In this dystopian environment we find ourselves in, the downturn in the U.S. economy will soon begin to ripple through the banking industry. Although the Federal Reserve appears to have acted prudently by establishing credit facilities should a liquidity crisis emerge, an equally important concern is what may be a wave of defaults and insolvencies by businesses forced to shut down due to the COVID-19 pandemic. This in turn will begin to impact financial institutions’1 balance sheets and capital calculations—which may inevitably lead to a new wave of cease and desist and capital directives by the “Banking Regulators.”2
This Alert is intended to refamilarize financial institutions and their officers, directors and affiliates with the bank enforcement process—with emphasis on the enforcement tools regularly employed by the Bank Regulators to address capital deficiencies.3
A. The Current Economic Situation
The U.S. economy has experienced extreme shock and losses as the COVID-19 pandemic has forced the closure of innumerable small, medium and large businesses for periods exceeding three months. Although the federal government adopted a series of economic stimulus measures intended to provide temporary funding to prevent layoffs of employees, the current major stimulus measure—the Paycheck Protection Act—has a shelf-life of eight weeks, following which recipients of stimulus funds will likely experience a lack of working capital to return to normal (or the new normal) operations.
Regardless of the size of a financial institutions (e.g., community, mid-sized or SIFI), a credit crisis is potentially looming. This is because the economic stimulus measures adopted by Congress might best be viewed as preventing an immediate shock to the banking system, since numerous credit defaults have been postponed for several months (another iteration of “flattening the curve”). Further, the Banking Regulators have encouraged the use of loan modifications by amending the “troubled debt restructuring” or “TDR” rules to avoid write-downs; similarly, mortgage relief has been afforded to homeowners whose home loans were purchased or insured by Fannie Mae, Freddie Mac, FHA and certain other federal mortgage-related agencies.
The effect of these efforts, which hopefully will avoid a liquidity crisis similar to that suffered in 2006-2008, may merely postpone credit deterioration, loan defaults, insolvencies and foreclosure actions undertaken by financial institutions. Eventually these deteriorating credit conditions will result in substantial increases in a financial institution’s “Allowance for Loan and Lease Losses” (“ALLL”), loan write-downs and reduction in a financial institution’s regulatory capital—resulting in a new wave of enforcement actions not experienced by financial institutions for more than a decade.