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05.23.19

LIBOR is leaving—is your financial institution ready to make the most of it?

In July 2017, the UK’s Financial Conduct Authority announced the phasing out of the London Interbank Offered Rate, commonly known as LIBOR, by the end of 20211. With less than two years to go, US federal regulators are urging financial institutions to start assessing their LIBOR exposure and planning their transition. Here we offer some general impacts of the phasing out, some specific actions your institution can take to prepare, and, finally, background on how we got here (see Background at right).

How will the phase-out impact financial institutions?

The Federal Reserve estimates roughly $200 trillion in LIBOR-indexed notional value transactions in the cash and derivatives market2. LIBOR is used to help price a variety of financial services products,  including $3.4 trillion in business loans and $1.3 trillion in consumer loans, as well as derivatives, swaps, and other credit instruments. Even excluding loans and financial instruments set to mature before 2021—estimated by the FDIC at 82% of the above $200 trillion—LIBOR exposure is still significant3.

A financial institution’s ability to lend money is largely dependent on the relative stability of its capital position, or lack thereof. For institutions with a significant amount of LIBOR-indexed assets and liabilities, that means less certainty in expected future cash flows and a less stable capital position, which could prompt institutions to deny loans they might otherwise have approved. A change in expected cash flows could also have several indirect consequences. Criticized assets, assessed for impairment based on their expected future cash flows, could require a specific reserve due to lower present value of expected future cash flows.

The importance of fallback language in loan agreements

Fallback language in loan agreements plays a pivotal role in financial institutions’ ability to manage their LIBOR-related financial results. Most loan agreements include language that provides guidance for determining an alternate reference rate to “fall back” on in the event the loan’s original reference rate is discontinued. However, if this language is non-existent, contains fallbacks that are no longer adequate, or lacks certain key provisions, it can create unexpected issues when it comes time for financial institutions to reprice their LIBOR loans. Here are some examples:

  • Non-existent or inadequate fallbacks
    According to the Alternative Reference Rates Committee, a group of private-market participants convened by the Federal Reserve to help ensure a successful LIBOR transition, "Most contracts referencing LIBOR do not appear to have envisioned a permanent or indefinite cessation of LIBOR and have fallbacks that would not be economically appropriate"4.

    For instance, industry regulators have warned that without updated fallback language, the discontinuation of LIBOR could prompt some variable-rate loans to become fixed-rate2, causing unanticipated changes in interest rate risk for financial institutions. In a declining rate environment, this may prove beneficial as loans at variable rates become fixed. But in a rising rate environment, the resulting shrink in net interest margins would have a direct and adverse impact on the bottom line.

  • No spread adjustment
    Once LIBOR is discontinued, LIBOR-indexed loans will need to be repriced at a new reference rate, which could be well above or below LIBOR. If loan agreements don’t provide for an adjustment of the spread between LIBOR and the new rate, that could prompt unexpected changes in the financial position of both borrowers and lenders3. Take, for instance, a loan made at the Secured Overnight Financing Rate (SOFR), generally considered the likely replacement for USD LIBOR. Since SOFR tends to be lower than three-month LIBOR, a loan agreement using it that does not allow for a spread adjustment would generate lower loan payments for the borrower, which means less interest income for the lender.

    Not allowing for a spread adjustment on reference rates lower than LIBOR could also cause a change in expected prepayments—say, for instance, if borrowers with fixed-rate loans decide to refinance at adjustable rates—which would impact post-CECL allowance calculations like the weighted-average remaining maturity (WARM) method, which uses estimated prepayments as an input.

What can your financial institution do to prepare?

The Federal Reserve and the SEC have urged financial institutions to immediately evaluate their LIBOR exposure and expedite their transition. Though the FDIC has expressed no intent to examine financial institutions for the status of LIBOR planning or critique loans based on use of LIBOR3, Federal Reserve supervisory teams have been including LIBOR transitions in their regular monitoring of large financial institutions5. The SEC has also encouraged companies to provide investors with robust disclosures regarding their LIBOR transition, which may include a notional value of LIBOR exposure2.

Financial institutions should start by analyzing their LIBOR exposure beyond 2021. If you don’t expect significant exposure, further analysis may be unnecessary. However, if you do expect significant future LIBOR exposure, your institution should conduct stress testing using LIBOR as an isolated variable by running hypothetical transition scenarios and assessing the potential financial impact.

Closely examine and assess fallback language in loan agreements. For existing loan agreements, you may need to make amendments, which could require consent from counterparties2. For new loan agreements maturing beyond 2021, lenders should consider selecting an alternate reference rate. New contract language for financial instruments and residential mortgages is currently being drafted by the International Securities Dealers Association and the Federal Housing Finance Authority, respectively3—both of which may prove helpful in updating loan agreements.

Lenders should also consider their underwriting policies. Loan underwriters will need to adjust the spread on new loans to accurately reflect the price of risk, because volatility and market tendencies of alternate loan reference rates may not mirror LIBOR’s. What’s more, SOFR lacks abundant historical data for use in analyzing volatility and market tendencies, making accurate loan pricing more difficult.

Conclusion: Start assessing your LIBOR risk soon

The cessation of LIBOR brings challenges and opportunities that will require in-depth analysis and making difficult decisions. Financial institutions and consumers should heed the advice of regulators and start assessing their LIBOR risk now. Those that do will not only be better prepared―but also better positioned―to capitalize on the opportunities it presents.

Need help assessing your LIBOR risk and preparing to transition? Contact BerryDunn’s financial services specialists.

1 https://www.washingtonpost.com/business/2017/07/27/acdd411c-72bc-11e7-8c17-533c52b2f014_story.html?utm_term=.856137e72385
2 Thomson Reuters Checkpoint Newsstand April 10, 2019
3 https://www.fdic.gov/regulations/examinations/supervisory/insights/siwin18/si-winter-2018.pdf
4 https://bankingjournal.aba.com/2019/04/libor-transition-panel-recommends-fallback-language-for-key-instruments/
5 https://www.reuters.com/article/us-usa-fed-libor/fed-urges-u-s-financial-industry-to-accelerate-libor-transition-idUSKCN1RM25T

Related Industries

Related Professionals

A popular reference rate used by financial institutions of every size, LIBOR is the average interest rate at which major global banks borrow from one another. Each day, the Intercontinental Exchange asks major global banks what they would charge other banks for varying short-term loan maturities, and then use this information to calculate LIBOR. LIBOR rates are published daily for five different currencies and seven different borrowing periods ranging from overnight to one year, the most common of which is the three-month US dollar rate1.

In recent years, LIBOR’s reliability has come under increased scrutiny. Fewer banks participate in LIBOR calculations, and an increase in overnight-secured funding from repurchase agreements has caused a decline in unsecured borrowing, on which LIBOR rates are based. Both of these changes mean LIBOR is calculated using fewer transactions and, thus, is less representative. Rate-rigging allegations have also eroded trust in the metric’s credibility2.

1 https://www.investopedia.com/terms/l/libor.asp
https://www.fdic.gov/regulations/examinations/supervisory/insights/siwin18/si-winter-2018.pdf
 

Background
LIBOR: What it is and why it's going away

Read this if you are a bank.

On October 20, 2020, the FDIC Board of Directors voted to issue an interim final rule (the Rule) to provide temporary relief from the Part 363 Audit and Reporting requirements. Banks have experienced increases to their consolidated total assets as a result of large cash inflows resulting from participation in the Paycheck Protection Program (PPP) and the effects of other government stimulus efforts. 

Since these inflows may be temporary, but are significant and unpredictable, the Rule allows banks to determine the applicability of Part 363 of the FDIC’s regulations, Annual Independent Audits and Reporting Requirements, for fiscal years ending in 2021 based on the lesser of the bank’s:

  1. consolidated total assets as of December 31, 2019, or
  2. consolidated total assets as of the beginning of its fiscal year ending in 2021.

This Rule provides relief to banks that were going to meet the $1 billion FDICIA internal control audit requirement, or the $500 million management report and independence requirements, for 2021 due to asset growth from PPP loan activity and deposit liquidity. 

Note, a bank may be required to comply with one or more requirements of Part 363 if the FDIC determines that asset growth was related to a merger or acquisition. 

Planning tip

Despite the temporary relief, based on pre-COVID total assets and organic growth, banks could meet the requirements in 2022. Therefore, we recommend banks continue preparing internal control over financial reporting documentation and conduct preliminary testing to ensure a comfortable project timeline and smooth implementation. 

If any questions arise, please contact the BerryDunn FDICIA compliance team. We're here to help.
 

Article
FDIC grants some banks temporary regulatory relief of Part 363 Audit and Reporting requirements

Read this if you administer a 401(k) plan.

On December 20, 2019, the Setting Every Community up for Retirement Enhancement (SECURE) Act was signed into law. The SECURE Act makes several changes to 401(k) plan requirements. Among those changes is a change to the permissible minimum service requirements.  
 
Many 401(k) retirement plan sponsors have elected to set up minimum service requirements for their plan. Such requirements help eliminate administrative burden of offering participation to part-time employees who may then participate in the plan for a short period of time and then keep their balance within the plan. Although plan sponsors do have the ability to process force-out distributions for smaller account balances, a minimum service requirement, such as one year of service, can help eliminate this situation altogether.  

Long-term part-time employees now eligible

The SECURE Act will now require that long-term part-time employees be offered participation in 401(k) plans if they are over the age of 21. The idea behind the requirement is that 401(k) plans are responsible for an increasingly larger amount of employees’ retirement income. Therefore, it is essential that part-time employees, some of which may not have a full-time job, have the ability to save for retirement.  
 
Long-term is defined as any employee who works three consecutive years with 500 or more hours worked each year. This new secondary service requirement becomes effective January 1, 2021. Previous employment will not count towards the three-year requirement. Therefore, the earliest a long-term part-time employee may become eligible to participate in a plan under the secondary service requirement is January 1, 2024.  

403(b) plans not affected 

Please note this provision is only applicable for 401(k) plans and does not impact 403(b) plans, which are subject to universal availability. Furthermore, although long-term part-time employees will be allowed to make elective deferrals into 401(k) plans, management may choose whether to provide non-elective or matching contributions to such participants. These participants also may be excluded from nondiscrimination and top-heavy requirements.  
 
This requirement will create unique tracking challenges as plans will need to track hours worked for recurring part-time employees over multiple years. For instance, seasonal employees who elect to work multiple seasons may inadvertently become eligible. We recommend plans work with their record keepers and/or third-party administrators to implement a tracking system to ensure participation is offered to those who meet this new secondary service requirement. If a feasible tracking solution does not exist, or plans do not want to deal with the burden of tracking such information, plans may also consider amending their minimum service requirements by reducing the hours of service requirement from 1,000 hours to 500 hours or less. However, this may allow more employees to participate than under the three-year, 500-hour requirement and may increase the employer contributions each year. 

If you have questions regarding your particular situation, please contact our Employee Benefit Audits team. We’re here to help.

Article
New permissible minimum service requirements for 401(k) plans

Read this if you are a bank with over $1 billion in assets.

It’s no secret COVID-19 has had a substantial impact on the economy. As unemployment soared and the economy teetered on the edge of collapse, unprecedented government stimulus attempted to stymie the COVID-19 tidal wave. One tool used by the government was the creation of the Paycheck Protection Program (PPP). Part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the PPP initially authorized the lending of $349 billion to encourage businesses to keep workers employed and cover certain operating expenses during the coronavirus pandemic. The PPP was then extended through August 8, 2020 with an additional $310 billion authorized.

Many financial institutions scrambled to free up resources and implement processes to handle the processing of PPP loan applications. However, such underwriting poses unique challenges for financial institutions. PPP loans are 100% guaranteed by the US Small Business Administration (SBA) if the borrowers meet certain criteria. Establishing appropriate controls over the loan approval and underwriting process is more a matter of ensuring compliance with the PPP, rather than ensuring the borrower can repay their loan.

Federal Deposit Insurance Corporation Improvement Act of 1991 compliance 

Banks with total assets over $1 billion as of the beginning of their fiscal year must comply with the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). Amongst other things, FDICIA requires management perform an assessment and provide a resulting attestation on the operating effectiveness of the bank’s internal controls over financial reporting (ICFR) as of the bank’s fiscal year-end. Although this attestation is as of year-end, management must perform testing of the bank’s ICFR throughout the bank’s fiscal year to obtain sufficient evidence regarding the operating effectiveness of ICFR as of year-end. Key controls over various transaction cycles are typically housed in a matrix, making it easy for management and other users, such as independent auditors, to review a bank’s key ICFR. 

Internal control documentation

If the process for originating PPP loans is different from the bank’s process for traditional loan products, it’s likely the internal controls surrounding this process is also different. Given that $659 billion in PPP loans have been granted to date, it is possible PPP loans may be material to individual banks’ balance sheets. If PPP loans are material to your bank’s balance sheet, you should consider the controls that were put in place. If the controls are deemed to be different from those already documented for other types of loans, you should document such controls as new controls in your FDICIA matrix and test accordingly.

As noted earlier, the risks a financial institution faces with PPP loans are likely different from traditional underwriting. If these unique risks could impact amounts reported in the financial statements, it’s smart to address them through the development of internal controls. Banks should assess their individual situations to identify any risks that may have not previously existed. For instance, given the volume of PPP loans originated in such a short period of time, quality control processes may have been stretched to their limits. The result could be PPP loans inaccurately set up in the loan accounting system or loan files missing key information. Depending on the segregation of duties, the risk could even be the creation of fictitious PPP loans. A detective internal control that could address inaccurate loan setup would be to scan a list of PPP loans for payment terms, maturity dates, or interest rates that appear to be outliers. Given the relatively uniform terms for PPP loans, any anomalies should be easily identifiable. 

Paycheck Protection Program loan fees

Aside from internal controls surrounding the origination of PPP loans, banks may also need to consider documenting internal controls surrounding PPP loan fees received by the SBA. Although the accounting for such fees is not unique, given the potential materiality to the income statement, documenting such a control, even if it is merely addressing the fees in an already existing control, exhibits that management has considered the impact PPP loan fees may have on their ICFR. 

The level of risk associated with PPP loan fees may differ from institution to institution. For instance, a bank that is calculating its PPP loan fees manually rather than relying on the loan accounting system to record and subsequently recognize income on these fees, inherently has more risk. This additional level of risk will need to be addressed in the development and documentation of internal controls. In this example, a periodic recalculation of PPP loan fees on a sample basis, including income recognition, may prove to be a sufficient internal control.

With the calendar year-end fast approaching, it is time to take a hard look at those FDICIA matrices, if you haven’t already done so:

  • Consider what has changed at your bank during the fiscal year and how those changes have impacted the design and operation of your internal controls. 
  • Ensure that what is happening in practice agrees to what is documented within your FDICIA matrix. 
  • Ensure that new activities, such as the origination of PPP loans, are adequately documented in your FDICIA matrix. 

With Congress considering another round of PPP loans, there is no time like the present to make sure your bank is ready from an ICFR perspective. If you have questions about your specific situation, or would like more information, please contact the FDICIA compliance team

Article
Do your FDICIA controls "CARES" about the Paycheck Protection Program?

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. 
 

Article
How does your control environment look in a remote world?

Editor’s note: Read this if you are a Chief Executive Officer, Chief Financial Officer, Chief Risk Officer, Chief Information Officer, or Controller.

Last month, the Office of the Comptroller of the Currency (OCC) issued its Semiannual Risk Perspective for Fall 2019. The report addresses key issues facing banks and focuses on those that pose threats to their safety and soundness. According to the report:

  • Bank financial performance is strong due to a favorable credit environment and the longest economic expansion in U.S. history.
  • Capital levels have reached historical highs.
  • Return on equity was above its 2006 pre-crisis level for the first time at 12.7%.
  • Net income grew 8.22% from the same period a year ago; however, net interest income grew only 4%, as loan growth is below historical averages and an increasing number of banks are facing a flat or declining net interest margin.
  • There is continued weakness in residential and commercial real estate loan growth.
  • Delinquent and nonperforming loans remain below their long-term averages.


Banks can thrive even with economic uncertainty

While these trends indicate that 2019 was by and large an excellent year, banks cannot afford to be complacent, as 2019 also saw increasing risks to the industry. For instance, in 2019 there was much discussion of the future cessation of the London InterBank Offer Rate (LIBOR). The OCC has indicated it will increase its regulatory oversight regarding the anticipated cessation, to ensure banks assess their exposure to LIBOR and are appropriately planning their transition from the widely used benchmark rate. The Financial Accounting Standards Board (FASB) is also working on a project to address accounting issues that could arise from the transition from LIBOR.

And, although 2019 continued the longest economic expansion in US history, economic uncertainty exists due to, in part, the US-China trade conflict and ongoing Brexit discussions. This economic uncertainty has caused volatility in the interest rate environment. Aside from the yield curve inverting in 2019, banks also saw the Federal Funds target rate increase 25 basis points prior to decreasing 50 basis points. Given the typically asset-sensitive nature of banks’ balance sheets, the current interest rate environment will also put pressure on net interest margins. The current volatility of interest rates has caused the OCC to conclude interest rate risk is currently at heightened levels. 

Net interest income continues to be the most significant driver of net revenues for community banks, comprising nearly 80% of net revenues. With a difficult interest rate environment and lackluster loan growth in residential and commercial real estate, banks may face a difficult path ahead. Banks should tread cautiously, especially if this uncertainty persists. Asset-liability management will need be a significant focus (more than usual) as banks try to position themselves to not only maintain profitability through this uncertainty, but also come out stronger than before. Specifically, if lower rates persist, asset growth will need be a priority over deposit growth to maintain profitability at lower net interest margins. If loan growth continues to wane, this will prove to be difficult.

Innovations to compete with new lending sources

Adding to the list of threats to performance is the increasing amount of alternative financial resources available to borrowers. Banks have traditionally been the only source of credit for borrowers. However, technology has rapidly changed that landscape. Person-to-person (P2P) lending (also known as crowd lending, or social lending), allows people to borrow funds directly from another person, cutting out traditional lending sources (banks). Additionally, blockchain technology, if the hype is accurate, has the potential to eliminate the need of a financial intermediary altogether. 

Banks are adapting to this competition and to customers looking for more convenience and alternative services by offering new, unique services that differentiate themselves from others and provide added value to the customer. Banks have delivered through remote deposit, ATMs, and interactive teller machines (ITMs). Banks will need to continue to adopt innovative services to remain competitive. 

For instance, banks could offer video conferencing services, in which customers could have a live conversation with a bank representative through their smartphone. This convenience would allow a customer to conduct a transaction, such as apply for a loan, from the convenience of their home, while still maintaining human interaction throughout the transaction. Such a service would help banks compete with digital channels offered by non-banks, such as Quicken Loans, which is now the largest mortgage originator in the United States.

Strategies to protect against technological risks

These services all require the use of existing and new technologies, which have caused banks to hold more personally identifiable information (PII) digitally across an increasing number of digital platforms. As noted by the OCC, this digital exposure has created persistent cybersecurity risks for banks. Adopting a robust cybersecurity framework is no longer an option. 

Banks should bring cybersecurity to the forefront of their strategic planning. Any strategic plan must consider cybersecurity implications, as a single disaster can be detrimental to a bank’s reputation. And, given this rapidly changing environment, the cybersecurity conversation must be ongoing through relevant bank committees and the board of directors.

Furthermore, these technological solutions require partnerships with businesses that banks would not traditionally partner with. Financial technology (fintech) companies don’t just pose as a competitor to traditional banks. Many fintech companies are offering their technological solutions to traditional banks. However, outsourcing technological solutions to fintech companies and other businesses does not relieve a bank from performing its own due diligence and ensuring those companies meet the bank’s standards. 

Banks should evaluate potential vendors to ensure they comply with the bank’s vendor management policy. Since environments are constantly changing, this evaluation should be ongoing. Many vendors now provide System and Organization Controls (SOC) reports which detail the control environment at the vendor and involve independent third-party testing of those controls that exist at the vendor. SOC reports can provide a useful starting point for evaluating a vendor’s ongoing compliance with the bank’s vendor management policy. However, it is not a substitute for ongoing communication with a vendor.

There is no doubt 2019 was a successful year for banks. But past performance is not a guarantee of future success. Banks face many challenges, risks, and uncertainties, of which only a few have been outlined above. The current landscape may be challenging but it is also filled with opportunity. Banks should consider expanding their services, adopting new technologies, and partnering with other companies to leverage their strengths. Doing so should help position themselves for an exciting decade ahead.

If you have specific concerns about challenges facing your institution, please contact the team

Article
Banking and finance: 2020 challenges and what to do to overcome them

The IRS announced plans to conduct examinations of the universal availability requirements for 403(b) plans (Plans) this summer. Noncompliance with these requirements results in operational errors for Plans―ultimately requiring correction. Plan sponsors should review their Plans for proper inclusion and exclusion of employees. Such review can help you avoid costly penalties if the IRS does conduct an examination and uncovers an issue with the Plan’s implementation of universal availability.

Universal availability requires that, if you permit one employee to make elective deferrals into a 403(b) plan, then all other employees must receive the same opportunity. There are a few exceptions to this rule. Plan sponsors may exclude employees who meet one of the following exceptions:

  • Employees who will contribute $200 annually or less
  • Employees eligible to participate in a § 401(k), 457(b), or other 403(b) plan of the same employer
  • Employees who normally work less than 20 hours per week (the equivalent of less than 1,000 hours in a year)
  • Students performing services described in Internal Revenue Code § 3121(b)(10)

Of these exceptions, errors in applying the universal availability requirements are typically found with the less than 20 hours per week exception. Even if an employee works less than 20 hours per week (essentially a part-time employee), if this employee works 1,000 hours or more, you must allow this employee to make elective deferrals into the Plan. Further, you can’t revoke this permission in subsequent years―once the employee meets the 1,000 hour requirement, they are no longer included in the less than 20 hours per week employee class.

We recommend Plan sponsors review their Plan documents to ensure they are appropriately applying elected eligibility provisions. Further, we recommend Plan sponsors annually review an employee census to ensure those exceptions (listed above) remain appropriate for any employees excluded from the Plan. For instance, if you note that an employee worked 1,000 hours during the year, who was being excluded as part of the “less than 20 hours per week” category, you should ensure you notify this employee of their eligibility to participate in the Plan. In addition, you should retain documentation regarding the employee’s deferral election or election to opt out of the Plan. Such practices will help ensure, if your Plan is selected for IRS examination, it passes with no issues.

For more information: https://www.irs.gov/retirement-plans/403b-plan-fix-it-guide-you-didnt-give-all-employees-of-the-organization-the-opportunity-to-make-a-salary-deferral
 

Article
Not the summer of love: IRS universal availability examinations

In auditing, the concept of professional skepticism is ubiquitous. Just as a Jedi in Star Wars is constantly trying to hone his understanding of the “force”, an auditor is constantly crafting his or her ability to apply professional skepticism. It is professional skepticism that provides the foundation for decision-making when conducting an attestation engagement.

A brief definition

The professional standards define professional skepticism as “an attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.” Given this definition, one quickly realizes that professional skepticism can’t be easily measured. Nor is it something that is cultivated overnight. It is a skill developed over time and a skill that auditors should constantly build and refine.

Recently, the extent to which professional skepticism is being employed has gained a lot of criticism. Specifically, regulatory bodies argue that auditors are not skeptical enough in carrying out their duties. However, as noted in the white paper titled Scepticism: The Practitioners’ Take, published by the Institute of Chartered Accountants in England and Wales, simply asking for more skepticism is not a practical solution to this issue, nor is it necessarily always desirable. There is an inevitable tug of war between professional skepticism and audit efficiency. The more skeptical the auditor, typically, the more time it takes to complete the audit.

Why does it matter? Audit quality.

First and foremost, how your auditor applies professional skepticism to your audit directly impacts the quality of their service. Applying an appropriate level of professional skepticism enhances the likelihood the auditor will understand your industry, lines of business, business processes, and any nuances that make your company different from others, as it naturally causes the auditor to ask questions that may otherwise go unasked.

These questions not only help the auditor appropriately apply professional standards, but also help the auditor gain a deeper understanding of your business. This will enable the auditor to provide insights and value-added services an auditor who doesn’t apply the right degree of skepticism may never identify.

Therefore, as the white paper notes, audit committees, management, and investors should be asking “How hard do our auditors get pushed on fees, and what effect does that have on the quality of the audit?” If your auditor is overly concerned with completing the audit within a fixed time budget, professional skepticism and, ultimately, the quality of the audit, may suffer.

Applying skepticism internally

By its definition, professional skepticism is a concept that specifically applies to auditors, and is not on point when it comes to other audit stakeholders. This is because the definition implies that the individual applying professional skepticism is independent from the information he or she is analyzing. Other audit stakeholders, such as members of management or the board of directors, are naturally advocates for the organizations they manage and direct and therefore can’t be considered independent, whereas an auditor is required to remain independent.

However, rather than audit stakeholders applying professional skepticism as such, these other stakeholders should apply an impartial and diligent mindset to their work and the information they review. This allows the audit stakeholder to remain an advocate for his or her organization, while applying critical skills similar to those applied in the exercise of professional skepticism. This nuanced distinction is necessary to maintain the limited scope to which the definition of professional skepticism applies: the auditor.

Specific to the financial statement reporting function, these stakeholders should be assessing the financial statements and ask questions that can help prevent or detect flaws in the financial reporting process. For example, when considering significant estimates, management should ask: are we considering all relevant information? Are our estimates unbiased? Are there alternative accounting treatments we haven’t considered? Can we justify our selected accounting treatment? Essentially, management should start by asking itself: what questions would we expect our auditor to ask us?

It is also important to be critical of your own work, and never become complacent. This may be the most difficult type of skepticism to apply, as most of us do not like to have our work criticized. However, critically reviewing one’s own work, essentially as an informal first level of review, will allow you to take a step back and consider it from a different vantage point, which may in turn help detect errors otherwise left unnoticed. Essentially, you should both consider evidence that supports the initial conclusion and evidence that may be contradictory to that conclusion.

The discussion in auditing circles about professional skepticism and how to appropriately apply it continues. It is a challenging notion that’s difficult to adequately articulate. Although it receives a lot of attention in the audit profession, it is a concept that, slightly altered, can be of value to other audit stakeholders. Doing so will help you create a stronger relationship with your auditor and, ultimately, improve the quality of the financial reporting process—and resulting outcome.

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Professional skepticism and why it matters to audit stakeholders