In 1978, David Ruffin got his first mortgage. The rate was 12% and he thought it was a bargain.
Not many people who remember those days are working in the banking industry, and that’s a concern. Ruffin, who is 74 years old, still is combing through loan files as an independent loan reviewer and principal of IntelliCredit. And he has a stark warning for bankers who haven’t seen a rising interest rate environment, such as this one, in more than 40 years.
“Credit has more hair on it than you would want to acknowledge,” Ruffin said recently at Bank Director’s Bank Audit & Risk Conference. “This is the biggest challenge you’re going to have in the next two to three years.”
Borrowers may not be accustomed to higher rates, and many loans are set to reprice. An estimated $270.4 billion in commercial mortgages held at banks will mature in 2023, according to a recent report from the data and analytics firm Trepp.
Nowadays, credit risk is low on the list of concerns. The Office of the Comptroller of the Currency described credit risk as moderate in its latest semiannual risk perspective, but noted that signs of stress are increasing, for example, in some segments of commercial real estate. Asset quality on bank portfolios have been mostly pristine. In a poll of the audience at the conference, only 9% said credit was a concern, while 51% said liquidity was.
But several speakers at the conference tried to impress on attendees that risk is buried in loan portfolios. Loan review can help find that risk. Management and the board need to explore how risk can bubble up so they’re ready to manage it proactively and minimize losses, he said. “The most toxic thing you could fall victim to is too many credit surprises,” he said.
Some banks, especially smaller ones, outsource loan review to third parties or hire third parties to independently conduct loan reviews alongside in-house teams. Peter Cherpack, a partner and executive vice president of credit technology at Ardmore Banking Advisors, is one of those third-party reviewers. He says internal loan review departments could be even more useful than they currently are.
“Sometimes [they’re] not even respected by the bank,” he says. “It’s [like] death-and-taxes. If [loan reviewers are] not part of the process, and they’re not part of the strategy, then they’re not going to be very effective.”
He thinks loan review officers shouldn’t report to credit or lending chiefs; instead, they should report directly to the audit or risk committee. The board should be able to make sense of their conclusions, with highlights and summaries of major risks and meaningful conclusions. Their reports to the board shouldn’t be too long — fewer than 10 pages, for example — and they shouldn’t just summarize how much work got done.
Loan review should communicate and collaborate with departments such as lending to find out about risk inside individual industries or types of loans, Cherpack says. “They should be asking [the loan department]: ‘What do you see out there?’ That’s the partnership that’s part of the three lines of defense.”
He adds, “if all they’re doing is flipping files, and commenting on underwriting quality, that’s valuable, but it’s in no way as valuable as being a true line of defense, where you’re observing what’s going on in the marketplace, and tailoring your reviews for those kinds of emerging risks.”
Many banks are stress testing their loan portfolios with rising rates. Cherpack suggests loan review use those results to adjust their reviews accordingly. For instance, is the bank seeing higher risk for stress in the multifamily loan portfolio? What about all commercial real estate loans that are set to reprice in the next six to 18 months?
“If [loan review is] not effective, you’re wasting money,” Cherpack says. “You’re wasting opportunity to protect the bank. And I think as, as a director, you have a responsibility to make sure the bank’s doing everything it should be doing to protect its shareholders and depositors.”
Carlyn Belczyk is the audit chair for the $1.6 billion Washington Financial Bank in Washington, Pennsylvania. She said the mutual bank brings in a third-party for loan review twice a year. But Cherpack’s presentation at the conference brought up interesting questions for her, including trends in loans with repricing interest rates or that were made with exceptions to the bank’s loan policy. “I’m fairly comfortable with our credit, our loan losses are minimal, and we probably err on the side of being too conservative,” she said.
Ruffin doesn’t think coming credit problems will be as pronounced as they were during the 2007-08 financial crisis, but he has some words of advice for bank boards: “Weak processes are a telltale sign of weaknesses in credit.” he said.
Historically, periods of high loan growth lead to the worst loan originations from a credit standpoint, Ruffin said.
“We do an unimpressive job of really understanding what’s sitting in our portfolio,” he said.
This article has been updated to correct Ruffin’s initial mortgage rate.