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FDIC Expectations on Ag Lending

2/21/2020

FDIC Expectations on Ag Lending

In January, the FDIC released a Financial Institution Letter (FIL) titled “Prudent Management of Agricultural Lending During Economic Cycles.” You can find the FIL here.
It’s no surprise that the continued pressures facing the agricultural economy are worthy of regulatory concern and rightfully so. Farm incomes have stabilized in recent years but remain well below the averages over the last decade with many farmers struggling to continue their operations. One might even suggest, we have fallen into a new normal. 
This isn’t the first time the FDIC has issued guidance on Agricultural Lending, in fact, this FIL replaces and rescinds FIL-39-2014, Prudent Management of Agricultural Credits Through Economic Cycles, dated July 16, 2014 which replaced a similar FIL from 2010, you get the point. During my time in banking, I always approached these publications as an expectation for the next 12-24 month examination cycle.
From that perspective, its important to know what new information the FDIC is communicating with the updated FIL. For the most part, when comparing the 2014 and 2020 FIL’s side by side, much of the information is the same apart from a few additional paragraphs in the most recent publication. 
First, the FDIC added the following language. 
“…cash flow margins for agricultural borrowers have become increasingly pressured by changes in supply and demand factors, poor weather conditions, and agricultural policy factors. Row crop operating expenses have risen while soybean, corn, and wheat prices have fallen. Livestock sectors have also been challenged, especially dairy farming and cattle feeding. Farm working capital levels have deteriorated, debt balances have increased, and debt repayment capacity has constricted.” 
“Despite the difficult agricultural environment, farm real estate and equipment values have remained fairly resilient. Restructuring carryover debt has been a reasonable approach for borrowers with strong equity positions. However, given strained cash flow, debt service has been challenging for borrowers with even moderate levels of term indebtedness. As headwinds facing the agricultural economy persist, insured institutions must be prepared for agricultural borrowers to face financial challenges by employing appropriate governance, risk management, underwriting, and credit administration practices.”
The FDIC didn’t go out on a limb here. They acknowledged what we all know, cash flows are break even and the solution for shortfalls has largely been to restructure against existing equity positions, particularly real estate. However, I would draw your attention to the last sentence which, from my perspective, provides a caveat into what the FDIC is expecting on a go forward basis. The FDIC is looking for a structured, long-term approach to troubled relationships. Consider the following paragraph from the FIL.
“Managing risk over the life of a loan includes: carefully documenting all lien perfections and other loan instruments; closely overseeing sale proceeds; conducting timely, independent collateral inspections; and developing a process for monitoring collateral values. A continuous credit grading program can help management identify credit risk early and take preemptive steps to prevent further deterioration. Assigning initial credit grades, ensuring timely grade changes, and assessing the adequacy of the Allowance for Loan and Lease Losses in light of grade changes are vital.”
 
The FDIC is giving you the playbook for what they expect to see for documentation on struggling ag relationships. 
·        Documentation of lien perfections,
·        Oversight of sales proceeds,
·        Independent collateral inspections,
·        A monitoring process for collateral values, and
·        An established and ongoing grading system.
While relatively basic, this playbook can be difficult to implement consistently across troubled relationships. After all, some struggling borrowers may have been prime borrowers not that long ago and implementation these risk mitigating strategies can feel like a breach of trust between the lender and the borrower. This elevates the importance of ongoing conversations between the lender and borrower concerning operating results and overall performance expectations over the long-term. Be sure these discussions are happening, especially with your less seasoned lenders who may not have experience with difficult conversations.
Lastly, the FIL discusses, in detail, the FDIC’s willingness to accept modifications of loans, including loan terms, with or without concessions. Especially in circumstances where modified terms allow for a borrower to maintain positive cash flow, weather adverse conditions and stabilize their operations. In fact, the FDIC goes out of their way by stating,
“Further, an institution that implements prudent loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse classification.”
In other words, you know your borrowers, which ones you want to work with and which ones you want to work out. Remember, a classified loan is an internal measure. It is not public information. Your risk rating system should be established, implemented and reported in such a way that those charged with governance roles can be informed of management’s assessment of risk and strategic direction.  However, don’t let a classified risk rating or Troubled Debt Restructuring classification get in the way of what is best for the bank and the borrower. You know your customers best. That is the core of community banking.
Guest Post: Published by Micheal Holdren – Former CFO turned CPA helping banks strategically with their banking, audits, loan reviews and accounting