Keeping an Eye on Credit Risk

U.S. banks have been posting strong profitability, and credit quality remains sound thus far in 2018. In fact, regulators have noted as much in both the FDIC’s third-quarter banking profile and the OCC National Risk Committee’s semiannual report on risks issued recently.

Despite the positive trends, these same regulators expressed concern in both reports that credit risk is building, and they are urging banks to maintain discipline in underwriting and with credit standards.

“In the broader financial sector, demand for higher-yielding assets remains strong and has driven an increased appetite for credit assets with higher risk, lower quality, and narrower pricing,” the OCC’s Semiannual Risk Perspective report released this week stated. “Banks continue to see increased competition from nonbanks for loan originations, which can stress banks’ willingness to maintain credit discipline.”

‘Heightened exposure to credit risk’

Despite positive quarterly results for FDIC-insured financial institutions, FDIC Chairman Jelena McWilliams said in November, “the extended period of low interest rates and an increasingly competitive lending environment have led some institutions to ‘reach for yield.’ Additionally, the competition to attract loan customers has been strong, and it will remain important for banks to maintain their underwriting discipline and credit standards. These factors have led to heightened exposure to interest-rate risk and credit risk.”

Linda Keith, CPA, a credit risk consultant who trains lenders in financial statement and tax return analysis, says the concern expressed by these regulators isn’t surprising to her or to many others in banking. Keith recently commissioned the 2018 Credit Risk Readiness Study because she sensed worry among her community bank and credit union clients. This worry was not about whether a recession or other credit disruption would come. As she notes, recessions and disruptions always come. Rather, Keith was hearing concern, “that we are backsliding from the lessons learned” during the Great Recession.

Through 30 in-depth interviews with senior credit professionals and a survey of 250 credit professionals from 235 institutions, Keith developed a snapshot of the U.S. banking industry’s readiness for the next major credit disruption. She will provide details on the 2018 Credit Risk Readiness Study during a Dec. 13 webinar hosted by Sageworks.

Backsliding in prudent credit risk practices?

Keith found in the survey that bankers have significant concern about a retreat from prudent lending practices – the same unease that regulators expressed in these recent reports. In the survey, 54 percent of respondents agreed with the statement, “Increased competition is causing backsliding in prudent credit risk practices in the banking industry generally,” while only 23 percent disagreed.

This finding is consistent with the FDIC commissioner’s comment and concerns about increased competition and bankers reaching for yield.

“Now, note that these respondents didn’t say that their company was backsliding; we didn’t ask that question,” Keith noted. “However, the large share of agreement about backsliding indicates that when financial institutions are trying to strengthen their credit risk readiness, it’s wise to recognize that there is more and more pressure to relax credit discipline.”

“That pressure is at all levels,” she said. “It’s originators trying to meet goals when their competition isn’t requiring guarantors or is giving in on loan to value, coverage ratios or other covenants. And it’s loan managers holding the line when asked: ‘Can’t we do this deal, because they’re getting this offer down the street?’ “

One manager of commercial credit at a $500 million community bank told Keith that the bank had learned lessons from the past recession. However, the banker said, “We quickly chose to forget and we’ve loosened up the lending. We were way too loose on commercial real estate, especially. It just concerns me that we’re getting to that point again.” Other senior credit professionals expressed success and determination in maintaining the needed credit discipline.

Webinar on credit risk readiness

Keith during the webinar plans to review many of her findings from the survey on credit risk readiness, and she will ask webinar participants about their own views. “The attendees will compare their thinking to their peers on the webinar as well as lending and credit professionals across the country. We’ll focus on concerns and best practices to improve credit risk readiness.”

In the OCC Semiannual Risk Perspectives report, regulators said that in new commercial loans, particularly in commercial and industrial lending and leverage loans, “abundant” investor liquidity is fueling demand and driving eased underwriting and risk layering. “Also, there is increasing concern that strong loan performance is masking the accumulated risk in loan portfolios from successive years of eased underwriting and low interest rates, as well as contributing to greater complacency in risk assessment,” the OCC report said. The regulator’s National Risk Committee said increased credit risk oversight is warranted, based on the number of matters requiring attention (MRA) notices that called out risk management weaknesses related to credit policy exceptions and credit analysis.

Continuing weakness in commodity prices, increasing expenses and the unknowns related to U.S. trade policies are among factors that are increasing agricultural lending risks, the OCC added. Commercial real estate concentrations seem to be less of a concern; the OCC said CRE concentrations remain elevated but noted growth has slowed, especially among community banks, based on results through the June quarter.

Keith said in her study that many senior credit professionals are paying more attention to either avoid, or adequately mitigate, a return to high concentration in CRE. Interestingly, however, she saw some differences of opinion between frontline workers and leadership about whether financial institutions have sufficiently mitigated the risk of CRE concentration. Among frontline staff, which includes credit analysts, underwriters and relationship managers, 43 percent agreed their institution had sufficiently mitigated the risk of CRE concentration. However, among leadership (CEOs, chief lending officers, chief operating officers, senior loan officers), agreement was 60 percent. “Generally, throughout the survey, the frontline agreed with the leadership, but not on the subject of CRE concentration,” Keith noted in her study. “Does the frontline have more of a pulse on this issue? Or does leadership have more experience with mitigation at the institutional level?”

Join Keith for a discussion of this and other credit risk issues during the webinar, “Credit Risk Readiness: One Decade After the Recession.”