What the Changing Regulatory Landscape Means for Credit

With one year of the new administration in the books, it’s clear that its broad deregulation philosophy extends to the banking industry. Among the proposed or implemented changes are radical modifications to the Consumer Financial Protection Bureau (CFPB), expedited approval of bank M&A deals, elimination of reputation and climate risk assessments, a reduction of the community bank capital ratio from 9% to 8% and promises of streamlined regulations for nonsystemic banks. 

Perhaps the most impactful of these changes is the volume of vacant federal examiner positions that are not expected to be filled under the Department of Government Efficiency (DOGE)-inspired reductions in the federal workforce. This will likely affect what periodic banking examinations look like going forward. With fewer resources, it can be deduced — and some industry experts with regulatory connection have surmised — that less frequent, fewer on-site, more superficial, call report-triggered exams will result.   

What does all this have to do with credit quality going forward? For starters, it wouldn’t take an industry-wide poll to confirm that these changes are largely welcomed, particularly by community financial institutions that have long felt post-financial crisis reforms failed to distinguish them sufficiently from the mega-banks. However, even skeptics would have to acknowledge that the Dodd-Frank Act’s requirements for more robust risk-avoidance protocols and higher capital levels ushered in one of the longest periods of benign credit performance in modern financial times. 

Thus, some important questions arise: Will less scrutiny enable or encourage riskier lending? Or, assuming acceptable credit quality remains an industry norm, how can banks maintain that standard with less regulatory oversight? These questions carry particular weight given the near-universal understanding that credit cycles don’t last forever, and as indicated, this one is already long in the tooth.

Credit Quality Strategies in a Less Regulated Environment

• While banking, with its regulatory and investor pressures, is not an entirely entrepreneurial enterprise, the premise remains that most bankers manage with an aim toward profitable and high-quality performance. Risky lending runs counter to this; just look back at the wave of bank failures about 15 years ago.
• Many bankers understandably manage to regulatory expectations and view thorough examinations as report cards on performance. With potentially lighter oversight and greater latitude, this may be the time for bankers to seize the moment and manage by their own wits in determining what’s needed to maintain a clean credit portfolio.
• When growing portfolios, be intellectually honest in matching the risks inherent in certain loan types with the skill sets available within the bank to underwrite and service those credits. Boards also play a critical role by setting clear risk appetite statements and strategic plans aligned with institutional capabilities. 
• Now more than ever, given the staffing challenges community financial institutions face in risk management, it’s important to seek and value trusted, competent third-party vendors who can provide cost-efficient expertise to help ensure regulatory compliance. Credible and thorough loan reviews, stress testing and portfolio analysis are among the must-have investments.  
• Avoid ignoring weakening credits. For example, with all the recent talk about repricing walls in commercial real estate (CRE) loans, some bankers — rather than renegotiating at higher current market rates and risking a lower debt service coverage ratio — are opting to extend or renew CRE loans at original terms. This kicking the can down the road approach both leaves money on the table and obscures the true condition of a potentially troubled loan. 
• Whatever credit strategies are employed, remember that nothing is more toxic to boards, regulators or investors than too many credit surprises. These connote possible issues of competence, transparency or both.   

There is understandably broad industry support for the current changing regulatory landscape. However, especially regarding credit quality, it’s prudent to remember that enforcement and economic cycles change, and pendulums swing. In the end, it’s up to bank management and boards to ensure sustainable loan quality. Above all, adherence to safety and soundness principles must remain constant, regardless of the tone or degree of supervisory oversight.