Issues : Risk

Is Your Bank Increasing Its Credit Risk?

9-22-14-Covington.pngOn June 25, 2014, the Office of the Comptroller of the Currency (OCC) released its Semiannual Risk Perspective, which identified key credit risk threats to the safety and soundness of banks. The OCC report stated that while some credit risk metrics (such as noncurrent loans and net charge-offs) showed improvement in 2013, credit risk appeared to be increasing in leveraged loans and auto loan portfolios. Other regulators have expressed similar concerns about the level of credit risk in bank loan portfolios.

The issuance of syndicated leveraged loans (i.e., corporate debt instruments issued to a group of lenders) reached a record high in 2013, driven by an increased risk appetite caused by the low interest rate environment. The OCC’s recent examinations of these and other commercial loan portfolios found that credit policies were being relaxed, largely in response to competitive pressures. Borrowers have increasingly demanded what are known as “covenant lite” leveraged loans, which have fewer covenants and lender protections, and many lenders have responded with more liberal underwriting standards.

Examiners also identified the loosening of credit standards and increased layering of risk (such as increasing collateral advance rates and waiving or loosening guarantees) for indirect auto loans. Average loan-to-value rates for vehicles are now above 100 percent, reflecting rising car prices and a greater bundling of add-on products (such as extended warranties, credit life insurance and aftermarket accessories) into financing. Moreover, the average loss per vehicle has risen substantially.

As a result of these changes in both the leveraged loan and auto loan sectors, the OCC intends to scrutinize banks’ underwriting standards more carefully and is encouraging banks to assess their credit risk appetite.

While the OCC’s report does not foreshadow widespread credit quality issues across the banking industry, bank directors should nonetheless heed the report’s warnings and review credit risk metrics—especially with respect to leveraged loan and auto loan portfolios—to determine whether their banks’ credit risk is trending upward. If credit risk is increasing, the bank should ensure that its risk management program is sufficient to capture and address this increased risk. For example, the bank should review its underwriting criteria to determine the factors that counter-balance the increased risk for these types of loans.

Similarly, the bank should ensure that it has appropriate ongoing monitoring so that action can be taken on individual credits as soon as the bank detects any softening in the borrower’s credit profile. Other functions, such as the bank’s allowance for loan and lease losses (ALLL) and management information systems (MIS), also should be reviewed to ensure that they are supporting the credit risk management function. Any increased credit risk should be reflected in the ALLL and should be monitored through formal MIS reporting.

In developing a risk management program to mitigate credit risk, banks also should pay special attention to guidance from the banking agencies relating to lending, including guidance specifically applicable to leveraged lending and auto lending. In March 2013, for example, the federal banking agencies finalized their interagency leveraged lending guidance, which has imposed greater regulation on such lending. The guidance includes requirements for underwriting, risk rating, credit management, portfolio and pipeline stress testing, as well as problem credit management. More generally, the guidance is quite broad and gives the agencies significant discretion in applying and enforcing its standards. Since last fall, the agencies have been examining banks’ compliance with the guidance. For that reason and because credit risk on these loans is increasing, a bank that is engaged in leveraged lending should monitor its portfolio to ensure compliance with the guidance.

The OCC’s report is a preemptive warning of trends that have the potential to turn into greater concerns. Increased competition and the low interest rate environment have spurred banks to relax leveraged lending and auto lending underwriting standards, and the OCC has observed that these trends may not be reversing in the near future. Bank directors should determine whether their institutions are affected by increased credit risk and, if so, oversee processes to mitigate such risk. By doing so, increases in credit risk can be effectively monitored and addressed without becoming greater problems for the bank down the road.