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How does your control environment look in a remote world?

04.09.20

Read this if you are a Chief Executive Officer, Chief Financial Officer, Chief Risk Officer, Chief Information Officer, or Controller.

While COVID-19 has forced many of us into a remote work environment, we also have to deal with the challenges that come along with it. The stark contrast between an office environment and one that potentially involves working in isolation can be a difficult adjustment. Office kitchen conversations have evolved into conversations with pets, our newest co-workers. A quick, in-person question has now turned into an email, phone, or video call. And job responsibilities expand as we try to not only juggle work but also ensure our children focus on school work―and don’t destroy the house. 

Not only has this forced environment caused social challenges, it has also opened the door for internal control challenges, as  internal controls designed to operate effectively in an office environment may not be ideal for a remote workplace. Even ones that are appropriately designed, may prove to be operating ineffectively in this new environment. Let’s take a look at some internal control challenges, and potential solutions, faced by working in a remote environment.

Establishing a remote control environment

Exercising appropriate tone at the top and establishing appropriate oversight can be challenging with a remote workforce. Ethics and governance policies play an important role in setting clear expectations about workplace behaviors. But, a workforce is much more apt to follow a leadership team’s example rather than a policy. All of those office conversations, even the conversations that are not work related, help set an expectation of appropriate and inappropriate behaviors. These conversations often happen naturally in the office via a quick conversation in passing in the hallway or a late-Friday happy hour with your department. However, these interactions do not naturally occur in a remote workplace. Leadership and department heads should make an active effort to maintain communication with their workforce. Some things to consider:

  • Send out weekly emails to the entire department and possibly more personal, one-on-one videoconferences or phone calls between your department heads or managers and individual members of their teams.
  • These department-wide emails should stress the importance of communication as well as continuing to produce high quality work and maintaining accountability. 
  • One-on-one meetings should be used to check in with employees to ensure their work needs are being met. 

Employees will most likely have many suggestions to improve their new work environment, including suggestions on how to improve communication amongst team members. 

The power of video

Videoconferencing also provides a great opportunity to stay connected. Virtual happy hours simulate an in-person happy hour. This is a great way to check-in with team members and show that, although people are out of sight, they are not out of mind. Town hall-type meetings can also be explored. Your leadership team can solicit open discussion. Agenda items may include office status updates, technological considerations, and an opportunity for employees to openly discuss current challenges due to working in a remote environment. Employees are going to have anxiety about the current environment. These meetings can help put employees at ease.

Risk assessment

Internal control environments are constantly evolving. Employees leave. Software is updated.  Offered services and products change. The list goes on. However, it is unprecedented that an internal control environment has changed so rapidly. Given these unprecedented times, there is potential for higher risk of fraud, internally and externally. Those responsible for designing internal controls (control owners) should reassess your company’s environment. Although internal controls can be designed in a manner in which they operate effectively regardless of the circumstances, it is possible there are unintended changes to processes that have occurred. 

For instance, let’s say the employee responsible for reviewing loan file maintenance changes is now working an alternative work schedule due to personal obligations. This employee does not have the ability to make loan file changes; therefore, segregation of duties has never been an issue. An employee within loan servicing has agreed to take some of the employee’s responsibilities and is now reviewing some of the loan file maintenance changes, which has put this employee in a position to review some of their own changes. 

Furthermore, some internal controls that require employees be at a physical location to operate may also be compromised, such as inventory cycle counts. If these controls are unable to operate, control owners will need to consider the impacts on the affected transaction areas, and if there are compensating controls that can be designed to alleviate some of the control risk.

Control activities

Accounts payable and check signing

The accounts payable and cash disbursement process will most likely be upended as a result of your new remote environment. Bills received through the mail will need to be scanned to the accounts payable clerk for entry into the accounting system. Some offices have designated certain personnel responsible for checking mail on an infrequent basis, for instance, weekly. Check signing may also prove to be a challenge as blank check stock may be inaccessible. Electronic receipt of invoices and signing of checks, as well as the use of wire and ACH transfers, lend themselves as feasible solutions. Email approvals may suffice when multiple signers are needed to approve high dollar disbursements.

Segregation of duties

As mentioned above, it is possible processes have inadvertently changed, exposing certain internal controls to ineffectiveness. Segregation of duties may become difficult as employees shift to alternative work schedules or have other issues. Maintaining segregation of duties should be a top priority for control owners and is something that should be constantly assessed as circumstances change. Challenging times may make segregation of duties difficult and may force you to get creative by requesting employees perform duties they are not otherwise accustomed to performing.

Digital sign-offs

You should also consider the manner in which you document the completion of controls. Control owners should be cautious about the integrity of an employee’s initials simply typed onto a digital document, as any employee can perform this task. Digital signatures, which require an employee to enter credentials prior to signing, enhance the integrity of a sign-off and are often time stamped. Digital signatures may also “lock down” the document, prohibiting any changes to the signed document.

Timely review

Given the circumstances, it is not unreasonable that preparation and review may take longer than under normal circumstances. Even if additional time is granted for the preparation and review of documents, you should consider the implications this has on the transaction class as a whole. The longer it takes to complete a control, the greater the consequences may be if you identify an error. For instance, the impact of an incorrect change to a loan rate index can be substantial if not identified timely. If identified quickly, you can avoid consequences later.

Information and communication

For many companies that have moved from a paper to a digital environment, sharing of information should not be an issue. However, for those that still operate in a mostly paper environment, performing tasks and sharing information with team members may prove to be difficult. And, those without the capability of scanning and sending documents from home could compromise a specific internal control altogether. Being forced to work remotely may be the perfect excuse to move paper processes into a digital format.

Monitoring

Monitoring your internal control environment is of the utmost importance given these significant changes. Frequent conversations should be had with control owners to ensure changes to processes do not render controls ineffective. Identified gaps in internal controls should be addressed proactively. Provide control owners with the opportunity to discuss changes to control processes with Internal Audit or Risk Management so such departments can consider the impact of changes on internal control. This also gives these departments the opportunity to cover any resulting gaps.

Permanent changes

Once the remote workplace requirements end, the effects of working in such an environment will not. There are many benefits and efficiencies to be found in working remotely. As people have now been forced to work in such an environment, they will be more apt to continue to do so. Therefore, let’s take this opportunity to revise processes and internal controls to be “remote workplace” compatible. This will provide a long-lasting impact to your organization far beyond the pandemic. 
 

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Read this if you are a plan sponsor of employee benefit plans.

UPDATE: On December 1, 2022, the proposed rule was finalized with changes and will be effective 60 days after publication in the Federal Register (therefore, January 30, 2023).

The Department of Labor (DOL) is preparing to finalize a proposed rule that changes the way environmental, social, and governance (ESG) factors are viewed in a plan sponsor’s investment process and proxy voting methods. The proposal, which was issued in October 2021, aims to help plan sponsors understand their responsibilities when investing in ESG strategies and makes significant changes to two previously issued ESG rules.

Here, we provide an update on the DOL’s proposed rule and seek to help plan sponsors understand their potential new responsibilities when considering ESG investments. 

Background on ESG rules

For many years, the DOL has considered how non-financial factors, such as the effects of climate change, may affect plan sponsors’ fiduciary obligations. Amid an increasing focus on ESG investments, the Trump administration issued a final rule on ESG in November 2020 that required plan fiduciaries to only consider financial returns on investments—and to disregard non-financial factors like environmental or social effects. The rule also banned plan sponsors from using ESG investments as the Qualified Default Investment Alternative (QDIA).

A separate ruling issued in December 2020 said that managing proxy and shareholder duties (for investments within the plan) should be done for the sole benefit of the participants and beneficiaries—not for environmental or social advancements. It also stated that fiduciaries weren’t required to vote on every proxy and exercise every shareholder right.

In March 2021, the Biden Administration said it would not enforce the previous year’s rulings until it finished its own review. The current proposed rule is the result of that research.

Overview of the new proposed ESG rule

In October 2021, the DOL proposed a new rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” According to the proposed rule, fiduciaries may be required to consider the economic effects of climate change and other ESG factors when making investment decisions and exercising proxy voting and other shareholder rights. The proposal states that fiduciaries must consider ESG issues when they are material to an investment’s risk/return profile. The rule also reversed a previous provision on QDIAs, paving the way for ESG investment options to be used in automatic enrollment as long as such investment options meet QDIA requirements.

The new ESG rule also made several changes to fiduciaries’ responsibilities when exercising shareholder rights. First, it changed a provision on proxy voting, giving fiduciaries more responsibility in deciding whether voting is in the best interest of the plan. Second, it removed two “safe harbor” examples of proxy voting policies. Next, the proposed rule eliminated fiduciaries’ need to monitor third-party proxy voting services. Lastly, the proposal removed the requirement to keep detailed records on proxy voting and other shareholder rights.

In addition, the DOL updated the “tie-breaker test” to allow fiduciaries the ability to choose an investment that has separate benefits (e.g., ESG factors) if competing investments equally serve the financial interests of the plan.

Comment letter analysis shows broad support for the proposed rule

The DOL received more than 22,000 comment letters for the proposed regulation. Ninety-seven percent of respondents support the proposed changes according to an analysis of the comment letters by the Forum for Sustainable and Responsible Investment (US SIF), a membership association that promotes sustainable investing. While some respondents asked the DOL to revisit the tie-breaker provision and other specifics of the proposed rule, many respondents agreed that the proposed rule clears the way for fiduciaries to consider adding ESG investment options to benefit plans.

Insight: Consider how the proposed ESG rule affects your plan today

Based on the typical timeline for similar rule changes, the DOL is expected to issue its final version of the proposed rule by mid- to late-2022. This means that plan sponsors shouldn’t have to wait long for clarification on their ability to add ESG investments to their plans. To prepare for the potential changes, plan sponsors should review the proposed rule and consider creating a prudent selection process that reviews all aspects that are relevant to an investment’s risk and return profile. As always, documentation is a critical step in this process.

If you have any questions about your specific situation, please reach out to our employee benefit consulting team. We're here to help.

Article
DOL proposes changes to ESG investing and shareholder rights: What plan sponsors need to know

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its second quarter 2022 Quarterly Banking Profile. The report provides financial information based on call reports filed by 4,771 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In second quarter 2022, this section included the financial information of 4,333 FDIC-insured community banks. BerryDunn’s key takeaways from the report are as follows:

Community banks see quarterly growth in net income despite year-over-year decline.

Community bank quarterly net income increased to $7.6 billion in second quarter 2022, despite being down $523.0 million from one year ago. Higher noninterest expense, lower noninterest income, and higher provision expense offset growth in net interest income. Nearly three-quarters of community banks reported higher net income than one quarter ago. More than two-thirds of community banks reported an increase in net interest income from the year-ago quarter.


Loan and lease balances continue to show widespread growth in second quarter 2022.

Community banks saw a $82.3 billion increase in loan and lease balances from first quarter 2022. All major loan categories except commercial & industrial (C&I) and agricultural production grew year over year, and 69.9% of community banks reported annual loan growth. Total loan and lease balances increased $125.4 billion, or 7.7%, from one year ago. Excluding Paycheck Protection Program loans, annual total loan growth would have been 14.0% and annual C&I growth would have been 21.9%.

Community bank net interest margin (NIM) increased to 3.33% due to strong interest income growth.

Community bank NIM increased eight basis points from the year-ago quarter and 22 basis points from first quarter 2022. Net interest income growth exceeded the pace of average earning asset growth. The average yield on earning assets rose 25 basis points while the average cost of funding earning assets rose three basis points from the previous quarter. The quarterly increase in NIM was the largest reported since second quarter 1985. However, NIM remains below the pre-pandemic average of 3.63%. 

Slightly more than half of community banks reported quarter-over-quarter reductions in noncurrent loan balances.

The allowance for credit losses (ACL) as a percentage of total loans and leases decreased six basis points from the year-ago quarter to 1.25%. The coverage ratio for community banks is 46.4 percentage points above the coverage ratio for noncommunity banks. The coverage ratio increased 54.1 percentage points from the year-ago quarter to 245.4%, a record high since Quarterly Banking Profile data collection began in first quarter 1984.

It has been a time of momentous change for the banking industry; this has been the case since the pandemic but continues to hold true. The Federal Open Market Committee (FOMC) had already risen the target federal funds rate by 225 basis points in 2022 at the time of writing this summary, with further increases throughout the remainder of 2022 anticipated. Although rising rates have been the largest contributor to strengthening net interest margins, the impact these rate increases will have on the long-term economy is still to be seen.

Inflation also continues to run rampant, with rate increases thus far seeming to be ineffective in slowing inflation. The continued inflation has many wondering if rate increases are not the answer and that there may be other, inalterable forces at play. If this is the case, the FOMC’s target rate increases could have the effect of worsening an economic slowdown. Furthermore, although loan growth remained relatively strong in quarter two, deposit growth waned. Community banks saw only a 0.4% increase in deposits from a quarter ago. This has put some institutions in a liquidity crunch, having to rely more heavily on wholesale funding to fund loan growth. However, making funding decisions has proven to be difficult, given the economic uncertainty and potential target rate increases.

Community banks will have to continue to remain vigilant and remain a resource to their customers. Banks’ customers are facing many of the same challenges that banks are facing—interest rate uncertainty, rising costs, staffing shortages, etc. Therefore, as we’ve previously mentioned, it continues to be important for banks to maintain open dialogue with customers. As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions. You can also visit our Ask the Advisor page to submit your questions.

Article
FDIC Issues its Second Quarter 2022 Quarterly Banking Profile

Read this if you are a chief executive officer, chief operations officer, or chief retail officer at a financial institution.

There’s been much buzz around the recent announcement by the Biden administration that up to $20,000 in federal student loans will be cancelled for low- to middle-income families. And, rightfully so, as the debt cancellation is anticipated to be eligible for up to 43 million Americans with roughly 20 million borrowers expected to have their remaining student loan debt eliminated entirely.1 Although the relief does not apply to private loans, financial institutions should see this as an opportunity to enhance the customer experience. 

Trusted advisors 

Financial institutions are often seen as trusted advisors by their customers and may be a go-to resource for customers when making financial decisions. Debt cancellation of up to $20,000 can have a major financial impact on households, especially provided relief is only eligible to borrowers with household income below $250,000 ($125,000 for individuals).2 And, with roughly 20 million borrowers expected to have their remaining student loan debt eliminated, this may free up significant monthly cash flow for those borrowers. Even though student loan repayments have been on hold for the past couple of years for many borrowers, the cancellation of this debt may free up deposits those borrowers had set aside in anticipation of the recommencement of loan payments. Now that this remaining debt is expected to be forgiven, how might they use this debt forgiveness to better their financial health? Community banks and credit unions are in the driver’s seat to assist customers in making this decision.

Data analytics

With the onset of data analytics—the understanding of how transaction, financial, and other information may be used to understand customer needs—many financial institutions are well-positioned to recommend services tailored to each customer. Although making sense of this data and putting it into something actionable can be challenging, the rewards can be tremendous. For instance, analyzing spending habits or cash flow trends can equip an institution with the insights needed to assist a customer when asked how best to deploy this excess wealth. Do they have any loans with your institution they should pay off or pay down? Given the current interest rate environment, this may also prove to be beneficial for the institution, as it could then re-deploy these funds at a higher interest rate. 

Knowing your customer

A simpler approach than using data analytics to provide actionable insights is just simply knowing your customer. This is something community financial institutions excel at and is one of their biggest value propositions. When working on financial institution audits, we often ask about specific customers as part of our audit procedures. I am always awed by our clients’ ability to provide one of their customer's stories on a whim. Bankers have well-developed relationships with their customers. Customers are neighbors, restaurant servers, bartenders, firefighters, the list goes on. These are people bankers see out in their communities—you may even have children that go to the same school together. The point I am trying to make is that these relationships are much deeper than any relationship data analytics can provide. What major life events are your customers anticipating? A wedding? A child? A vacation? Needing a new car? These are all items that data analytics may not be able to tell you but personal relationships with your customer, and general knowledge about your community, will. How can you, as their trusted advisor, provide them opportunities to save for these major life events? I don’t want to discount the importance of data analytics but, I also want to stress the importance of these personal relationships. However, combined, they create a powerful tool for community bankers.

Knowing your customer—an example

As an example, you may know your customer is planning for a wedding and that they took some wedding wish-list items off their list because they couldn't afford them. Does the proposed debt cancellation allow your customer to now afford—or save for—some of these items? You may not know the answer simply based off previous conversations with the customer but, a quick phone call and discussion will provide you with an answer. And, even if the answer is: “No, this does not change my wedding budget,” it at least shows them that you were looking out for your customer and being proactive. 

Knowing your customer combined with data analytics—an example

Taking this example a step further, what if you had data analytics that displayed your customer’s spending habits? Is there a way to query payment transactions that would allow you to identify which customers have federal student loans? This information, paired with your knowledge gained from knowing the customer, allows you to provide targeted, actionable insights. Knowing their monthly cash flow, what loans they have outstanding (based on cash outflows), and deposit balances, you can be more strategic in your outreach, not only in who you reach out to but how you structure your outreach. For instance, could a customer benefit from using those forgiven student loan payments to now pay down other debt carried at higher interest rates?  Or, going back to an earlier example, if you know when the customer’s wedding is and their monthly net cash flow, is there a deposit product you could sign them up for that would allow them to work towards affording some of their wedding wish-list items that previously couldn’t be afforded?

Saving for retirement

Another aspect to consider is saving for retirement. Although borrowers are eligible for loan forgiveness of up to $20,000, most will likely only be eligible for $10,000 in forgiveness, as the $20,000 is only for Pell Grant recipients.2 To some customers, $10,000 may not seem like a lot. But, when considering the time value of money, a customer’s perception may change. Using an example from a recent Accounting Today article1, a 40-year-old man is expected to live to 81.5 years old. Therefore, assuming an annual return of 6% over 40 years, $10,000 can turn into more than $110,000 over four decades. Those who live to 90 can turn $10,000 into more than $200,000. Institutions with wealth management divisions may find colleagues who have great suggestions on how best to approach these conversations. Even if the customer has short-term spending needs/desires, as many do, steering these forgiven student loan payments towards retirement may be the most prudent decision. But sometimes a customer needs to see the potential impact plotted out and hear it from an outside, trusted source.

Customers with loan repayments restarting

To this point, the discussion has been on those customers that will benefit from loan forgiveness. But what about those that will not benefit as well as those that will only partially benefit (i.e., the entirety of their loan balance will not be forgiven)? Loan repayments are set to recommence in January 2023. Many borrowers haven’t had to make loan payments for over two years and some newer college graduates have never had to make a loan payment. These loan payments could come as a shock to those who have never made such a payment, as well as to those who previously had, if their spending habits have changed due to loan forbearance. There are two different perspectives to consider for these customers: credit risk and, sticking with the theme of the article, the customer experience.

Credit risk

The end of the loan forbearance period could have a significant impact on certain customers’ financial situations. For some, it could be the make-or-break point on being able to make their loan payments on other loans, possibly some of which are with your institution. Does the recommencement of these student loan payments change your customer’s risk profile? Do they now require closer monitoring?

Customer experience

Closely linked to credit risk, financial institutions should also see the recommencement of student loan payments as an opportunity to enhance the customer experience. Financial institutions should be proactive in reaching out to customers they know will be impacted to see if they feel prepared. This may be a difficult conversation to have but, it is one your customers will likely appreciate. If they aren’t prepared, are there steps the institution can take to assist the customer? Deposit products may again be worth mentioning to customers. Or, for those severely impacted, does the institution need to consider workout agreements with such customers? This provides a prime opportunity to work with your institution’s collections and credit risk departments. Keeping them in the loop (and vice versa) will help provide a seamless customer experience.

Institutions should also consider if this presents itself as a larger marketing opportunity, to attract new business. Although marketing decisions are generally based on potential return on investment (ROI), the ROI in this case may not quite be there, given the relatively small amounts. However, is this an opportunity for your institution to highlight its financial advisory services? 

In closing

For something that seems so simple on the surface, there is a lot to consider once you start diving in. Financial institutions have a big role to play and should see this as an opportunity to increase what are hopefully already strong relationships with customers. For those customers anticipating debt cancellation, financial institutions should essentially ask themselves: how can customers utilize their debt cancellation in a way that makes the most sense for them given their current financial situation and anticipated life events? For those that aren’t anticipating debt cancellation, financial institutions have an opportunity to be proactive. This proactivity will not only benefit the institution but will also show the institution is prepared and cares about assisting their customers and helping them transition back into student loan payments as smoothly as possible. 

This is a lot to unravel, especially in such a short time. As always, your BerryDunn Financial Services team is here to assist. Also, please feel free to reach out via our Ask the Advisor feature.

1How student loan relief can turbocharge retirement savings | Accounting Today
2The Biden-Harris Administration's Student Debt Relief Plan Explained (studentaid.gov)

Article
Student loans: Forgiveness, the end of forbearance, and where financial institutions fit into all of this

Read this if you are a Chief Compliance Officer at a broker-dealer.

On August 3, 2022, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 22-18 (the Notice), which addresses the increasing number of reports regarding registered representatives and associated persons (representatives) forging or falsifying customer signatures, and in some cases signatures of colleagues or supervisors, through third-party digital signature platforms. The Notice details multiple FINRA Rules that may be violated in the case of a forgery or falsification and also provides five scenarios member firms reported to FINRA in which representatives forged or falsified customer signatures, including the methods firms used to identify the forgeries or falsifications. The detection methods outlined are:

  • Customer inquiries or complaint investigations
  • Digital signature audit trail reviews
  • Email correspondence reviews
  • Administrative staff inquiries
  • Customer authentication supervision

There is no doubt that digital signatures provide convenience for customers. But this convenience can sometimes lead to unethical or non-compliant behavior. Even situations that representatives believe pass the “straight face” test may be considered non-compliance under FINRA regulations. Member firms should review the Notice carefully and implement some of FINRA’s detection methods, if not already implemented. Some of these methods are likely already in place since they may be duplicative of methods used to satisfy other FINRA Rules. For instance, reviewing customer inquiries or complaints is likely already occurring to satisfy FINRA Rule 4530, Reporting Requirements. As always, if any questions arise, please don’t hesitate to reach out to BerryDunn’s broker-dealer services team.

Article
Digital signatures: FINRA sends reminder on supervision obligations

Read this if you are a Chief Financial Officer or Controller at a financial institution.

Back in April, we wrote about recently released Accounting Standards Update (ASU) No. 2022-02, Financial Instruments – Credit Losses (Topic 326). Here, we are going to look at the standard in more depth. 

One of the most notable items this ASU addresses, is that it eliminates the often tedious troubled debt restructuring (TDR) accounting and disclosure requirements. Accounting for loan modifications will now be maintained under extant US generally accepted accounting principles, specifically Accounting Standards Codification (ASC) 310-20-35-9 through 35-11. However, rather than eliminate loan modification disclosure requirements altogether, the Financial Accounting Standards Board (FASB) created some new requirements, inspired by voluntary disclosures many financial institutions made during the coronavirus pandemic. 

Rather than disclosing information on TDRs, financial institutions will now be required to disclose information on loan modifications that were in the form of principal forgiveness, an interest rate reduction, an other-than-insignificant payment delay, or a term extension (or a combination thereof) made to debtors experiencing financial difficulty. These disclosures must be made regardless of whether a modification to a debtor experiencing financial difficulty results in a new loan or not. 

ASC 310-10-50-42 through 50-44 establishes these new disclosure requirements, and ASC 310-10-55-12A provides an example of the required disclosures. 

New Loan Modification Disclosure Requirements

Financial institutions have long had internal controls surrounding the determination of TDRs given the impact such restructurings can have on the allowance for credit losses and financial statement disclosures. Banks may find they are able to leverage those controls to satisfy the new modification disclosures, with only minor adjustments. Similar to previous TDR determinations, the above disclosures are only required for modifications to debtors experiencing financial difficulty. Therefore, financial institutions will need to have a process —or defined set of parameters—in place to determine debtor “financial difficulty”, thus triggering the need for modification disclosure. Banks may also find that the specific data gathered for preparation of these new disclosures will change, but should be readily available, with (hopefully) only minor manipulation required.

ASU No. 2022-02 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years—the same effective date for those who have not yet adopted ASU No. 2016-13, more commonly referred to as CECL (Current Expected Credit Loss). As always, if you have any questions as to how this new ASU may impact your financial institution, please reach out to BerryDunn’s Financial Services team or submit a question via our Ask the Advisor feature.

Article
New loan modification disclosure requirements: A deeper dive

Read this if you are a depository institution.

Environmental, Social, and Governance (ESG) matters are all the rage right now. From new disclosures to personal, professional, investor, and social media pressures, ESG presents itself as a vast topic, encompassing many facets of an organization. It can be daunting to even know where to begin ESG efforts. 

ESG issues seem pervasive and may be best thought of as residing on a spectrum, with some industries further along this spectrum than others. However, each industry can make its own mark, with initiatives that can propel it along the ESG spectrum. Even within one industry, individual organizations may have their own initiatives and areas of focus. Equal importance does not need be given to the E, the S, and the G, and some industries may be better equipped to address one of these pillars over the others. We would like to share what we believe to be four areas of opportunity for banks as they think about ESG, their customers, and their employees.

Credit decisions

Many financial institutions currently base credit decisions on an array of financial metrics of the prospective borrower. Their reviews include financial forecasts, historical financial results, collateral values, etc., all with the intent of predicting if the prospective borrower will be able to repay the credit. Given the increasing regulatory and social pressure regarding ESG, bankers should be aware of how ESG requirements and industry initiatives could impact a borrower’s financial condition. For instance, consider the following:

  • Where does the prospective borrower reside on the ESG spectrum, collectively and individually (the separate E, the S, and the G spectrums)? 
  • If they are a carbon-intensive company, what additional risks does that pose to the relationship, if any? (E)
    • Are there pending regulations (or fines) that could significantly impact their operations?
    • Although their finances may be strong currently, are there alternative products or services that are seen as “greener” that may jeopardize future profits and cash flows?
    • If the company plans to become less carbon-intensive, either voluntarily or out of necessity, are there significant costs anticipated to be incurred during this transition?
  • Do they have, or anticipate, community investment initiatives? (S)
  • Are they viewed as a reputable company in their respective communities? (S)
  • Is there adequate board and executive management oversight? (G)

ESG-specific products

Financial institutions can reward borrowers for their stewardship. This concept is not new, as “green bonds” have been around for years to incentivize climate and environmental projects. Some financial institutions, such as TD Bank and Barclays, offer preferred interest rates to ESG-conscious borrowers, such as those that purchase houses that meet certain energy efficiency ratings. Financial institutions could further expand on this idea and offer loans earmarked for certain ESG-related purposes, such as development of low-carbon manufacturing techniques or investment in the company’s workforce. Such products can be a great way to position your financial institution as an ESG leader in the community and assist borrowers on their ESG journey. 

Financial institutions can act as a connector for like-minded parties

Financial institutions are in a unique position, as aside from the borrower themselves, a financial institution likely knows the most about the borrower’s business. Financial institutions may become aware of customers further along their ESG journeys and could help connect those resources to other customers who may want to know and learn more. Customers are increasingly looking for more from their financial institution outside of traditional banking services. Given their unique position, financial institutions are best equipped to act as a connector for like-minded parties. 

Customers and employees may want their supply chain/employer to be ESG conscious

Customers, whether they be individuals or businesses, and employees are increasingly considering the actions of potential vendors and employers before partnering with them. Likely a result of their own ESG mission, customers are starting to realize that, even if they feel as if they are ESG conscious, it is their responsibility to also hold their vendors accountable. Therefore, customers may elect to go to another financial institution that is more ESG conscious even if your financial institution offers a better product. Employees are also factoring this into employment decisions. Employees want to feel as if they are part of a larger mission. Focusing on ESG could give your financial institution a competitive advantage.

When considering ESG matters, some believe they are faced with two mutually exclusive decisions: (1) what makes the most sense financially, and (2) what will propel our organization further along the ESG spectrum? What some leading companies have found, however, is that by focusing first on where they lie on the ESG spectrum and defining where they want to be in the future helps clarify future decision-making so that cost and ESG progress are aligned rather than opposing forces. As always, BerryDunn’s Financial Services team is here to help.

Article
Propelling along the ESG spectrum: Four considerations for your financial institution

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its first quarter 2022 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,796 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In first quarter 2022, this section included the financial information of 4,353 FDIC-insured community banks. BerryDunn’s key takeaways from the report are as follows:

Community banks continue to feel the impact of shrinking net interest margins and inflation.

Community bank quarterly net income dropped to $7 billion in first quarter 2022, down $1.1 billion from a year ago. Lower net gains on loan sales and higher noninterest expenses offset growth in net interest income and lower provisions. Net income declined $581.3 million, or 7.7 percent from fourth quarter 2021 primarily because of lower noninterest income and higher noninterest expense.

Loan and lease balances continue to grow in first quarter 2022

Community banks saw a $21.5 billion increase in loan and lease balances from fourth quarter 2021. All major loan categories except commercial & industrial and agricultural production grew year over year, and 55.3 percent of community banks recorded annual loan growth. Total loan and lease balances increased $35.1 billion, or 2.1 percent, from one year ago. Excluding Paycheck Protection Program loans, annual total loan growth would have been 10.2 percent.

Community bank net interest margin (NIM) dropped to 3.11 percent due to strong earning asset growth.

Community bank NIM fell 15 basis points from the year-ago quarter and 10 basis points from fourth quarter 2021. Net interest income growth trailed the pace of earning asset growth. The yield on earning assets fell 28 basis points while the cost of funding earning assets fell 13 basis points from the year-ago quarter. The 0.24 percent average cost of funds was the lowest level on record since Quarterly Banking Profile data collection began in first quarter 1984. 

Community bank allowance for credit losses (ACL) to total loans remained higher than the pre-pandemic level at 1.28 percent, despite declining 4 basis points from the year-ago quarter.


NOTE: The above graph is for all FDIC-Insured Institutions, not just community banks.

The ACL as a percentage of loans 90 days or more past due or in nonaccrual status (coverage ratio) increased to a record high of 236.7 percent. The decline in noncurrent loan balances outpaced the decline in ACL, with the coverage ratio for community banks emerging 57.9 percentage points above the coverage ratio for noncommunity banks. 

The banking landscape continues to be one that is ever-evolving. With interest rates on the rise, banks will find their margins in flux once again. During this transition, banks should look for opportunities to increase loan growth and protect and enhance customer relationships. Inflation has also caused concern not only for banks but also for their customers. This is an opportune time for banks to work with their customers to navigate the current economic environment. Community banks, with their in-depth knowledge of their customers’ financial situations and the local economies served, are in a perfect position to build upon the trust that has already been developed with customers.

As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC issues its First Quarter 2022 Quarterly Banking Profile