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In 2021, an
anti-fraud
plan is the best investment your financial institution can make

05.18.21

Read this is you are at a financial institution and concerned about fraud.

The numbers tell a story: Financial fraud 

Back in 2016, BerryDunn’s Todd Desjardins wrote about occupational fraud at financial institutions. This article mainly cited information from a 2016 Report to the Nations (2016 Report) published by the Association of Certified Fraud Examiners (ACFE). Fast forward to 2021, and ACFE’s 2020 Report to the Nations: Banking and Financial Services Edition (2020 Report) displays that occupational fraud continues to be a concern.

Financial institutions account for 19% of all occupational fraud worldwide, up from 16.8% in the 2016 Report. These fraud causes have a median loss of $100,000 per case—down from $192,000 per case in the 2016 Report. Cases had risen slightly from the 2016 Report to 386—up from 368 cases.

What does a fraudster look like, and how do they commit their crimes? How do you prevent fraud from happening at your organization? And, how can you strengthen an already robust anti-fraud program? These questions, raised in Todd’s 2016 article, remain relevant today. 

A profile in fraud: Who can it be? 

One of the most difficult tasks any organization faces is identifying and preventing potential cases of fraud. This is especially challenging because the majority of employees who commit fraud are first-time offenders with no record of criminal activity, or even termination at a previous employer.

The 2020 Report reveals a few commonalities between fraudsters. The amounts from the 2016 Report are shown in parentheses for comparison purposes:

  • 3% of fraudsters had no criminal background (3%)
  • Men committed 71% of frauds and women committed 29% (69%, 31%)
  • 56% of fraudsters were an employee, 27% worked as a manager, and 14% operated at the executive/owner level (3%, 31%, 20%)
  • The median loss for fraudsters who had been with their organizations for more than five years was $150,000 compared to $86,000 for fraudsters who had been with their organizations for five years or less ($230,000, $74,500)

Employees who committed fraud displayed certain behaviors during their schemes. The ACFE reported these top red flags in its 2020 Report:

  • Living beyond means: 42% (45.8%)
  • Financial difficulties: 33% (30%)
  • Unusually close association with vendor/customer: 15% (20.1%)
  • Divorce/family problems: 14% (13.4%)

These figures give us a general sense of who commits fraud and why. But in all cases, the most pressing question remains: how do you prevent the fraud from happening?

Preventing fraud: A commonsense approach that works

As a proactive plan for preventing fraud, we recommend focusing time and energy on two distinct facets of your operations: leadership tone and internal controls.

It all starts at the top: Leadership

The Board of Directors and senior management are in a powerful position to prevent fraud. By fostering a top-down culture of zero-tolerance for fraud, you can diminish opportunity for employees to consider, and attempt, fraud.

It is crucial to start at the top. Not only does this send a message to the rest of the company, but frauds committed at the executive level had a median loss of $1,265,000 per case, compared to a median loss of $77,000 when an employee perpetrated the fraud. This is compared to a median loss of $500,000 and $54,000 per case, respectively, in the 2016 Report.

Improving your internal control culture

Every financial institution uses internal controls in its daily operations. Override of existing internal controls, lack of internal controls, and lack of management review were all cited in the 2020 Report as the most common internal control weaknesses that contribute to occupational fraud in the banking and financial services industry.

The importance of internal controls cannot be overstated. Every organization should closely examine its internal controls and determine where they can be strengthened—even financial institutions with strong anti-fraud measures in place.

We have created a checklist of the top 10 controls for financial institutions, available in our white paper on preventing fraud. This is a list that we encourage every financial leader to read. By strengthening your foundation, your company will be in a powerful place to prevent fraud. 

Get the keys to prevent fraud—free fraud prevention white paper

Employees are your greatest strength and number one resource. Taking a proactive, positive approach to fraud prevention maintains the value employees bring to a financial institution, while focusing on realistic measures to discourage fraud.

In our white paper on preventing financial institution fraud, we take a deeper look at how to successfully implement a strong anti-fraud plan.

Commit to strengthening fraud prevention and you will instill confidence in your Board, employees, customers, and the general public. It’s a good investment for any financial institution. If you have any questions, please contact our team. We’re here to help. 
 

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

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 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.

Article
FDIC issues its First Quarter 2022 Quarterly Banking Profile

Read this if you are a financial institution.

As you know by now, ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326), better known as the CECL standard, has already been implemented for some and will soon be implemented for all others (fiscal years beginning after December 15, 2022 to be exact). During your implementation process, the focus has likely been on your loan portfolio, and rightfully so, as CECL overhauls 40+ years of loan loss reserve practices. But, recall that the CECL standard applies to all financial instruments carried at amortized cost. So, it therefore includes held-to-maturity (HTM) debt securities. And, although not carried at amortized cost, the CECL standard also makes targeted enhancements to available-for-sale (AFS) debt securities. As if re-hauling your entire allowance methodology wasn’t enough! Before tearing out your hair because of another CECL-related change, let’s quickly review what is currently required for securities, and then focus on how this will change when you implement CECL.

Current US GAAP

Under current US generally accepted accounting principles (GAAP), direct write-downs on HTM and AFS debt securities are recorded when (1) a security’s fair value has declined below its amortized cost basis and (2) the impairment is deemed other-than-temporary. This assessment must be completed on an individual debt security basis. Providing a general allowance for unidentified impairment in a portfolio of securities is not appropriate. The previous amortized cost basis less the other-than-temporary impairment (OTTI) recognized in earnings becomes the new amortized cost basis and subsequent recoveries of OTTI may not be directly reversed into interest income. Rather, subsequent recoveries of credit losses must be accreted into interest income.

CECL: Held-to-maturity securities

Then comes along CECL  and changes everything. Once the CECL standard is implemented, expected losses on HTM debt securities will be recorded immediately through an allowance for credit loss (ACL) account, rather than as a direct write-down of the security’s cost basis. These securities should be evaluated for risk of loss over the life of the securities. Another key difference from current GAAP is that securities with similar risk characteristics will need to be assessed for credit losses collectively, or on a pool basis, not on an individual basis as currently prescribed. Also, contrary to current GAAP, since expected losses will be recorded through an ACL account, subsequent improvements in cash flow expectations will be immediately recognized through earnings via a reduction in the ACL account. CECL effectively eliminates the direct write-down method, with write-offs only occurring when the security, or a portion thereof, is deemed to be uncollectible. 

In practice, there may be some types of HTM debt securities that your institution believes have no risk of nonpayment and thus risk of loss is zero. An example may be a US Treasury debt security or possibly a debt security guaranteed by a government-sponsored enterprise, such as Ginnie Mae or Freddie Mac. In these instances, it is acceptable to conclude that no allowance on such securities is necessary. However, such determination should be documented and changes to the credit situation of these securities should be closely monitored.

Financial institutions that have already implemented CECL have appreciated its flexibility; however, just like anything else, there are challenges. One of the biggest questions that has risen is related to complexity, specifically from financial statement users in regards to the macroeconomic assumptions used in models. Another common challenge is comparability to competitors’ models and estimates. Each financial institution will likely have a different methodology when recording expected losses on HTM debt securities due to the judgment involved. These concerns are not unique to the ACL on HTM debt securities but are nonetheless concerns that will need to be addressed. A description of the methodology used to estimate the ACL, as well as a discussion of the factors that influenced management’s current estimate of expected losses must be disclosed in the financial statements. Therefore, management should ensure adequate information is provided to address financial statement users’ concerns.  

CECL: Available-for-sale securities

Upon CECL adoption, you are also expected to implement enhancements to existing practices related to AFS debt securities. Recall that AFS debt securities are recorded at fair value through accumulated other comprehensive income (AOCI). This will not change after adoption of the CECL standard. However, the concept of OTTI will no longer exist. Rather, if an AFS debt security’s fair value is lower than its amortized cost basis, any credit related loss will be recorded through an ACL account, rather than as a direct write-down to the security. This ACL account will be limited to the amount by which fair value is below the amortized cost basis of the security. Credit losses will be determined by comparing the present value of cash flows expected to be collected from the security with its amortized cost basis. Non-credit related changes in fair value will continue to be recorded through an investment contra account and other comprehensive income. So, on the balance sheet, AFS debt securities could have an ACL account and an unrealized gain/loss contra account. The financial institution will be responsible for determining if the decline in the value below amortized cost is the result of credit factors or other macroeconomic factors. In practice, the following flowchart may be helpful:

Although changes to debt securities may not be top of mind when working through CECL implementation, ensuring you reserve time to understand and assess the impact of these changes is important. Depending on the significance and composition of your institution’s debt security portfolio, these changes may have a significant impact on your financial institution’s financial statements from CECL adoption forward. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

Article
Don't forget about me! Changes in debt security accounting resulting from CECL 

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

The Financial Accounting Standards Board (FASB) issued its second Accounting Standards Update (ASU) of 2022 on March 31, 2022. Seen as a fairly quiet year thus far on the accounting standards issuance front, both ASUs issued so far should catch the attention of financial institutions’ accounting and finance teams. For readers who may have missed it, on March 31, 2022, we wrote about the FASB’s first ASU of 2022: ASU No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method. Seen as enhancing the flexibility of hedge accounting, this ASU, among other things, expands on the “last-of-layer” hedging method by allowing multiple hedged layers to be designated for a single closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments.

The most recently issued ASU, ASU No. 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, responds to feedback received during the FASB’s Post-Implementation Review process of ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Commonly known as the “CECL (current expected credit loss) standard,” financial institutions that have not yet adopted ASU No. 2016-13 should be well into their CECL implementation plan. ASU No 2016-13 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. 

The CECL standard is seen as a major disruptor event for financial institutions. I encourage you to check out my colleague Susan Weber’s CECL implementation series (the latest article can be found here) for best practices on a successful CECL implementation.

As soon as you see the acronym “CECL” in an article, especially one in regards to a new accounting standard, you may be already looking to “X” out of your web browser and save whatever horrors this ASU brings for another day. But, the changes that are forthcoming as a result of ASU No. 2022-02 are generally seen as being well received by accounting and finance teams (and likely credit teams as well). 

As its name implies, ASU No. 2022-02 addresses two separate issues: Troubled debt restructurings and vintage disclosures.

Troubled debt restructurings

The ASU eliminates the current troubled debt restructuring accounting guidance within Accounting Standards Codification (ASC) Subtopic 310-40 in its entirety. To help illustrate the impact of the proposed changes, let’s quickly review ASC Subtopic 310-40. ASC Subtopic 310-40, among other things, indicates a troubled debt restructuring should not be accounted for as a new loan because a troubled debt restructuring is part of a creditor’s ongoing effort to recover its investment in the original loan. A loan modification is considered a troubled debt restructuring if made to a borrower experiencing financial difficulty and if the modification grants a concession. Furthermore, all troubled debt restructurings are considered impaired loans. After adoption of the ASU, financial institutions will evaluate whether the modification represents a new loan or a continuation of an existing loan, in accordance with current ASC guidance (ASC 310-20-35-9 through 35-11). 

Current ASC guidance indicates a loan modification shall be treated as a new loan if the terms of the modification are at least as favorable to the lender as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the lender. This condition would be met if the new loan’s effective yield is at least equal to the effective yield for such loans and modifications of the original debt instrument are more than minor. A modification is considered “more than minor” if the present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument. However, even if the difference is less than 10 percent, the financial institution should evaluate whether the modification is more than minor based on the specific facts and circumstances surrounding the modification.

The ASU also modifies disclosure requirements. Rather than disclosing information on troubled debt restructurings, 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. Among other things, ASC 310-10-10-50-42 through 50-44 requires financial institutions to disclose, by class of financing receivable, the types of modifications utilized and certain financial effects of the modification, depending on the type of modification. ASC 310-10-55-12A provides an example of the disclosures required by ASC 310-10-10-50-42 through 50-44. The new disclosures must be made regardless of whether a modification to a debtor experiencing financial difficulty results in a new loan. In part, this section of the ASU is seen as providing structure around some of the types of modification disclosures financial institutions were providing during the coronavirus pandemic. 

Financial institutions have long had internal controls surrounding the determination of troubled debt restructurings given the impact such restructurings can have on the allowance for loan losses and financial statement disclosures. Although internal controls surrounding loan modifications will still need to exist, they will likely need to evolve as a result of ASU No. 2022-02. Furthermore, the data gathered for preparation of financial statement disclosures will also change. However, the data needed to satisfy the new disclosure requirements should be readily available, with possibly minor manipulation required to obtain the information needed under the new disclosure requirements.

Vintage disclosures

The ASU amends ASC 326-20-50-6 to require public business entities to disclose current-period gross writeoffs by year of origination for financing receivables and net investment in leases within the scope of ASC Subtopic 326-20. ASC 326-20-55-79 provides an example of this disclosure.

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. As always, if you have any questions as to how this 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
FASB is on a roll: Another ASU aimed at financial institutions

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

Back in November 2021, we wrote about Accounting Standards Update (ASU) No. 2017-12 and the flexibility it adds to hedge accounting. In the article we mentioned a proposed ASU the Financial Accounting Standards Board (FASB) had issued in May 2021. On March 28, 2022 the FASB finalized this proposed ASU with the issuance of its first ASU of 2022: ASU No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method. Among other things, the ASU expands on the “last-of-layer” hedging method by allowing multiple hedged layers to be designated for a single closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments. As a result, an entity may be able to achieve hedge accounting for hedges of a greater proportion of its interest rate risk inherent in the assets included in the closed portfolio, further aligning hedge accounting with risk management strategies. The “last-of-layer” method has thus been renamed the “portfolio layer” method. 

The ASU also allows an entity to reclassify debt securities classified in the held-to-maturity category at the date of adoption of the ASU to the available-for-sale category. However, this reclassification may only occur if the entity applies portfolio layer method hedging to one or more closed portfolios that include those debt securities. The decision of which securities to reclassify must be made within 30 days after the date of adoption, and the securities must be included in one or more closed portfolios that are designated in a portfolio layer method hedge within that 30-day period.

ASU No. 2022-01 is effective for public business entities for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2023, and interim periods within those fiscal years. Early adoption is permitted for those entities that have adopted ASU No. 2017-12 for the corresponding period.

This ASU further enhances the flexibility of hedge accounting and ultimately builds upon the framework set by ASU No. 2017-12. Financial institutions using, or looking to use, derivatives and hedge accounting to manage interest rate risk should review this ASU to determine if it provides opportunity for revised hedging techniques and strategies that may benefit the institution. As always, if you have any questions as to how this 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
FASB issues its first ASU of 2022: Much anticipated changes to hedge accounting are here

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its fourth quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,839 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In fourth quarter 2021, this section included the financial information of 4,391 FDIC-insured community banks. BerryDunn’s key takeaways from the community bank section of the report are as follows:

  • The banking industry as a whole saw a $132 billion increase in net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly attributable to the $163.3 billion decrease in provision expense, supported by continued economic growth and supplementary credit quality improvement. NIM declined to 2.54%, a 28 basis-point decrease from 2020 as the growth rate in average earning assets outpaced the growth rate in net interest income.
  • For community banks, full-year net income increased $7.4 billion to $32.7 billion. Despite the increase in annual net income, community banks saw a $719.9 million decrease in net income from third quarter 2021. Higher noninterest expenses continue to place pressure on community banks as inflation rates spike going into 2022. Annual NIM fell 12 basis points from 2020 to 3.27%. The average yield on earning assets fell 42 basis points to 3.58%, while the average funding cost fell 30 basis points to 0.31%. The percentage of unprofitable community banks declined to 3.2%, the lowest level on record. 

    *See Exhibit B at the end of this article for more information on the fourth-quarter year-over-year change in income.
     
  • Net gains on loan sales revenue declined $1.5 billion (50.6%) from fourth quarter 2020. However, growth in net interest income of $1.3 billion (6.7%) from fourth quarter 2020 overcame the $707 million decline in noninterest income. Net operating revenue increased $588.4 million (2.3%) from fourth quarter 2020.
  • Noninterest expense increased 3.4% from fourth quarter 2020. This increase was mainly attributable to higher data processing and marketing expenses. That being said, average assets per employee increased 10% from fourth quarter 2020. Noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020 to 2.51%, despite 69.4% of community banks reporting higher noninterest expense.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) declined by $1.1 billion to $11.1 billion from third quarter 2021. The noncurrent rate dropped 7 basis points to 0.58% from third quarter 2021, the lowest noncurrent rate on record for community banks.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 53.7 percentage points from a year ago to 223.8%. This ratio is well above the 147.9% reported before the pandemic in fourth quarter 2019 and continues to be a record high. The coverage ratio for community banks is 49.9 percentage points above the coverage ratio for noncommunity banks. As a result, provision expense declined $914.9 million from fourth quarter 2020, but remained at $320.8 million for fourth quarter 2021, representing a $39.2 million increase from third quarter 2021.
  • The net charge-off rate declined 6 basis points from fourth quarter 2020 to 0.09%.
  • Trends in loans and leases started looking up, as community banks saw an increase of $24.3 billion within fourth quarter 2021. This growth was mainly seen in the nonfarm nonresidential commercial real estate (CRE), which held a balance of $16.3 billion. Total loans and leases increased by $34.2 billion (2%) for the year 2021. Growth of $50.6 billion in CRE loans attributed to the increase. A decline in commercial and industrial loan balances of $62.3 billion (20.1%) from fourth quarter 2020 offset a portion of this increase. This decline was mainly due to Paycheck Protection Program (PPP) loan repayment and forgiveness.

    *See Exhibit C at the end of this article for more information on the change in loan balances.
     
  • More than 75% of community banks reported an increase in deposit balances for the fourth quarter. In total, deposit growth was 2.8% during fourth quarter 2021.
  • The average community bank leverage ratio (CBLR) for the 1,699 banks that elected to use the CBLR framework was 11.2%, nearly unchanged from third quarter 2021. The average leverage capital ratio was 10.16%.
  • The number of community banks declined by 59 to 4,391 from third quarter 2021, a decrease of 168 from December 2020. This change includes six banks transitioning from community to noncommunity banks, four banks transitioning from noncommunity to community banks, 54 community bank mergers or consolidations, and three community banks having ceased operations.

Fourth quarter 2021 was another strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 7.1% ($511.6 million). This quarter concluded another strong year financially for community banks. However, NIMs continue to show record lows, as shown in Exhibit A, which shows the trends in quarterly NIM.

The consensus remains that community banks will likely need to find creative ways to increase their NIM, grow their earning asset bases, or continue to increase noninterest income to maintain current net income levels. In regards to the latter, many pressures to noninterest income streams exist. Financial technology (fintech) companies are changing the way we bank by automating processes that have traditionally been manual (for instance, loan approval). Decentralized financing (DeFi) also poses a threat to the banking industry. Building off of fintech’s automation, DeFi looks to cut out the middle-man (banks) altogether by building financial services on a blockchain. Ongoing investment in technology should continue to be a focus, as banks look to compete with non-traditional players in the financial services industry. 

The larger, noncommunity banks are also putting pressure on community banks and their ability to generate noninterest income, as recently seen by Citi, Bank of America, and many other large banks following behind Capital One Bank in eliminating all overdraft fees. According to the Consumer Financial Protection Bureau, the financial services industry brought in $15.5 billion in overdraft fees in 2019. Seen as a move to enhance Capital One Bank’s financial inclusion of customers, community banks will also need to find innovative ways to enhance relationships with current and potential customers. As fintech companies and DeFi become more mainstream and accepted in the marketplace, the value propositions of community banks will likely need to change. Furthermore, as PPP loan forgiveness comes to an end, PPP loan fees will no longer supplement revenues. Although seen as a one-time extraordinary event, this fee income was significant for many community banks’ 2021 and 2020 revenues.

The importance of the efficiency ratio (see Exhibit D below) is also magnified as community banks attempt to manage their noninterest expenses in light of low NIMs and inflationary pressures. Although noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020, such expenses increased 3.4% from fourth quarter 2020. And, inflationary pressures will likely be exacerbated as a result of Russia’s invasion of Ukraine. Inflationary pressure was already seen in fourth quarter 2021, as net income decreased $719.9 million from third quarter 2021, despite only a $39.2 million increase in provision expense from third quarter 2021. Banks with manual processes can improve efficiency and support a remote workforce with increased automation.

Furthermore, many of the uncertainties that we have been discussing quarter-over-quarter, and that have thus become “themes” for the banking industry in 2021, still exist. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. Also, payment deferrals have made some credit quality indicators, such as past due status, less reliable. Payment deferrals for many borrowers are coming to a halt and many community banks had nominal amounts of borrowers that remained on deferral as of December 31, 2021. So, the true financial picture of these borrowers may start to come into focus. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy.

The outlook for office space remains uncertain. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. As noted in a recent FDIC article, “the full effects of changing dynamics in the sector are still developing. Office property demand may take time to stabilize as tenants navigate remote work decisions and adjust how much space they need.” The FDIC article further mentions reduced office space could also have implications for the multifamily and retail markets that cater to those office employees. Similarly, the hotel industry remains in flux and the post-pandemic success of the industry is likely dependent on the recovery of business travel and gas prices for hotels dependent on summer tourism. If virtual conferences and meetings become the new norm, the hotel industry could see itself having to pivot. Even a transition to a hybrid model, which is more likely to occur, could have significant implications for the industry. Banks should closely monitor these borrowers, as identifying early signs of credit deterioration could be essential to preserving the relationship.

The financial services industry is full of excitement right now. While the industry faces many challenges, these challenges also bring opportunity for banks to experiment and differentiate themselves. Bank customers arguably need the assistance of their bank more than ever as they navigate continued financial uncertainty. This need allows community banks to do what they do best: develop long-lasting relationships with customers and become a trusted advisor. If there is anything this pandemic has shown to the financial industry, it is that community banks are truly one of the leaders of their communities. 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 Fourth Quarter 2021 Quarterly Banking Profile