testing, and collections/workout management.” Additional focus will be on real estate concentrations and concentration risk management (both retail and commercial) and on other portfolios with “material concentrations, especially those in sectors hard hit by the pandemic.” The FRB similarly directs its supervisors to focus on these same issues.

Credit quality. While the results of the 2020 Shared National Credit Program have not yet been published, some information from the 2019 report may shed light on that market going forward. The 2019 report indicated that credit risk was elevated from the prior year, especially for Leveraged Loans, adding that “many of these Leveraged Loans possess weak structures,” and that many of these attributes including “high leverage, aggressive repayment assumptions, weakened covenants, and ability for borrowers to draw additional funds” are the result of competitive market conditions and were not materially present in previous downturns.” These findings reflect increased risk and regulatory concerns, prior to the start of the COVID-19 pandemic, and will likely remain a primary focus through 2021. Recent regulatory reports note that offerings of proprietary relief and mandated programs along with stimulus efforts may mask credit quality issues. Credit risk will evolve based on the duration of assistance programs and economic factors such as unemployment.

LIBOR transition. With the expected phased discontinuation of LIBOR between end of 2021 to mid-June 2023, supervisory focus will increase for institutions with significant LIBOR exposure or less-developed processes. Regulators are looking for all institutions to have processes in place to identify and mitigate their LIBOR transition risks, commensurate with the size and complexity of their exposures. Regulators encourage institutions to determine, “without delay,” the appropriate replacement reference rates, including credit-sensitive alternatives, given their funding costs and customers’ needs. The expectation has been set that from the end of 2021 new contracts should not reference USD LIBOR. In addition, all new contracts should either utilize a reference rate other than LIBOR or include fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation. The federal banking agencies indicate the use of SOFR is voluntary and they will not criticize other rates, including a credit-sensitive rate, for loans. Disclosures should be made to credit customers in advance of rate changes to mitigate consumer protection and compliance risks.

Near zero rate environment. The current zero rate environment and economic uncertainty may ultimately make negative rates (e.g., negative yields, negative implied interest rates, and in some cases negative interest rate central bank policy) a possibility in the United States. The impacts of negative interest rates will vary among institutions based on business models and exposures, though financial services companies of all sizes may want to prepare by updating frameworks to adapt, inclusive of products and contracts with interest rate exposure (e.g., LIBOR), and models and systems (internal and third-party) that are interest rate dependent.