How Does A Community Bank Prepare For A Recession?

The economic environment is more uncertain than ever. As it is, our crystal balls this time of year, when most banks are deep in the throes of the budget process, is quite cloudy. We now find predicting the future a formidable challenge. With a war unfolding as we speak, and the impending threat of further terrorist attacks, the future is less certain than ever. This, coupled with an unprecedented year in interest rate movements, makes budgeting a greater challenge than ever, and credit quality deterioration a likely event.

How does a community bank prepare for the anticipated increase in all the major risks typically facing community banks: credit, interest rate and liquidity? Below are some actions that I recommend considering taking to mitigate the rising risks embedded in our environment today:

1. Credit risk.
   • Reassess your desired asset mix. In the past, many companies were more inclined to make commercial real estate loans, given the demand in our marketplace and our intimate knowledge of the borrowers. Many set targets for all lending lines of business in the company. At CCB, for example, there were six such businesses: mortgage (originated almost exclusively for sale and fee income); consumer; commercial and industrial; SBA; commercial real estate; and leasing. Those goals need review and possibly change to reflect a reduced emphasis on CRE loans, coupled with greater emphasis on other types of loans, such as C&I and SBA loans. In every market new opportunities will arise for credit-worthy borrowers across lending businesses. The key is to assure that the loans made reflect the new economic conditions. This implies not only tighter credit standards where appropriate, but also more variable rate than fixed, an important component in everyone's interest rate risk management program.
   • Review current credit underwriting standards. Pristine asset quality is more important than ever. Even companies with excellent track records are well advised to take a fresh look at their underwriting criteria, since we are in uncharted waters. It is prudent to assess how appropriate are they in today's environment.
   • Increase frequency of loan review. Many community banks use an outside firm to review their loan portfolio periodically. Again, given the likelihood of more rapid credit deterioration, it may be wise to increase the frequency of loan review to get even earlier warnings, if applicable.
   • Increase frequency of document refreshers in targeted sectors. We have identified specific industry segments that appear to present greater risk in today's environment, such as hospitality or airlines. Speak with these borrowers more frequently than ever before, get more current financials on them and get closer to your top borrowers as well. All these steps are designed to put you as far ahead of the curve as possible.
   • Line up participants and upstream correspondents. While community banks are committed to make sure we're in the market for our clients at all times, we may not have the appetite for the risk profile that some of them may present going forward, OR we may have reached capacity in terms of our own acceptable concentration levels. Either way, it helps to have a ready buyer or participant for the loan. As we all know, someone's sow's ear is someone else's silk purse
   • Shift originations to buyer's specifications. Many banks have been originating mortgages for others for quite some time. The loans generate fee income for us instead of a margin. Similarly, we can shift other origination power to for sale specs such that the loans originated will leverage our internal origination capacity toward fee income rather than spread income, while meeting customers needs. Commercial real Estate and SBA loans are prime examples of such opportunities.

     Bottom line: greater scrutiny; tighter controls; and more frequent customer and internal contact.

2. Interest rate risk.
   • Improve quality of information. Start slicing and dicing our assets and liabilities in many different ways to reflect the possibility of embedded interest risk in the portfolio. For example, consider reporting on all variable loans vs. fixed, and possibly also on all variable loans that have reached their floors and those that will reach their floors within the rate shock range. Increase the frequency of our asset/liability reports to gain a better understanding of your risk on a more frequent basis.
   • Using the information you now have, monitor the portfolio to reach and maintain a balanced position. Toward that end, you may want to review your capacity for fixed rate lending monthly, and direct your loan officers not only with respect to industry segment and loan type, but also regarding interest rate parameters.
   • Building a robust network of correspondents and buyers creates greater flexibility for interest rate management as well, as you can now selling loans that don't fit the IRR profile we're looking for. While credit worthy and highly valuable to your buyers/participants, some loans may have a negative impact on your interest rate risk exposure that you'd prefer to control.

     Bottom line: Better information; more frequent information; clear guidelines to the lenders; and broader options.

3. Liquidity risk.

   Many banks in California and nationwide are having difficulty funding organically their robust loan demand. While deposits enjoy a respectable growth rate, loans are growing even faster. What steps can you take now to manage this situation and avoid a liquidity crunch?

   • Clearly identify your secondary liquidity sources. For example, if you have loans that are available for sale, classify them as such and have the buyers/participants ready to take the loans of your hands. Or another illustration: if you have FHLB borrowing opportunities, make the necessary arrangements to activate the line (eg enough FHLB stock; educate your board; prepare an exit strategy for the borrowing, should it take place; etc.).
   • Create secondary liquidity sources. For example, if you have your own sweep program, you may wish to outsource it and use your own securities as a secondary liquidity source.
   • Prioritize deposit growth. At CCB, we have tested the market to identify the best combination of rate and maturity our clients are willing to accept. Once identified, we have developed deposit-gathering programs in a needs-based selling mode to increase deposit inflows.
   • Consider deposit incentives, campaigns etc. Your people will ultimately deliver what you're clearly looking for, so being clear about the importance of deposits to your future and setting up the incentives to reflect that will speak volumes.
   • Maintain pricing discipline. Inappropriate pricing can attract rate surfers. While in the short term that could be positive, relying on such funding will come back and bite you when rate start rising.
   • Ask your lending teams to generate deposits as well. Some lending businesses, such as C&I, are accustomed to bringing the entire relationship into the bank, including both deposits and loans. Others, most notably CRE lenders, typically look only for the loan. Making credit extension conditional upon deposit commitments (through accounts of analysis, of course) is another effective way to address possible liquidity shortages while building franchise value.

     Bottom line: Communicate emphasis; prepare secondary sources; and incorporate into ALL lending businesses.

These are just a few of the risk management, measurement and monitoring steps I feel are important during such uncertain times. We know with certainty that we can't predict the future. All we can do is to generate information that will allow us to take corrective actions as soon as possible, and take the necessary steps to lower the company's overall risk profile without mortgaging its future until the storm passes.