Questions and Answers From the November CEO Community Banker Forums

Attendees at the November CEO Community Banker Forums in Charlotte and Richmond had the opportunity to ask questions and provide comments. Here are some of the questions that were asked and the answers that were provided:

Virginia Economic Overview

Q: Is there any way to quantify the impact of our exposure to federal government contract expenditures?
A: It is useful to measure the presence of the federal government not only in terms of employment, but also in terms of the spending or contract dollars spent by the federal government through all of its departments and agencies. There is a recent article in our Region Focus publication (Third Quarter 2011) on the impact of the federal government in the Fifth District. The article has a nice map showing the concentration of government contract spending, as well as the location of military installations and government-owned properties. Virginia is among the top states for contracting with the federal government. There was also a study done by Steven Fuller with George Mason University on the impact of federal government spending reductions on the state economies.

Q: Could you comment on some of the recent Fed actions, such as Operation Twist, and their overall effectiveness?
A: Operation Twist involves the Fed’s buying more Treasury securities on the longer end (six to 30 years), while simultaneously selling shorter-term government securities (three years or less). Its intended effect is to bring down long-term interest rates that are tied to business investment and thus stimulate economic activity. Indeed, longer-term interest rates came down a bit, but whether you can attribute all of that to the Fed actions is not clear. Certainly, the Fed actions have moved long-term interest rates in that direction, but additional market forces also come into play.

Q: Do you have any data to support that education and health services will continue to expand?
A: Recent trends would suggest that education and health services should continue to expand. In health services, there is an issue of health care reform, and hopefully next spring we will get more clarity on what’s going to happen as the Supreme Court takes up the issue. However, the demographics of our country are such that we will continue to have growth in health services. In education, there seems to be plenty of demand as well, particularly as people enter training programs or degree programs to retool for re-entry into the workforce.

National and Regional Economic Outlook

Q: What’s going on with the economic crisis in Europe, and why is it important to the U.S.?
A: It’s important to us for a couple of reasons. We do operate in an increasingly globalized economy. So there are several channels through which adverse impacts of a default in Europe could trickle through, if not rush through, to the U.S. economy. First is through its impact on trade. Europe is a major trading partner of ours, and it does appear that Europe is about to slip into at least a mild recession in coming quarters, and that reduces a potential market for our exported goods. Second, if we continue to see problems in Europe, we could see that show up in currency translation. The euro could lose ground against the dollar, and that makes the goods and services we produce here more expensive on global markets than some of our key competitors. But, the biggest challenge we would face would be the impact that any default on debt would have on financial markets. We could see significant disruptions in credit markets and heightened volatility (and big losses) in equity markets.

Q: How much attention is the Federal Reserve Bank focusing on municipal debt right now, nationwide?
A: We’re paying close attention to it. We do have a team that has been established to look at all of the fiscal issues surrounding the state and local governments. We have a working group in which we have at least one person, and in some cases more than one person, from each Federal Reserve District participating in this working group. We are monitoring the ways in which the recession has impacted state and local fiscal positions and how it’s impacting the municipal debt and municipal ratings across each of our Districts. And importantly, we are monitoring how those problems are manifesting themselves in the real economy.

Troubled Debt Restructurings (TDRs)

Q: I know that a B note has to be charged off because of GAAP, but if you have collateral to support the B note, why can’t you keep it and pay the B note on the back end?
A: Unfortunately, that’s not an option if you want to return the A note to accrual status. You need an A/B split, with the A note being prudently underwritten and the B portion charged off. There is more to prudent underwriting than the value of the collateral. Cash flow for the B note is as important as the CLTV (combined loan to value ratio), and, in the instances we've seen, the B note basically doesn't cash flow; therefore, it wouldn't be considered prudently underwritten. Another question that comes up operationally with A/B splits is, “Do we have to get two notes signed?” The answer to that is, yes, it has to be two new legal obligations signed by the borrower. Without two new legal obligations signed, you technically would have a partial charge-off that would preclude you from placing the A note back on accrual status after an appropriate period of time and performance.

Q: As a follow up question, for Call reporting purposes, how long is “the life of the loan?”
A: If it’s a market rate of interest and the loan is in compliance with its modified terms, it can drop off the next year. TDRs made at a market rate of interest that are in compliance with their modified terms need only be reported in the calendar year of the restructuring.

Q: One of the biggest conversations we’ve had internally about this guidance is the inability to obtain “take-out” financing, which has led us to believe that if you have a raw land loan, an ADC (Acquisition, Development and Construction) loan, or a builder line of credit, you essentially have a TDR. Do you have any suggestions of how we test obtaining take-out financing, rather than just assume that there is no one willing to put that loan on their portfolio?
A: We have seen some situations where, as part of the negotiations with the borrower, banks have asked about option number one, which is to get financing outside the bank. Documentation is the key issue when dealing with TDRs. As part of negotiating the restructuring, some bankers directly ask the borrower to refinance the loan elsewhere. If the borrower is unable to do that, the bank should document that in the credit file. Always remember though, that the first seminal question is, is the borrower experiencing financial hardship? If the answer to that question is "No," then it doesn't pass the first test of even being a TDR.

Allowance for Loan and Lease Losses (ALLL)

Q: After a merger or an acquisition, and assuming that purchase accounting is used and you fair-value the balance sheet — post the transaction — the allowance essentially goes away and you’ve got an implied credit mark. Can you comment on how you view the credit mark vis-a-vis the allowance provision as you begin to build back the provision after the transaction?
A: Whenever the bank acquires a portfolio of loans, they are marked to market and a reserve balance is not always required for those loans. While this activity can significantly skew the reserve levels based on the total loan portfolio size, composition and risk, management should still perform analysis of the reasonableness of the overall reserve level. This may be accomplished several ways, either by segregating the purchased loans out of the general portfolio and comparing asset quality indicators from the legacy portfolio against peer data, or by adjusting the total portfolio balances by the market adjustment to create a relevant analysis. Regardless of the method chosen by bank management, documentation of key assumptions and analysis is imperative.

Q: Have you started seeing reserve releases or negative provisions from the community banks in the Fifth District, and what would you advise them before they pull the trigger?
A: In the Fifth District, we have not seen much of that activity. Once economic conditions are such that banks are seeing improvements and strengthening in their loan portfolios, it is inevitably going to happen. Over the past several years, reserve balances have increased significantly based on loan quality and expected losses. However, if asset quality is improving, there are adequate risk management procedures in place to ensure risks are properly identified, and there is adequate documentation to show an excess in the reserve, it is an acceptable practice to decrease the level. Examiners may use additional scrutiny when reviewing reserve decreases to make certain levels remain reasonable based on institutional risk and estimated losses.

Q: Can you comment on examiner expectations of a bank that uses an ALLL vendor supplied model to help them arrive at the reserve level?
A: We see banks utilizing vendor models quite a bit. In fact, Fifth District-specific examination procedures have been developed for examiners reviewing results provided by one of the more common vendors. Many vendor models come with predetermined assumptions, and use of the non-bank-specific assumptions or information may result in an inadequate reserve level. Management must review and, when needed, adjust assumptions to ensure bank-specific analysis and reserve levels. Furthermore, while it is an acceptable practice for bank management to utilize external models in conjunction with their risk management processes, we still have an expectation that management will perform reasonableness tests outlined in the Interagency Policy Statement on the Allowance for Loan and Lease Losses (SR 06-17). Complete documentation should be maintained to support all assumptions, analysis and reasonableness tests.

Stress Testing

Q: What are your expectations for community banks around stress testing?
A: There is proposed stress testing guidance for firms with assets of $10 billion or greater. While the guidance would not apply to firms below the asset threshold set by the proposed guidance, they are still subject to the aspects of subject-specific risk management guidance (such as for CRE, interest-rate risk or liquidity risk) that discuss stress testing. Generally, banking organizations should conduct some type of forward-looking analysis to understand the potential impact of various types of adverse outcomes on their financial condition. In other words, they should consider what could go wrong and how that might impact their firm. This can consist of a relatively simple analysis that is an extension of existing risk management and does not have to be structured along the lines in the proposed guidance for firms over $10 billion.

Q: It seems to me that we need a little more transparency in the stress testing, especially on capital, from the regulators. What are your thoughts?
A: The important point is that you know your institution. Tell us about your institution and your process: what information you used, what assumptions you made, and what judgments were applied to assess your capital adequacy.  Transparency is important for both bankers and regulators, and there needs to be an open dialogue with your examiners about your internal capital assessment process.

Panel Discussion

Q: What are you doing to help get capital into the industry?
A: We want a vibrant banking industry, and we want to do what we can to support that. What we try to do, and what our role really entails, is to understand the deals and investments that are being proposed and to make the best decision about whether those investments are in the best interest of the industry, of the bank and of the insurance fund. Our job is to evaluate every transaction and try to work with the bank to do something that makes sense for us, given our guidance, and that makes sense for the institution.

The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any laws, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.

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