Ring in the New Year by Focusing on Risk
December brought the third publication of the OCC's Semiannual Risk Perspective. This is the fall edition, and it analyzes the data captured by the regulators as of the end of the second quarter of 2013. While in today's volatile banking market that may be a bit stale, this report is still an excellent source to reference as we move into 2014 and the next round of exams. The areas of concern highlighted in this analysis will be ones fresh in the mind of the examiners as they arrive to conduct your bank's next exam.
KEY RISK THEMES
Overall the news was mildly positive - earnings were increasing, and credit quality indicators were also moving in the right direction. Even within those positives there were still indications of potential threats, and those were documented in the report. There were three overall areas of concern expressed as 'key risk themes'. They will undoubtedly sound familiar, and will be revisited by examiners multiple times in the coming year. They are as follows:
- Strategic risk remains high for many banks as management searches for sustainable ways to generate target rates of return.
- Narrow growth opportunities and unusual interest rate climate further complicate bank risk management.
- Increasingly sophisticated cyber-threats, expanding reliance on technology and changing regulatory requirements heighten operational risk.
From a credit quality and loan review perspective, there was one risk identified that the OCC felt was a concern at both the midsize/community and large bank levels, and that was the erosion of underwriting standards due to competitive pressure. The supervisory plan includes instructions to regulatory staff to focus on this area, and to "scrutinize the underwriting practices of new or renewed originations from the indirect auto, asset-based lending, middle market C&I, and energy portfolios for slippage in structure and terms." The standards were reported to be lower in commercial and retail loan portfolios, with large banks easing even more than the midsize banks, but both at levels of concern.
In the large bank category there will also be increased focus on the underwriting of leveraged loans, and HELOCs, as those are expected to face increasing risk events over the coming year. Leveraged lending was identified especially this past year with the publication in March of the "Interagency Guidance on Leverage Lending," and expectations were raised at that point for banks to implement "strong risk management processes" to appropriately address this type of credit risk. If volume is any indicator of the issue, the report points out that in the first six months of 2013, leveraged loan issuance exceeded $400B, nearing a volume only achieved in the same period of 2007. The loans are apparently also being closed with higher ratios and weaker 'incurrence' type covenants as opposed to the more traditional maintenance covenant structure.
HELOC lending is a concern in part related to timing. As more HELOC's reach the maturity point where amortization payments are required, the OCC staff will be evaluating banks for their ability to quantify the risks and address the loans which reach their 'end-of-draw' periods. There is concern that many borrowers will not be able to qualify for refinancing into another product that will allow continued minimal repayment, possibly made even more difficult due to the loss of value in the collateral.
Although it was completed subsequent to the June cutoff for the data in this OCC report, the Federal Reserve Board's report in July 2013 on 'Senior Loan Officer Opinion Survey on Bank Lending Practices" confirmed the concerns being raised here by the OCC. In their 'confessions', 20% of these senior loan officers reported that their lending standards had eased on C&I loans made in the second quarter of 2013. This continues a trend that has been ongoing with respect to C&I lending standards for 12 of the past 13 quarters. These opinions are further supported by the reports of recent regulatory examinations, which document increased risk appetites and an overall easing of underwriting standards.
RETURN TO PROFITABILITY
Interestingly, there has been improvement in bank profitability in areas of the country dramatically affected by the housing crisis, although there are still regions that are above the national average for the percentage of banks which are reporting losses. The two regions cited in the report as being above the national average with minimal improvement and therefore a continuing concern are the Mid-Atlantic (DE, MD, VA, WV, NC, SC) and the region represented by Arizona, California and Nevada. Neither of these areas, which suffered significant impacts during the housing downturn, have reported more than minimal improvement in 2013. On the bright side, the Florida/Georgia market, which was the second worst hit region in the country in 2009, has continued to improve and is only slightly above the national average of 11% of banks reporting losses through June 2013.
Credit quality indicators continue to show some improvement, as the bright spots in an otherwise dreary picture. Noncurrent loans and the levels of ALLL relative to total loans declined at both large and midsize banks in the first half of 2013. The level of noncurrent loans is still above historical averages, so there is a prudent level above the historical average for the ALLL as well. Charge-offs also continued to decline for most loan types in the first half of 2013. HELOC's and one-to-four-family residential loans were the loan categories that continue to remain above long term averages with respect to charge-off levels.
WHERE TO LOOK FOR PORTFOLIO GROWTH?
Year over year, large banks reports show just over 4% loan growth and for banks under $1B in assets the growth rate was only 1%. The return to profitability will require banks to find markets for prudent portfolio growth. Where are those markets? Commercial lending is the focus for all size banks, but small banks tend to lend to small businesses which are still struggling, so the growth at small banks is 'uneven'. The primary industries reporting growth in borrowing are
- non-bank financials,
- real estate,
- construction and
Energy in particular is a new area which many banks are aware of, however the OCC cautions that banks should have the appropriate industry expertise before they lend in this market.
Overall, while the OCC points out some broad areas of concern, there are few surprises for bankers in this report. The risks are well recognized at the broad market level, and by understanding what the regulators are seeing, individual bankers can prepare their own institution to address them appropriately, and demonstrate their preparations when their examiners arrive.
For a more complete review, go to the published report on the OCC website at the location below: