On June 23, 2020, the Federal Reserve, FDIC, OCC, NCUA, and state financial regulators (“the agencies”) issued guidance outlining the supervisory principles for assessing the safety and soundness of institutions amidst the COVID-19 pandemic. The guidance highlights that while examiners will consider the unique stresses caused by COVID-19 on financial institutions, the agencies will continue to assess institutions in accordance with existing policies and procedures and may provide supervisory feedback, or downgrade institutions’ composite or component ratings under the applicable rating system when conditions have deteriorated. Although an assessment may result in a lower rating, in determining the appropriate supervisory response, examiners will consider whether weaknesses were caused by external economic problems related to the pandemic or by intrinsic risk management and governance issues. Overall, the guidance suggests that while examiners will take into account the unique impact of the pandemic on financial institutions, ratings will depend on each individual institution’s ability to assess and manage risk appropriately, including taking appropriate action in response to stresses caused by the COVID-19 pandemic.
In order to promote consistency and transparency across the agencies, agency examiners will continue to use CAMELS and ROCA to assign supervisory ratings, respectively, to banks and to the branches and agencies of foreign banking organizations. In addition, Federal Reserve examiners will continue to apply the RFI/C(D) and LFI ratings systems to bank holding companies, as applicable depending on a holding company’s size.
The guidance discusses specifically how examiners should evaluate the components that make up CAMELS and ROCA ratings amidst the pandemic:
Capital Adequacy: The agencies acknowledge that increases in lending, unusually large deposit flows, or inflows from various government programs could cause a temporary decline in an institution’s regulatory capital ratios. Examiners will evaluate capital relative to the nature and extent of an institution’s risk. If an institution’s risk profile is not supported by its capital levels, examiners will determine whether management has a satisfactory plan to maintain, and if necessary, build capital.
Asset Quality: This component includes consideration of a number of items, which are enumerated in the guidance. These items are: classification of credits, credit risk review, new loans, the Paycheck Protection Program (PPP), credit modifications, nonaccrual, allowances for loan and lease losses/allowances for credit losses, obligations of taxing authorities (e.g., municipal bonds), real estate values, and appraisal and evaluation delays. The guidance acknowledges certain specific impacts that the pandemic may have on these elements of asset quality and emphasizes the importance of an institution’s ability to react to these challenging circumstances in a way that is both proactive and reasonable. For example, the guidance reiterates the agencies’ support of institutions’ participation in the PPP and indicates that examiners will not criticize institutions that do so “in accordance with SBA program guidelines.”
The agencies acknowledge that they have encouraged institutions to work with borrowers experiencing pandemic-related difficulties in meeting their credit obligations; the guidance says expressly that examiners will not criticize institutions for making loan modifications even if the restructured loans subsequently develop weaknesses. The guidance is clear, however, that loan modifications should be prudent and consistent with safety and soundness. Similarly, the agencies acknowledge that they have temporarily permitted institutions to defer obtaining an appraisal on the real estate collateral for a loan; the guidance emphasizes, however, that institutions should make “best efforts” to obtain a credible valuation of real property before a loan closes.
Management: In rating an institution’s management, examiners will distinguish between problems caused by the institution’s management and those caused by external factors beyond management’s control. Management of an institution with problems largely related to the pandemic may warrant a more favorable rating than management of an institution operating with problems stemming from weak risk management practices substantially within the institution’s control.
Earnings: Examiners will consider the duration of any reductions to core earnings caused by the pandemic, including expenses that may increase due to asset quality deterioration. The agencies acknowledge that due to an increased level of loan modifications associated with the pandemic, levels of deferred interest in relation to total earnings may be elevated. As such, examiners will assess the quantity, quality, and trend of prior earnings as well as the pandemic’s influence on earnings prospects. They will also assess the impact of earnings prospects on major business lines and significant customers and the adequacy of revisions to an institution’s budget and strategic plan, including projections from participation in government programs related to the pandemic.
Liquidity: The agencies acknowledge that considerable uncertainty remains about the impact of COVID-19 on liquidity profiles. Examiners will evaluate management’s ability to reassess or revise liquidity planning to accommodate changes from the pandemic. Examiners will not criticize an institution for appropriate use of the discount window or other Federal Reserve lending programs, or the NCUA’s Central Liquidity Facility. Moreover, examiners will not criticize an institution’s prudent use of its liquidity buffer to support economic recovery, in accordance with the institution’s liquidity risk management framework.
Sensitivity to Market Risk: Examiners will recognize that management may need time to assess changes to an institution’s interest rate risk profile and distinguish between permanent structural changes versus short-term fluctuations during a transitional period. Moreover, the agencies highlight that institutions may experience temporary shifts in their interest rate risk profiles from changes in cash flows associated with the pandemic. Examiners will evaluate if management has procedures for reviewing and updating asset and liability management models for fluctuations in deposit balances, adjustments to loan payments, changes in interest rates, and other modifications to ensure the integrity, accuracy, and reasonableness of such models.