Dealing with a Critical Bank Exam: A Case Study in Using the Right Tool for the Job

As the coronavirus financial fallout continues, many community bank executives may soon be dealing with tough safety and soundness exams. That was the situation in 2018 for Middlefield Bank, a $1.3 billion Ohio institution. “We had to meet the FDIC’s demands,” recalled John Lane, EVP and Chief Credit and Risk Officer.

Examiners, dissatisfied with the bank’s high CRE concentrations, told the management team it needed to comply with commercial real estate concentration guidance, which includes stress testing. The bank went out and purchased software from a well-known vendor to do stress testing on its own.

But the FDIC wasn’t satisfied at the next exam.  “No way, not even close,” examiners said, according to Lane.

“We had data. We didn’t have the rationale for the assumptions that created the data,” Lane said. Nor did the board know what the stress tests really showed, and whether the bank’s growth strategy was too risky.

Enter the Invictus Group, with a proprietary stress testing advisory service that stresses the entire bank portfolio using a PD/LGD methodology. The results demonstrate how much capital a bank would need under a severely adverse economic downturn. An Invictus team of experts customizes the tests to a bank’s specifications.

“I loved it. I thought it was exactly what we needed for two reasons. We had to comply with the CRE guidance. Period,” Lane said. “What I liked, and hadn’t experienced before, was we always struggled with what the rest of the portfolio was doing. The Invictus stress testing addresses all of that. We have a really holistic view of all the risk in our portfolio.”

Once Invictus came on board, the management team had a short window to present the new stress test results to the board before the examiners returned. This time, the presentation wasn’t just data. It included charts and analytical findings that showed precisely how much capital the bank would need in an economic crisis. And it reinforced to the board that the management’s strategy was indeed safe, even with the high concentrations.

“It was almost like they took a collective deep breath. They had this dark cloud hanging over them. They took what the FDIC was telling them, that this was risky, and they were very concerned,” Lane said. “Once the information was presented in a way that made sense, and they saw the impact of an adverse scenario and knew it wasn’t going to the break the bank, they really appreciated it.”

Lane was happy with the Invictus tests, but shortly before the examiners were due to arrive, he decided he wanted another supporting document that broke out the bank’s data for its sub-limits. “Within a week, we had the information. We had the transparency for talking with a regulator. It was an ad hoc request that everyone reacted to and got done,” he said.

The FDIC meeting went off without a hitch. The Invictus tests enabled Lane to present clear, concise and detailed information to the FDIC, backed by supportable assumptions. “It’s transparent. They didn’t have to guess. They knew exactly how the results were derived,” Lane said. “They worked hard to make sure there were no holes in it. They walked out completely satisfied. They were satisfied we understood the risk in our portfolio. They were satisfied we were well-capitalized under a severely adverse scenario. They were comfortable with our growth plan.”

The regulators were happy with the results, and the bank gained extra knowledge about its own strategy. “From a pure regulatory perspective, for a community bank our size and a little bigger, you are not only in compliance with guidance, you are in compliance with guidance as if you are a much larger institution,” Lane said.

He said the tests provide a meaningful window into the bank’s portfolio that allow for better decision-making. “There’s the additional benefit of knowing how you can set a lower capital ratio and use that capital for other things.” While the bank hasn’t done that yet, Lane said “there may be a time when that is meaningful, and we can do our next acquisition when no one else can.”

Middlefield has continued to use Invictus for COVID-19 stress testing, which is informing the size of the bank’s loan loss provisions.

“There is no doubt you are getting value for what you are paying, no doubt in my mind,” he said. “The time you save. I couldn’t do that on my own, no way. With any other tool, it’s not feasible at all.”