Credit quality in financial institutions remains strong. When we look at traditional performance metrics such as delinquencies, nonaccruals, charge-offs, and classified assets, the credit picture is indeed rosy. One thing to keep in mind is that these are lagging indicators — great at measuring the past, but not necessarily indicative of future results. In its Semiannual Risk Perspective, the OCC discusses the embedded risk from elevated corporate borrowing, higher corporate leverage, eased underwriting standards, and agricultural sector challenges. Furthermore, the slower economic growth on the horizon could add additional risk with weaker corporate revenue and earnings.
Let’s take a closer look at some potential areas of credit concern facing financial institutions in 2020.
We’ll start with one of the biggest areas of concern — the agricultural industry. Inflation-adjusted prices for row crops such as corn, soybeans and wheat are at or below their 20-year averages. The same can be said for milk prices as the dairy industry continues to be under a significant level of stress. The agricultural industry has been impacted by foreign trade issues along with severe weather and increased operating costs. We continue to suggest lenders be proactive in working with all borrowers, but particularly those agricultural producers being impacted by these conditions in order to develop plans to work through these issues to the benefit of both borrowers and lenders.
Commercial real estate (CRE) lending is an area that has performed well for the past several years. Because of this and the fact that it has been a staple loan product for many lenders over the years, the concentration level has continued to increase. Most lenders display sound underwriting and management of CRE borrowers and concentrations. However, regulators maintain a supervisory focus on CRE lending and risk management. The FDIC recently noted CRE underwriting-related supervisory recommendations were observed for more than 27% of its reviews despite overall sound underwriting practices. While the recommendations varied widely, they were commonly related to inadequate analyses of repayment capacity, including inadequate global debt service coverage analyses. Generous interest-only terms and extended amortizations or other relaxed structures were also noted in supervisory recommendations. Another common recommendation is exceptions to underwriting policies. The NCUA recently issued a supervisory letter discussing concentration risk and that management should be able to identify and demonstrate appropriate risk management and mitigation practices to minimize the risk of significant financial condition decline.
Non-depository financial institutions (NDFI) continue to have a profound impact on commercial lending and particularly retail lending markets. According to the OCC, NDFIs originate over 50% of government-supported mortgages, hold a majority of mortgage servicing rights, lead in market share for unsecured personal loans, and participate in direct leveraged and other forms of commercial lending. This “outside” competition puts increased pressure on traditional lenders to remain competitive in these markets. There has also been increased lending by traditional lenders to NDFIs, which indirectly increases credit risk in these sectors. Lenders need to monitor their response to this increased competition to ensure they maintain and control prudent underwriting practices to remain within their level of risk tolerance.
In an effort to continue to increase earning assets and diversify their asset base, more lenders are venturing into the leveraged lending market. OCC examiners have noted higher leverage levels across a wide range of credit types with many leveraged loans exhibiting marginal or weak transaction structures, aggressive repayment assumptions, or marginal repayment capacity. They also noted that although higher risk, leveraged loans held in financial institution portfolios are generally of satisfactory credit quality, and holdings of collateralized loan obligations are generally of high quality. However, as the FDIC noted, leveraged lending presents heightened risk if internal risk management programs are not established and effectively managed. Leveraged lending volumes have continued to increase, and as a result, regulatory scrutiny of this sector will continue.
It is important that lenders be proactive in preparing for the next downturn. Lenders need to understand how the external factors described above along with the accumulated credit risk from years of growth, weaker underwriting, increased credit concentrations, and risk layering can impact their loan portfolios. Risk management is of heightened significance. Lenders should expect regulatory exams to include a review of commercial and retail underwriting practices, with a focus on evaluating credit risk appetites, risk layering, and portfolio risk exposure. In addition, exams will include commercial and retail credit oversight and control functions, including portfolio administration, independent loan review, concentration risk management, policy exception tracking, collateral valuation, stress testing, and collections management.
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