The Return of the Credit Cycle

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It has been like waiting for the second shoe to fall.

The first shoe was the Covid-19 pandemic, which forced the U.S. economy into lockdown mode in March 2020. Many banks prepared for an expected credit apocalypse by setting up big reserves for future loan losses — and those anticipated losses were the second shoe. Sure enough, the economy shrank 31.4% in the second quarter of 2020 as the lockdown took hold, but the expected loan losses never materialized. The economy quickly rebounded the following quarter – growing an astonishing 38% — and the feared economic apocalypse never occurred.

In fact, two and a half years later, that second shoe still hasn’t dropped. To this day, the industry’s credit performance since the beginning of the pandemic has been uncommonly good. According to data from S&P Global Market Intelligence, net charge-offs (which is the difference between gross charge-offs and any subsequent recoveries) for the entire industry were an average of 23 basis points for 2021. Through the first six months of 2022, net charge-offs were just 10 basis points.

Surprisingly, the industry’s credit quality has remained strong even though U.S. economic growth was slightly negative in the first and second quarters of 2022. The Bureau of Economic Analysis, which tracks changes in the country’s gross domestic product, had yet to release a preliminary third quarter number when this article published. However, using its own proprietary model, the Federal Reserve Bank of Atlanta estimated in early October that U.S. GDP in the third quarter would come in at 2.9%.

This would suggest that the industry’s strong credit performance will continue for the foreseeable future. But an increasing number of economists are anticipating that the U.S. economy will enter a recession in 2023 as a series of aggressive rate increases this year by the Federal Reserve to lower inflation will eventually lead to an economic downturn. And this could render a significant change in the industry’s credit outlook, leading to what many analysts refer to as a “normalization of credit.”

So why has bank loan quality remained so good for so long, despite a bumpy economy in 2022? And when it finally comes, what would the normalization of credit look like?

Answering the first question is easy. The federal government responded to the pandemic with two major stimulus programs – the $2.2 trillion CARES Act during President Donald Trump’s administration, which included the Paycheck Protection Program, and the $1.9 trillion American Rescue Plan Act during President Joe Biden’s administration — both which pumped a massive amount of liquidity into the U.S. economy.

At the same time, the Federal Reserve’s Federal Open Market Committee cut the federal funds rate from 1.58% in February 2020 to 0.05% in April, and also launched its quantitative easing policy, which injected even more liquidity into the economy through an enormous bond buying program. Combined, these measures left both households and businesses in excellent shape when the U.S. economy rebounded strongly in the third quarter of 2020.

“You had on one hand, just a spectacularly strong policy response that flooded the economy with money,” says R. Scott Siefers, a managing director and senior research analyst at the investment bank Piper Sandler & Co. “But No. 2, the economy really evolved very quickly on its own, such that businesses and individuals were able to adapt and change to circumstances [with the pandemic] very quickly. When you combine those two factors together, not only did we not see the kind of losses that one might expect when you take the economy offline for some period of time, we actually created these massive cushions of savings and liquidity for both individuals and businesses.”

The second question — what would a normalized credit environment look like? — is harder to answer. Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities, says the bank’s economists are forecasting that the U.S. economy will enter a relatively mild recession in 2023 from the cumulative effects of four rate increases by the Federal Reserve — including three successive hikes of 75 basis points each, bringing the target rate in September to 3.25%. The federal funds rate could hit 4.4% by year-end if inflation remains high, and 4.6% by the end of 2023, based on internal projections by the Federal Reserve.

“There’s obviously a lot of debate around the [likelihood of a] recession today, but generally our view is that we will gradually start seeing [a] normalization and higher credit losses next year, even if it were not for an outright recession,” Poonawala says. While a normalized loss rate would vary from bank to bank depending on the composition of its loan portfolio, Poonawala says a reasonable expectation for the industry’s annualized net charge-off rate would be somewhere between 40 and 50 basis points.

That would be in line with the six-year period from 2014 through 2020, when annual net charge-offs for the industry never rose above 49 basis points. And while loan quality has been exceptional coming out of the pandemic, that six-year stretch was also remarkably good — and remarkably stable. And it’s no coincidence that it coincides with a period when interest rates were at historically low levels. For example, the federal funds rate in January 2014 was just 7 basis points, according to the Federal Reserve Bank of St. Louis’ FRED online database. The rate would eventually peak at 2.4% in July 2019 before dropping back to 1.55% in December of that year when the Federal Reserve began cutting rates to juice a sagging economy. And yet by historical standards, a federal funds rate of even 2.4% is low.

Did this sustained low interest rate environment help keep loan losses low during that six-year run? Siefers believes so. “I don’t think there’s any question that cheap borrowing costs were, and have been, a major factor,” he says.

If interest rates do approach 4.6% in 2023 — which would raise the debt service costs for many commercial borrowers — and if the economy does tip into a mild recession, the industry’s loan losses could well exceed the recent high point of 49 basis points.

“There is a case to be made that a recession could look a bit more like the 2001-02 [downturn] in the aftermath of the dot-com bubble [bursting],” says Poonawala. “You saw losses, but it was an earnings hit for the banks. It wasn’t a capital event.”

That recession lasted just eight months and the decline in GDP from peak to trough was just 0.3%, according to the National Bureau of Economic Research. The industry’s net charge-off ratio rose to an average of 107 basis points in 2002 before dropping to 86 basis points in 2003, 59 basis points in 2004 and bottoming out at 39 basis points in 2006.

This same cyclical pattern repeated itself in 2008 — the first year of the financial crisis – when the average net charge-off rate was 1.30%. The rate would peak at 2.67% in 2010 before declining to 68 basis points in 2013 as the economy gradually recovered.

When we talk about the normalization of credit, what we’re really talking about is the return of the normal credit cycle, where loan losses rise and fall with the cyclical contraction and expansion of the economy. Banks have experienced something akin to a credit nirvana since 2014, but it looks like the credit cycle will reappear in 2023 — aided and abetted by higher interest rates and an economic downturn.

Crafting and Implementing an Effective Loan Review Function

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Performing the loan or credit review function is a regulatory requirement for banks of all sizes and a key credit risk management practice.

Loan review not only helps banks assess emerging risk in their portfolios, but can also protect the institution by identifying loans with potential risk rating downgrades before regulators do. Sometimes called the last or “third line of defense,” an effective loan review function includes a partnership between the loan review staff and the lenders and credit teams that make up the first and second lines of defense to ensure the ongoing constructive monitoring of the bank’s credit quality.

Bank boards have several options when choosing how to implement the commercial credit/loan review function. This includes outsourcing the function to an expert third party loan review service provider, building out their own loan review department internally staffed or blending the two approaches for a hybrid, co-sourced arrangement. Each model has elements and considerations that executives should explore before making final decisions, including the cost to the bank, regulatory expectations, overhead, internal staffing issues and quality of work. Some bank executives are also sensitive to perceptions that institutions above a certain size should internalize the loan review function.

According to high-level members of bank regulatory agencies we have talked with, there is no regulatory expectation for a bank’s loan review model based on the bank’s asset size and no expectation of rotating outsourced loan review providers. The factors most important to the regulators are independence from the internal lending and approving function, the expertise of the loan review analysts, the supportability of loan review’s conclusions and the quality of the entire process. The bank and its board has great freedom to shape the department and its scope to accomplish these objectives.

Outsourced Loan Review
The outsourced loan review model has a number of advantages over internal models. It is almost always the most cost-effective approach. A competent outsourced provider can typically review borrowers in the portfolio more quickly than internal staff, due to their use of best practices and concise analytical approach. Third-party experts usually have deep expertise in a wider range of credit specialty areas, such as commercial real estate segments, agriculture, commercial and industrial, leveraged lending or leasing. An outsourced provider with a broad view of the industry and into similar institutions’ portfolios can add valuable perspective, such as best practices, regulatory intelligence and general peer information. Additionally, the tight labor market has underlined the difficulty of attracting and maintaining staff; loan review departments have had significant issues finding and keeping people. Outsourcing avoids that issue completely, leaving the efforts of hiring, training and retaining competent staff to the provider.

Internal Loan Review
Setting up and maintaining an internal loan review department can help executives build stronger team interaction and relationships within the bank. Internal staff can attend meetings like loan committees and special assets to better understand the bank’s risk appetite. Continuously monitoring the lending portfolio internally can enable the bank to more easily detect shifts in underwriting quality or patterns of emerging risk. A loan review department manager with effective internal staffing can build relationships and set expectations for resolving conflicts. In most cases, the most efficient and effective internal loan review departments use specially developed loan review automation software to enable better staff management, perform more efficient exams and provide consistent results. The competition for seasoned loan review staff can also make effective internal staffing difficult.

Hybrid Loan Review
Using a “hybrid” loan review model where internal staff works with external third-party loan review experts can offer some of the best of both models. Hybrid models can have various configurations: the third party can function like an extension of the internal staff in an arrangement sometimes called “co-sourcing,” or can work independently, reporting to the outsourced provider’s management when working on specific segments of the portfolio. These segments could be the larger or smaller borrower relationships, special problem assets or borrowers in specialized industries or loan types.

The advantages of this model include being able to quickly scale up or down in department size and scope while gaining the benefit of external knowledge from the third-party provider. The hybrid approach works best when all exam work — internal and external — is performed on automated loan review software. Software ensures that the results and findings of the exams are reasonably consistent in nature and the work product and other reports are comprehensive, regardless of whether internal or external resources do the analysis.

Bank boards should leverage loan review resources constructively, no matter what model they choose, being mindful of pitfalls and expense along the way. An effective loan review program protects the bank’s safety and soundness, its customers and shareholders — as well as the board, no matter what model they used.

How America’s Newest Adults are Changing Banking

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Believe it or not, Generation Z is already dipping their toes into the banking world. Are banks ready?

With the oldest Gen Z members reaching their mid-20s, America’s newest adults are starting to generate their own forms of income, graduate from college, budget for large financial decisions and even learn the basics of money management from their favorite TikTok creators. Banks must prepare for this mass generational shift in wealth and personal financing.

For years, financial institutions have adjusted their core offerings to accommodate millennials’ financial preferences and patterns in spending behavior. These 73-million-strong tech-savvy adults have become the most populous generation in U.S. history, surpassing baby boomers.

Entering the job market during the Great Recession, which forced millennials to make more risk-averse spending decisions. With the exception of outstanding student loans, many avoid debt and prioritize spending on life experiences over material possessions to avoid regretting financial decisions down the line.

Millennials are now the largest driver of net new loan demand, according to Morgan Stanley loan forecasts and historical household information. This lending “sweet spot” falls between the ages of 25 and 40, and could persist for to a decade. But seemingly unbeknownst to the majority of banks, Gen Z is nearing — and entering — their early 20s.

It is time for banks to update their reality: America’s youngest adults – Gen Z – are about to age into that lending sweet spot. Combined, millennials and Gen Z will reach the largest generational demographic in the country: 140 million adults whose loyalty to existing financial institutions is very much in flux. This wealth shift will undoubtedly be the impetus for an industry-wise reimaging of consumer banking and lending.

Reports from Morgan Stanley’s population forecasts suggest that Gen Z will comprise of the most populous American generation ever by 2034, with an estimated peak of 78 million. By that time, this generation of “kids” are expected to have increased their aggregated borrowing levels, eventually accounting for a third of all consumer debt in the U.S.

Still thinking of them as kids? It’s understandable, but they could set the tone for how the entire banking industry evolves in the coming years — including your company. When it comes to generational and demographic shifts, there is no recipe for success, especially in banking. However, the tools needed to survive are readily available for the banks that are willing to seize them.

At a bare minimum, banks will need to redesign their legacy systems and offerings by adding digital enhancements, similar to the industry-wide digitization brought on by millennials in recent years. Though the behavioral characteristics of millennials and Gen Z overlap, don’t make the mistake of thinking that they are the same teams playing the same game.

Some Gen Zers are given a smartphone before they are even the age of 10, according to The Harris Poll. Furthermore, those children are allowed to create their own social media accounts by the age of 13, oftentimes earlier. During these formative years, Gen Z kids begin to develop their own personalities, live their own lives and form digital relationships with people, communities and brands alike.

Why does this matter? Because banks have relegated themselves to the adult world, where you must be 18 or older to open your own account. They are losing out on the most influential years of America’s youngest adults — when they begin to associate with their favorite brands and subsequently spend money to engage with them.

The same digitized offerings that banks have spent years formulating for millennials are simply not going to cut it for Gen Z. Banks will need to redefine the concept of “traditional” banking and create a “neo-normal” standard if they have any hopes of engaging this massively influential generation of young Americans. Don’t simply market differently to them. It’s time to shift the strategy – design differently for them.

Gen Z isn’t just about TikTok dance challenges and viral memes. Most of them were seeking answers to their curiosities via search engines around the same age we were reading “Curious George.” This generation is the most diverse and well educated to date, and they are very keen on being treated like adults — especially when it comes to managing their personal finances. How does your bank plan to greet them?

Using Profitability to Drive Banker Behavior

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There used to be a perception that bankers found it tough to innovate because they are largely left-brained, meaning they tend to be more analytical and orderly than creative right brainers. While this may have been true for the founding fathers of this industry, there’s no question that bankers have been forced into creativity to remain competitive.

It could have been happenstance, natural evolution, or the global financial crisis of 2008 — it doesn’t matter. Today’s bankers are both analytical and creative because they have had to find new, more convenient pathways to profitability and use those insights for continuous coaching.

The current economic landscape may require U.S. banks to provision for up to $318 billion in net loan losses from 2020 to 2022, the Deloitte Center for Financial Services estimates. These losses are expected to be booked in several lending categories, mainly driven by the pandemic’s domino effect on small businesses, income inequality and the astounding impact of women leaving the workforce pushing millions into extreme poverty. Additionally, net interest margins are at an all-time low. Deloitte forecasts that U.S. commercial banks won’t see revenues or net income reach pre-pandemic levels until 2022.

In the interim, bankers are still under pressure to perform and increase profitability. Strong performance is possible — economic “doom and gloom” isn’t the whole story. In fact, the second-largest bank in America is projecting loan growth in 2021, of all years, after six years of decline. These industry challenges won’t last forever. so preparation is key. One of the first steps in understanding profitability is establishing if your bank’s business model is transactional, relational or a mix of the two, then answering these questions:

  • How much does a loan pay for the use of funds? How much does a deposit receive for the use of funds?
  • How much does a loan pay for the current period and identified level of credit risk?
  • How much capital does the bank need to assign to the loan or deposit?
  • What are the appropriate fees for accounts and services used by our clients?
  • What expenses are allocated to a product to determine its profitability?

There should never be a question about why loans need to pay for funds. The cash a bank provides for a loan comes from one of three sources: capital investments, debt and borrowing or client deposits.

From there, bankers have shown incredible creativity and innovation in adopting simpler, faster ways to better understand their bank’s profitability, especially through sophisticated technologies that can break down silos by including all clients, products and transactions in a single database. By comparison, legacy databases can leave digital assets languishing in inaccessible and expensive silos. Bankers must view an entire client relationship to most accurately price the relationship.

This requires a mindset shift. Instead of thinking about credit structure — the common approach in the industry – to determine relationship pricing, think instead about the client relationship holistically and leave room to augment as necessary. Pricing models should reflect your bank’s profitability calculations, not adjusted industry average models. And clients will need a primary and secondary owner to break down silos and ensure they receive the best experience.

How does any of this drive optimal banker behavior? A cohesive, structurally sound system that allows bankers to better understand profitability via one source of the truth allows them to review deal performance every six months to improve performance. Further, a centralized database allows C-suite executives to literally see everything, forging connections between their initiatives to banker’s day-to-day actions. It creates an environment where bankers can realize opportunities through execution, accountability and coaching, when necessary.

Can the Industry Handle the Truth on Credit Quality?

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Maybe Jack Nicholson was right: “You can’t handle the truth!”

The actor’s famous line from the 1992 movie “A Few Good Men” echoes our concern on bank credit quality in fall 2019 and heading into early 2020.

Investors have been blessed with record lows in credit quality: The median ratio of nonperforming assets (NPA) is nearly 1%, accounting for nonperforming loans and foreclosed properties, a figure that modestly improved in the first half of 2019. Most credit indicators are rosy, with limited issues across both private and public financial institutions.

However, we are fairly certain this good news will not last and expect some normalization to occur. How should investors react when the pristine credit data reverts to a higher and more-normalized level?

The median NPA ratio between 2004 and 2019 peaked at 3.5% in 2011 and hit a record low of 60 basis points in 2004, according to credit data from the Federal Deposit Insurance Corp. on more than 1,500 institutions with more than $500 million in assets. It declined to near 1% in mid-2019. Median NPAs were 2.9% of loans over this 15-year timeframe. The reversion to the mean implies over 2.5 times worse credit quality than currently exists. Will investors be able to accept a headline that credit problems have increased 250%, even if it’s simply a return to normal NPA levels?

Common sense tells us that investors are already discounting this potential future outcome via lower stock prices and valuation multiples for banks. This is one of many reasons that public bank stocks have struggled since late August 2018 and frequently underperform their benchmarks.

It is impressive what banks have accomplished. Bank capital levels are 9.5%, 200 basis points higher than 2007 levels. Concentrations in construction and commercial real estate are vastly different, and few banks have more than 100% of total capital in any one loan category. Greater balance within loan portfolios is the standard today, often a mix of some commercial and industrial loans, modest consumer exposure, and lower CRE and construction loans.

Median C&I problem loans at banks that have at least 10% of total loans in the commercial category — more than 60% of all FDIC charters — showed similar trends to total NPAs. The median C&I problem loan levels peaked at 4% in late 2009 and again in 2010; it had retreated to 1.5%, as of fall 2019. The longer-term mean is greater due to the “hockey stick” growth of commercial nonaccrual loans during the crisis years spanning 2008 to 2011, as well as the sharp decline in C&I problem loans in 2014. Over time, we feel C&I NPAs will revert upward, to a new normal between 2% to 2.25%.

Public banks provide a plethora of risk-grade ratings on their portfolios in quarterly and annual filings, following strong encouragement from the Securities and Exchange Commission to provide better credit disclosures. The nine-point credit scale consists of “pass” (levels 1 to 4), “special mention/watch” (5), “substandard” (6), “nonperforming” (7), “doubtful” (8) and “loss” (9, the worst rating).

They define a financial institution’s criticized assets, which are loans not rated “pass,” indicating “special mention/watch” or worse, as well as classified assets, which are rated “substandard” or worse. The classified assets show the same pattern as total NPAs and C&I problem loans: low levels with very few signs of deterioration.

The median substandard/classified loan ratio at over 300 public banks was 1.14% through August 2019. That compared to 1.6% in fall 2016 and 3.4% in early 2013. We prefer looking at substandard credit data as a way to get a deeper cut at banks’ credit risk — and it too flashes positive signals at present.

The challenge we envision is that investors, bankers and reporters have been spoiled by good credit news. Reversions to the mean are a mathematical truth in statistics. We ultimately expect today’s good credit data to revert back to higher, but normalized, levels of NPAs and classified loans. A doubling of problem credit ratios would actually just be returning to the historical mean. Can investors accept that 2019’s credit quality is unsustainably low?

We believe higher credit problems will eventually emerge from an extremely low base. The key is handling the truth: An increase in NPAs and classified loans is healthy, and not a signal of pending danger and doom.

As the saying goes: “Keep Calm and Carry On.”