FOCUS ON BANK CONTROLS

Ever since the GFC, there has been growing focus on ensuring banks have a heightened control environment around risk profiles. Sometimes, that means the formation of a risk committee with experienced members, or recognising the growing role of the CRO, risk appetite articulation or even director training programs.  And to be fair, the need for adequate controls is not new. Murphy (2004) writes that the FDIC Improvement Act of 1991 establishes accounting, governance and reporting requirements upon all but the smallest banks and holds senior management and their auditors responsible for robust internal controls. One of the most important aspects of reporting discretion in commercial banks is the level of loan loss reserves and such measures can account for 15% or more of earnings (Lobo, 2017). In academic literature, there is compelling evidence that better governed firms strictly and conservatively follow reserve policies and even allow income smoothing to produce greater levels of reserves (Zagorchev and Goa, 2015).  

It is therefore surprising to see a Moody's report this week in their Credit Outlook piece (Moody's March 13, 2017) that identifies Webster Financial Corporation, a $25bio BHC based in the northeast which as been a darling in the stock market lately, on credit negative watch following the disclosure of weak internal controls relating to governance deficiencies in its loan loss provision and reserve model. Moody's adds that no misstatement of reserves appears to have occurred, quoting the BHC's filings. Webster disclosed its concerns in a 10k filing and explains further: the aggregation of control deficiencies in management’s review of the allowance for loan loss model including certain process level controls preventing unapproved changes in modelling assumptions as well as the precision of management’s review over the valuation of allowance for loan and lease losses balance.

This episode underscores the need for strong internal risk controls for banks of all sizes, big global players and community banks like Webster. It also validates the role of external monitoring as a corporate governance mechanism, as perceptions of credit quality can impact rating stability and investor perceptions, and possibly even funding costs if unchecked over time. There is little doubt that Webster, which just earned several community awards for "Best of Business", will move to promptly address the concerns it has identified and reported.