Loan Review Observations and Recommendations for Effective Risk Management
By: Tommy Troyer, Executive Vice President
Over the recent past, there have been a number of public assertions, warnings, or observations that credit risk is rising in the banking industry. These statements have come in many forms, and while we do not intend to present an exhaustive review of such statements here, it is easy to present a brief list showing the various forms and messengers:
- Public Comments by Regulatory Officials: Thomas Curry, the Comptroller of the Currency, devoted his speech to the RMA Annual Risk Management Conference in November of last year to evidence that credit risk was rising and to the need for the industry to respond with appropriate risk management tools and ALLL decisions. Similarly, at the Ohio Bankers League’s CEO Symposium in May, Julie Blake, Assistant Deputy Comptroller, shared with attendees that credit risk had moved to the top of the OCC’s risk priorities and provided some evidence of increases in risk appetite over recent years.
- Formal Regulatory Publications: This category includes issuances of regulatory guidance, such as the December 2015 CRE guidance (discussed in a previous 90-Day Note) that was issued not to provide new guidance to banks but simply to highlight what regulators believed to be increasing risk in the CRE space and to remind banks of risk management expectations. This category also includes more informational publications, such as the OCC’s Semiannual Risk Perspective, which has been highlighting some increases in credit risk recently.
- Private Sector Commentary: Any bankers who may be inclined to brush off such regulatory comments as simply arising from regulatory conservatism should pay special attention to comments about credit risk originating from bankers themselves. The July-August edition of the Risk Management Association’s RMA Journal includes an article written by a banker and quoting numerous other private sector risk executives about their feelings that credit risk has likely increased and that heightened diligence on the part of banks is needed to appropriately manage that risk.
Ultimately, all of these comments are based on observations that underwriting standards have loosened and concentrations of credit may be increasing. Unlike typical asset quality measures that provide lagging indicators of credit risk (such as nonaccrual or charge-off rates), underwriting standards can provide a leading indicator of changes in credit risk.
Loan Review Observations
Given these industry-wide observations, what does the situation look like for community banks? Our contribution to this topic is primarily anecdotal, and is based on observations gleaned from the independent loan reviews we perform for community banks. While it must be acknowledged that the diversity of community bank practices and circumstances means that no generalization will apply to all community banks, our anecdotal observations would seem to support the belief that credit risk has risen in recent years. For our community bank clients, the loosening of credit standards is actually less evident in changes to formal underwriting standards (in part because community banks often do not employ as detailed of a set of underwriting standards as larger banks) and more evident in the decisions banks are making on what might be described as “borderline” credits. In other words, our clients have not slashed their required minimum debt service coverage ratios or FICO scores as much as they have begun saying “yes” a little more often on deals that could go either way. Healthy debate in credit committees is important and should be encouraged. One interesting piece of information for banks to consider is whether more deals have recently been approved in credit committee by a split vote rather than unanimously, which may indicate that banks are saying yes to a few more “on-the-fence” deals than they have historically.
Closely related to the concept of approving the borderline deal, and an issue commonly discussed by regulators, is the increase in loans approved with one or more exceptions to loan policy. Making commercial loans on a non-recourse basis is perhaps the classic community bank commercial credit policy exception, and these types of deals may well be increasing.
Other examples of increasing risk include an increased willingness to finance start-up ventures or significant expansions of current businesses and, in some cases, a reflection of the eased CRE terms referred to in the aforementioned 2015 regulatory guidance, such as longer interest-only payment periods. Especially in more urban markets or markets where larger banks are active, competition is undoubtedly a major factor in some of these developments, as banks unwilling to make any concessions on terms or price today can quite quickly find themselves with a shrinking loan portfolio.
What Should Community Banks Do?
Young & Associates recognizes, as do most community banks, that an increase in risk appetite is not necessarily a bad thing. However, an increase in risk appetite that is not matched by a corresponding increase in risk management is a bad thing. So how should community banks ensure that any loosening credit standards now do not result in major issues later? The following actions are a good start:
- Monitor and report to the board forward-looking measures of asset quality. If a bank’s appetite for credit risk is increasing, it should be because of a conscious decision of the board. It should not be something the board discovers several years later when asset quality problems begin to manifest. Forward-looking measures are key to monitoring changes in credit risk before it is too late. Such measures include reporting on the rate of policy exceptions (including loans with multiple exceptions); tracking loan performance by vintage, which can provide an early warning when the performance of a recent vintage early in its time on book is notably weaker than that of previous vintages; and even a measure as simple as monitoring the rate of loan growth compared to peers.
- Enhance risk management practices. At a time when credit risk may be increasing, banks should be sure that risk management practices are also heightened. In such a situation, it may be appropriate to increase the scope of independent loan review so that a greater percentage of credits, and especially new originations, are reviewed. Steps to quantify risk, such as stress testing higher-risk portfolios or portfolios that represent concentrations, are even more important at times of increased risk. And personnel should not be overlooked: increased volumes of higher-risk loans without a corresponding increase in the credit staff’s capacity may be a recipe for trouble.
- Ensure that capital planning factors in any increases in risk. As noted, a measured and controlled increase in the credit risk a bank is willing to accept can be a positive for its shareholders and community. For this to be true over the long term, however, the bank’s capital planning process must appropriately account for this increase in risk. Regulatory minimum capital ratios are but a small part of capital planning, and capital planning can only be effective when it is sensitive to changes in a bank’s risk profile. Banks must ensure that their capital planning process accounts for changes in risk across the bank and that they are able to effectively identify such changes.
We have not seen from our clients (nor do we expect to see) the type of extremely risky loans that people write books and movies about in the aftermath of a credit crisis. However, there is anecdotal evidence to support the widely-held belief that credit risk in the banking sector is higher than it was a few years ago. It is crucial that banks effectively identify and manage any such increases. Young & Associates, Inc. can assist banks in both identifying and managing credit risk. Contact Tommy Troyer at 1.800.525.9775 or click here to send an email to discuss loan review, stress testing, or capital planning services.