Taking a hard look at your financial institution’s challenges can help you fine-tune your approach in the coming year and beyond. With that in mind, here is a review of some of the key developments from this year.
CRE Crisis Lingers for Community Banks
With interest rates falling, some banks are beginning to exhale over the risk in their commercial real estate (CRE) portfolios. Many smaller banks may even consider the CRE bullet dodged.
Unfortunately, the CRE sector still faces a potential crisis, with lower‐rate loans set to mature or reset in early 2025. The Federal Reserve seems reticent to lower interest rates quickly enough to change that. Exposure to high-risk CRE very much depends on geography, underwriting, CRE sector, a building’s square footage and loan size. That said, a recent study by the Federal Reserve Bank of Kansas City reported that essentially the bigger an office building is, the higher the chance that the borrower will default. This suggests that the largest banks will face the most exposure to the highest-risk properties.
Even though the headwinds may be weakening, there will still be a normalization of CRE loans for most banks; prudent risk management is a necessity. Concentration management and stress testing are proven credit management practices to apply now.
M&A Trending Up
According to a KPMG survey, 70% of private equity (PE) firms expect more bank M&A in 2024 than in 2023, while 49% of corporates said the same. Eighty-four percent of PE firms anticipate more deals in 2025 than 2024, compared with 48% for corporates.
Ardmore advises clients looking at possible M&A to start with a strengths, weaknesses, opportunities and threats (SWOT) analysis of the proposed acquisition. Be thorough and comprehensive without getting lost in the weeds. Get an understanding of the target’s credit culture and credit administration practices. Conduct thorough due diligence on the loan portfolio’s creditworthiness. Most bank failures include risky loan portfolios.
Loan Review and Credit Risk
The loan review function in most commercial banks is a key part of proactive credit risk management.
By employing common credit risk analytic techniques for concentration management, portfolio stress testing and analysis of key financial ratios when creating the loan review sample, loan review departments can bring more value to management and more advanced control of emerging risks.
Pockets of credit risk can be buried in loan portfolios. Using basic analytics, loan review can help find that risk. Management and the board must explore how risk can potentially escalate and ensure that they’re ready to manage it proactively and minimize losses. If your bank’s loan review department is ineffective at identifying emerging risk, you’re wasting an opportunity to protect the bank.
Climate-Related Credit Risk
Regulators are increasingly viewing climate risk as credit risk. While regulators are not considering the carbon footprint or environmental impact that a potential lender can create, they are asking banks to consider whether a flood, earthquake or wildfire could render borrowers ineffective or delinquent.
Smaller institutions can begin to show awareness of this emerging credit risk in their portfolios using common credit risk techniques like concentration management and available free resources like the Federal Emergency Management Association’s National Risk Index scores, that rank risk of natural disasters by county and census tract. This process is rapidly becoming part of the fabric of credit risk management for banks of all sizes, and is of growing interest to bank management, boards and even customers.
Artificial Intelligence Growth Slowing at Many Banks
Artificial intelligence (AI), particularly generative AI adoption, is becoming widespread across all sizes of financial institutions.
While most smaller institutions can identify valuable potential uses for AI tools, identifying and locating data needed and extracting and organizing it safely, has proven to be a major stumbling block — often ending projects before they begin.
Regulators are increasing their scrutiny of AI models and projects, expecting that banks show transparency, human oversight, accountability, non‐discrimination and fairness as well as privacy and data governance in their AI use cases.
Many smaller banks that consider themselves AI fast followers are pumping the breaks in late 2024, while others are opting out altogether and waiting for easier, cheaper technology solutions and clearer regulatory guidance before restarting their AI projects. It may be a few years until many of the smaller banks choose to make AI a priority.