Credit Stress Contingencies: Why Wait Until It Comes?

Over the past five years, persistent uncertainty has dominated industry surveys on the outlook for credit quality and loan growth. This is hardly surprising given the aftermath of a global pandemic, the sharp rise in interest rates from historic lows to decade highs and ongoing shifts in political and policy landscapes — all of which have contributed to a widespread sense that, at best, the credit environment remains challenging.

While the trailing quarter-to-quarter public call report data remains generally benign, unmistakable signs of stress are emerging. Delinquencies and non-performing loans are on the rise, while reserve coverage ratios are declining, particularly among community financial institutions. At the same time, banks with assets under $10 billion continue to hold a disproportionate slice of commercial real estate (CRE) loans — a segment facing significant challenges related to property use and obsolescence.

Since the high-profile, liquidity-induced bank failures of 2023, bank finance chieftains have been under constant investor and regulatory scrutiny regarding contingency funding plans. However, the credit function itself, beyond reliance on the allowance for credit losses (ACL), has not yet faced the same level of inquiry.

It has now been nearly a generation since the Great Recession, with its massive loan losses and bank failures. While the industry has subsequently adopted more robust risk management practices, many current bankers have only known periods of benign credit performance. Credit cycle shifts tend to be abrupt and contagious, so why wait until credit stress becomes palpable? Now is the time for banks to take inventory of their credit stress contingency plans.

Assuming a bank’s underwriting standards are delivering sound loans on the front-end, best practice credit stress contingencies should focus on several critical areas, including:

• Updating loan policies. Regulators frequently use banks’ loan policies as tripwires for criticism, whether due to exception levels or relevance to current lending environments. For example, a bank touting a three-year, interest-only inducement for CRE loans would be out of step with today’s CRE risk environment.
• Assessing industry risk. Technology shifts and changing public policy have elevated industry risk to a level of importance comparable to traditional borrower or entity underwriting. Modern credit assessments must give industry risk equal weight alongside traditional repayment capacity analyses.
• Quantifying CRE market supply and demand. A common thread in recent regulatory orders has been criticism of inadequate supply and demand assessments in markets where CRE products are financed. Because real estate characteristics are inherently local, it’s essential to understand marketplace absorption potential — specifically for the CRE subset being financed (e.g., hospitality, multifamily, or industrial) — regardless of borrower or project risk profile.
• Planning for workout capacity. The long period since the last major credit downturn has resulted in a shortage of experienced credit workout specialists. Now is the time to identify where the bank can obtain this expertise — by developing talent internally or by partnering with external specialists.
• Ensuring board awareness. In a regulatory environment where “if it didn’t appear in board minutes, it didn’t happen,” ensure that boards are kept abreast of both credit risk strategies and contingencies. Specifically, this should be linked to adjustments in risk appetite statements and even potential capital contingency plans.
• Discerning loan growth strategies. As many banks over the past few quarters have assuaged fears over robust loan growth, it’s important to ensure that, even in a heightened credit stress environment, the bank remains in the lending business. Finetuning the underwriting risk lens will help avoid the damaging perception that loans are not being made.

Enhancing the Three Pillars of Post-Booking Credit Risk Management
The time-proven axiom that early detection stems losses still holds true.

Loan-level stress testing: Ensures that whatever the theoretical stress levels calculated, the process renders a practical list of loans/borrowers most at risk under greater stress. Conventions like monitoring covenant compliance and ensuring timely annual and independent review strategies should be prioritized to give adequate attention to these heightened suspects.

Quality loan review: A bank’s credit team must always see loan review as a risk assessment partner. Under greater stress, the scope of the review must be expanded and performed by reviewers with real credit experience.

Portfolio analysis: Banks should mine their non-public loan data vigorously to detect emerging trouble spots early. Waiting for public call report data to determine the bank’s credit risk profile will prove even more costly in a credit downturn.

There is no clear direction on short- to interim-term credit quality trends but the bank’s vigilance toward any future credit risk degradation is essential.