Audit Committee Insights in Response to COVID-19

The COVID-19 pandemic brings new challenges to financial institutions: liquidity and executing on contingency funding plans, managing interest margins with historically low interest rates, and anticipating a decrease in credit quality leading to significant judgment in the determination of additional loan loss reserves. Not to be overlooked, there is also the sudden need for significant resources to originate and fund extraordinary volumes of the new Paycheck Protection Program (PPP) loans to small and mid-size businesses.

Now is the time for directors and audit committees to closely monitor operations and financial results of their financial institutions, understand operational and financial changes, challenge decisions and courses of action, and help ensure their financial institutions are equipped to emerge strong from this crisis.

DHG has summarized several relevant topics elevated by the COVID-19 pandemic to prepare audit committee members and bank directors for discussions in the coming months.

Loan Monitoring
Deferred and Restructured Loans – Troubled Debt Restructurings (TDRs)

The interagency guidance and the Coronavirus Aid, Relief, and Economic Security (CARES) Act suspended the TDR accounting for providing payment deferrals to certain defined customers impacted by COVID-19.

For the next six months, it may be challenging to determine how the financial institution portfolio will perform. The typical monitoring controls of past due and impaired loan reporting for these deferred loans may not be as relevant in identifying problems loans.

Financial institutions should modify their monitoring and reporting procedures for loan performance in light of modifications, programs and changes in accounting by the CARES Act, in order to properly monitor the portfolio, inform the board and be prepared for the post-pandemic environment.

Some items audit committees may expect to review:

  • A summary of loans subject to payment deferral – a list of the number of loans, dollar amount, interest recognized, repayment timelines and the borrower’s industry.
  • Modify past due reporting on deferred loans segregated from others.
PPP Loans

Many financial institutions have processed and funded large numbers of PPP loans in a short period of time without established, vetted control procedures in place due to unprecedented circumstances. Financial institutions may need to evaluate the internal control procedures around these loans for Sarbanes-Oxley/FDICIA compliance purposes, as well as future credit and compliance risk. Financial institutions must evaluate the need for timely, targeted quality reviews for proper documentation and compliance with ever-changing regulatory requirements, including proper verification and loan customer certification.

Audit committees will need to understand the credit risk for these loans to determine if these are typical Small Business Administration (SBA) loans or have additional risk attributes. Additional monitoring controls may be needed to supplement historical processes.

Allowance for Loan and Lease (ALL)

While COVID-19 did not yet have a significant effect on credit performance during the first quarter of 2020, most institutions anticipate the impact will materialize during the second quarter as borrowers struggle to make their loan payments. As part of regular meetings, directors and audit committee members should expect to see not just the ALL calculation, but also a granular analysis of the various components and the rationale for adjustments, to be certain that adjustments in ALL levels are reasonable and adequate – regardless of whether the financial institution still uses an incurred loss model or has adopted the new current expected credit loss (or CECL) model. Directors and committee members should be questioning: did general reserves increase because of increases in qualitative factors or due to an increase in historical loss factors; were changes made to qualitative factors due to economic conditions or implementation of new loan programs and policy changes; or did the ALL increase as a result of a change in the methodology?

It is important for directors and audit committee members to quantify the extent and the basis for the adjustments to be able to properly monitor this estimate and ensuring levels are appropriate.

Internal Audit

Audit committees should focus on the institution’s internal audit plan and evaluate if any changes in scope or timing should be considered. Some of these items included:

  • Credit Administration – Determine risk grading of impacted industries along with the need for revised monitoring controls.
  • Allowance for Loan Losses – Increase the focus on allowance qualitative factors as many credit issues may not have surfaced yet.
  • Liquidity Risk Management – Evaluate the financial institution’s contingency funding plan.
  • Accounting and Financial Reporting – Review controls and processes to help reduce error risk or misstatements due to remote workforces and subsequent events.
  • Impairment of Intangibles – Perform a thorough goodwill or intangibles analysis due to depressed stock prices or other possible triggering events to evaluate potential impairment.
  • Mortgage Banking – Re-evaluate whether this area is now material based upon increased mortgage loan activity. Understand the controls over market fluctuations impacting the valuation of derivative instruments. Review indemnification reserves to monitor for an increase in payment defaults.
  • Information Security – Educate your team members to be wary of phishing attempts from external correspondence or additional risks posed from team members working from home.
Budget/Strategic Plans

Are institutions still measuring financial condition and results against strategic goals and budgets developed last year? If budgets and strategic plans have not been revised, they will need to be updated soon. In the past month alone, balance sheets have changed to include significant levels of liquidity, increased volume of short-term, government guaranteed loans, as well as mortgage loans held for sale, potential ALL volatility and non-traditional deposit increases. Meanwhile, net income has been impacted by declining interest margins, significant increases loan loss provisions, declines in the fair value of certain derivatives and reduced deposit activity and related charges. With all these recent changes, there is an expectation that elevated levels of past due loans and potential problem loans are likely, whereas on the bright side, a significant level of loan fee income is expected. Budgets and projections should be updated in the near-term, so governance leaders can be able to accurately measure financial results against financial goals inclusive of recent developments in order to be able to make sound and realistic decisions.

Capital Ratios

Up until a few months ago, the banking industry, as well as most others, were profiting from continuous economic growth, record low unemployment levels, a robust housing market, strong credit quality and healthy regulatory ratios. However, all of these factors have changed, and should now be reconsidered. Events previously deemed unlikely should be reassessed and incorporated, not only to estimate realistic financial projections, but to determine whether the institution will remain adequately capitalized.

The following are factors that should be evaluated in the financial institution’s capital projections and monitoring:

  • Increased provisions and charge-offs later in the year.
  • Potential for net operating losses through the end of the year.
  • Dividends and stock buyback strategies for the year.
  • Potential breach of the capital conservation buffer. This would trigger constraints on anticipated equity repurchases, dividend payments and executive compensation.

Those charged with governance should monitor capital ratio projections, as well as contingency plans, should the regulatory ratios be adversely impacted.

Financial Statement Disclosures

In the current COVID-19 environment, there are certain disclosures that deserve closer scrutiny by audit committees:

  • Operational Change Disclosures: Changes in the way that the financial institution interacts with customers, how employees have changed their behavior and any changes to service offerings or products.
  • Customer Assistance Disclosures: Consist of fee waivers, payment deferrals and extensions, funding of PPP loans, etc. Items that should be disclosed include impact on fee revenue, amount and types of loan modifications and the number of funded PPP loans.
  • Financial Statement Estimates Disclosures: Allowance for loan losses is likely the most significant estimate. Credit quality disclosures should include not only how the financial institution developed its estimate, but also loan portfolio segments that may be significantly impacted by the current economic environment. Identify estimates that have changed, or may be subject to change, as a result of the COVID-19 pandemic, and how the financial institution is monitoring its process for making those estimates, including: fair value measurements (particularly for investment securities), impairment assessments, deferred tax asset valuation allowances and any potential recourse exposure such as mortgage indemnifications or repurchases.

Also, the U.S. Securities and Exchange Commission (SEC) has issued a document with numerous COVID-19 disclosure considerations for additional information.

As management teams work through COVID-19 challenges, it will be important for the audit committee to be informed in order to provide governance and oversight.

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