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Credit Quality – Chinks in the Armor?

Feb 28, 2019

Overall, credit quality remains strong based on most asset quality metrics. The level of nonaccrual and past due loans has continued to decline. However, these traditional asset quality indicators are lagging indicators and do not point to the underlying risk in the loan portfolio. 


The OCC noted in its Fall 2018 Semiannual Risk Perspective that credit risk is increasing because of accumulated risk in loan portfolios from successive years of incremental easing in underwriting, risk layering, concentrations, and rising potential impact from external factors. Despite rating most credit policies as satisfactory and most underwriting practices as moderate or better, examiners identified more supervisory issues related to credit underwriting. Most of these concerns resulted from internal control weaknesses, including inadequate credit analyses or weaknesses in the ability to identify, track, mitigate, and document underwriting exceptions.


The increase in credit risk has been accompanied by a steady easing of underwriting standards over the past several years for both commercial and retail products. The current environment reflects trends in underwriting standards similar to those seen just prior to the financial crisis in 2008. This is concerning to us and should be to your senior management team and Board.


The biggest reason given for relaxed underwriting standards is competition. Competition is not always in the form of traditional financial institutions. There has been an upward shift toward nonbanks for new loan originations. This is particularly true in retail lending as nonbanks originate over half of all new residential loans and increasingly originate more automobile and personal loans. Nonbanks are also grabbing market share in commercial real estate (CRE) loans as well as larger credits such as leveraged loans and middle market loans. 


Here are a few examples of relaxed underwriting standards and policy exceptions that we have seen over the past two to three years and continue to see and hear about:


  • More aggressive advance rates. This has become more common in CRE loans and also includes higher levels of cash out in refinance transactions. Residential mortgages and auto loans also reflect increased loan to value ratios.


  • Longer fixed rate terms and interest only periods. This has become more prevalent in CRE, agricultural, and equipment loans.


  • Extended amortization periods. CRE loans are often being pushed to 25- and 30-year amortization periods. Agricultural, equipment, and auto loans also have longer amortizations, with auto loans frequently still outstanding when the owner sells the vehicle. Leveraged loans increasingly have terms that extend the amortization period or liberalize the loan payments.


  • Carryover debt. Operating lines are not being paid off as structured, resulting in the unpaid portion being rolled into the new operating line.


  • Limited guarantees and non-recourse loans. Commercial and CRE borrowers are increasingly requesting, and receiving, non-recourse loans. These are frequently negotiated with limited personal guarantees.


  • Less stringent covenant and financial reporting requirements. Commercial, CRE, and leveraged loan borrowers are taking advantage of this relaxation. The most common covenant that we see relaxed is for debt service coverage. This covenant as well as other covenants are not always well-described and are subject to interpretation or, in some cases, generous add-backs to the calculation.


  • Aggressive pricing. Aggressive pricing, along with reduced or waived fees, has become more prevalent in all areas of lending by financial institutions. In some cases, it calls into question whether the risk is worth the reward.


Policy exceptions are not necessarily a bad thing and may be a part of a very strong credit. Exceptions need to be properly documented and mitigated as a part of the loan presentation.  Policy exceptions should also be tracked and reported to the Board of Directors on a regular basis. If a pattern and practice of approved exceptions develops, then additional reporting would be warranted. For example, if a financial institution was approving an increasing number of non-recourse loans, then aggregate limits should be established, measured, and reported on a regular basis.


Commercial real estate lending has grown significantly over the past several years and has become a staple for many community financial institutions. We are seeing financial institutions exceeding the 100% construction and development threshold and even more financial institutions exceeding the 300% total CRE guidelines. Such growth heightens the need for effective credit and concentration risk management. As a result, examiners will expect to see a more detailed concentration risk management plan. 


According to the FDIC’s 2018 Annual Performance Plan, “FDIC examiners now devote additional attention during the examination process to assessing how well financial institutions are managing the risks associated with concentrated credit exposures and concentrated funding sources.” The NCUA recently echoed this point: “Examiners will have a continued focus on large concentrations of loan products and concentrations of specific risk characteristics.” The NCUA went on to state, “Excessive credit concentrations are a common cause of financial losses.”


While never mandated for community financial institutions, there is an expectation by examiners that financial institutions with CRE concentrations will conduct portfolio stress testing. This will assist financial institution management, as well as the board, in determining the level of capital needed by the institution. 


Portfolio stress testing and sensitivity analysis may not necessarily require the use of a sophisticated portfolio model. Depending on the risk characteristics of the CRE portfolio, stress testing may be as simple as analyzing the potential effect of stressed loss rates on the CRE portfolio, capital, and earnings. More rigorous stress testing would include running multiple scenarios and making sure that assumptions for changes in borrower income and collateral values are severe enough. Financial institutions’ stress test assumptions and scenarios should continue to change as their current strategic plan changes.


Regulators tend to be less focused on the technicalities of the stress test and more focused on how management uses the results of the test to assist in the critical decisions related to capital and strategic planning. Even financial institutions without a concentration should include loan level stress testing as a part of their underwriting process for CRE loans.


Therefore, it is important to stay committed to sound underwriting practices and continue to do the things that have led to success in the past while incorporating new risk management strategies into financial institution policies and procedures. While there remains pressure to grow the loan portfolio, along with the increased pressures of competition, maintaining a sound loan structure and extending loans to creditworthy borrowers will lead to more success in the long run.


Now is not the time to reduce credit quality oversight. Having an independent loan review is not just for when the economy, borrower payment performance, and new loan requests are weak, but it should also be utilized when the economy, borrower payment performance, and new loan requests are strong in order to root out issues before delinquency and charge-off levels rise. This is part of a strong credit culture.



Eric E. VanDoren, CRC
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