Credit Quality Indicators for a Unique Cycle

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“Bring back burn downs!”

This is a frequent request via phone or email since Silicon Valley Bank and Signature Bank failed in early March. Burn downs are statistical models generated during the 2007-08 financial crisis that recorded credit cycle losses on banks’ loan portfolios and determined what was left over after loans, reserves and capital were “burned down” for credit losses.

As a survivor of the financial crisis era, burn down models were not a pleasant experience for either the bank or the research analyst. Massive valuation deterioration and losses exceeded most banks’ capital and reserves, due to excess leverage from the credit extended on land and other construction properties. Weak earnings meant bank cash flows were little help to the credit recognition process. It was a terrible feedback loop that I prefer to forget. Perhaps forgetting is not realistic, since memory and learning from mistakes should be an analyst’s top skills.

Loan Loss Modeling
When the Covid-19 shutdown first unfolded in March 2020, Janney’s research team developed a new credit risk model to address how many loans could go bad and what losses should be assigned to these possible problem loans. We tried to be thoughtful: Not all loans would go bad. We argued that out of 100 loans, there were 10 to 15 that would have problems; many of those could be addressed in advance and often at small losses. Janney’s 2020 loss expectations were 2% to 3% across-the-cycle loss rates for banks. Fortunately, the Janney model proved fairly accurate, and actual losses were significantly less than we thought.

In 2023, we have a new credit cycle unfolding with three failed banks, a presumed recession starting soon and explosive predictions of commercial real estate loan losses galore. Hotel worries from 2020 have been replaced by office CRE in 2023 — credit mayhem is here! What should banks do to get ahead of the credit risk recognition cycle? How do banks ease investors’ fears of a charge-off surge and reduction in tangible book value per share? Bank management teams should take each issue seriously and address them immediately.

Updated Playbook
First, bank executives must speak clearly and plainly about their wide open disclosure on pass versus non-pass risk ratings that are standard in quarterly and episodic public filings, such as 8-Ks. The Federal Deposit Insurance Corp. still redacts these disclosures in call reports — public banks have a chance to provide investors with real data.

Given these disclosures, criticized loans are better understood in 2023 than in 2008. The 2.5% to 3% of non-pass rated loans at banks today are a fraction of criticized loans in 2009 and 2010. We encourage companies to disclose their criticized levels from 2009 and prior, which hit highs in the range of 10% to 12%. Investors may appreciate how bad it was then and how fortunate banks are today facing modest credit issues.

Next, we encourage bank managers to explain their long-run experience that loan defaults are limited, which can help combat investor negativity toward problem loans. Begin with statistical proof that supports how most loans are good and will repay as agreed. Then, share how your company mitigates potential problems in advance of a default or rating change to non-pass, including special mention or substandard rating.

Most investors have no idea how often loans encounter issues that are addressed by management long before becoming a charge-off. This leads to more reserves assigned to loans, broader loan categories and ultimately reduced loss exposure.

Finally — and perhaps most importantly — preach and shout about underwriting that features less leverage today compared to past cycles. Today’s loans have more equity, lower loan-to-value ratios and less dirt (little to no raw land) versus the similar loans made 15 years ago in the run up to the financial crisis. It is imperative that banks make explicit comparisons between a 2023 loan and a 2008 loan: how each could be resolved and what loss expectation occurs from each credit cycle. To analogize, investors and analysts tend to be from Missouri: “Show us!”

The bottom line is that credit issues in 2023-24 do exist. Banks must take ownership of current credit problems they may encounter and determine how they can be swiftly resolved and at what cost. Loss content should be far lower; providing specific data and examples will be critical to repairing the lost confidence from the recent bank failures.

Compensation Lessons in a Banking Crisis

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Between March 10 and May 1, three regional U.S. banks failed. How were these bank failures similar, or different, than the bank failures of the Great Recession? We already know that there will be more regulatory pressure on banks, but what lessons can these failures teach directors about compensation? First, it is important to compare the Great Recession to the 2023 banking crisis.

Credit Versus Liquidity
The Great Recession was defined by a general deterioration in loan credit quality, incentive compensation that overly focused on loan production and a lack of a risk review process that incorporated the role incentives and compensation governance played.

Contrast that to 2023: Banks have upgraded credit processes and their risk review processes to evaluate the role of incentive compensation under the 2010 regulatory guidance of sound incentive compensation policies. Unfortunately, the banks that failed did not have enough liquidity to cover depositors who desired to move their money.

General Versus Unique
The three failed banks had unique patterns that responded dramatically to the increase in interest rates by the Federal Reserve and complicated each firm’s ability to fulfill depositor withdrawals. Silicon Valley Bank’s bond portfolio was long duration, and First Republic had a material portion of its portfolio tied to long-term residential mortgages. In contrast to the Great Recession, this banking crisis has more to do with business model and treasury management than actions of mortgage or commercial lenders.

Poor Risk Review
This is one area of commonality between the Great Recession and 2023. The Federal Reserve’s postmortem report on Silicon Valley Bank noted that the institution’s risk review processes were lacking. Specifically, the bank’s incentive plans lacked risk measures, and their incentive compensation risk review process was below expectations of a $200 billion bank.

“The incentive compensation arrangements and practices at [Silicon Valley Bank] encouraged excessive risk taking to maximize short-term financial metrics,” wrote the Fed in its postmortem report. This is a responsibility of the board of directors: Examiners review the board’s incentive risk review process as a part of their effectiveness evaluation, as well as a foundational principle of sound incentive compensation policies.

Going Forward
Lessons for the compensation committee must include considerations for what should be in place now versus what committees should be thinking about going forward. The compensation committee should have a robust process in place that examines all incentive compensation programs of the bank in accordance with regulatory guidance.

This process should evaluate each incentive compensation plan according to risk and reward, and monitor how each plan is balanced through risk mitigating measures. In addition, the incentive review process should be governed by a sound overall incentive compensation governance structure.

This structure is anchored by the compensation committee and works with a management incentive compensation oversight committee. It should dictate how plans are approved, how exceptions to plans are made and when the compensation committee is brought in for review and approval. As an example, if a major change is made to a commercial lender incentive compensation plan midyear, what is the process to review and ultimately approve the midyear change? Regulators expect those processes to exist today.

But all crises present new learnings to apply to the future. While there are a number of lessons related to a bank’s business model and treasury management, there are also takeaways for the compensation committee.

Going forward, banks need to move their mindset from credit risk mitigators to overall risk mitigators in incentive compensation. Credit risk metrics are often found within executive incentive plans as a result of the Great Recession. Banks should think how they can incorporate overall risk mitigators, beyond credit risk, and how those mitigators could affect executive incentive plans.

A risk modifier could cover risk issues such as credit, legal, capital, operational, reputational and liquidity risk factors. If all these risks rated “green,” the risk modifier would be at 100%; however, if credit or liquidity turned “yellow” or “red,” this modifier could apply a decrement to the annual incentive plan payout. In this way, a compensation committee can review all pertinent risks going forward and help ensure incentive compensation balances risk and reward.

As Interest Rates Rise, Loan Review Gets a Second Look

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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.”

Be Independent
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.

Collaborate
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.”

Targeted Reviews
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.

Managing Credit Risk Without Overburdening Resources

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Increased labor costs and related challenges such as talent acquisition have affected all industries, including banks. Additionally, banks are facing potential deteriorating credit quality, growth challenges amid tightening credit standards and increased scrutiny from regulators and auditors.

Loan origination, portfolio management and credit quality reviews are key areas to successfully managing increasing credit risk. It’s critical that banks understand their risk appetite and credit risk profile prior to making any changes in these areas. You should also discuss any material changes you plan to implement with your regulatory agencies and board, to ensure these changes don’t create undue risks.

Lending
Originating new loans doesn’t have to be cumbersome and complex for both the bank and the client. The risk and rewards are a delicate balancing act. And not all loans require the same level of due diligence or documentation.

Banks might want to consider establishing minimum loan documentation requirements and underwriting parameters based on loan amounts. This can put them at a competitive advantage compared to financial institutions requiring more documentation that can increase the loan processing time.

Centralizing the loan origination process for less complex and smaller loan amounts can streamline the workflow, potentially helping with consistency and efficiency and allow less-experienced staff to process loans.

Automation may be useful if your bank has a high volume of loan origination requests. The board should consider conducting, or hiring a consultant to complete, a cost-benefit analysis that could consider automating various aspects of the underwriting process. You may find automation is not only cost effective but might reduce human errors and improve consistency in credit decisions.

Portfolio Management
Ongoing management of the loan portfolio also doesn’t have to be time consuming. Not all loans are created equal or create equal risk for the bank; ongoing management should correspond to the risk of the loan portfolio. Consider evaluating the frequency of the internal loan reviews based on various risk attributes, including risk ratings, loan amounts and other financial and non-financial factors.

Internal Credit Reviews
An annual internal credit review might be all that’s necessary for loans that have lower risk attributes, such as small-dollar loans, loans secured by readily liquid collateral and loans with strong risk ratings. Banks should instead conduct more-frequent internal reviews on larger loans, loans in higher-risk industries, highly leveraged loans, marginal performing loans and adversely risk rated loans.

When completing frequent reviews, focus on key ratios relevant to the borrower and monitor and identify financial trends. An internal review doesn’t necessarily require the same level of analysis as an annual review or effort performed at loan origination.

Payment performance or bulk risk rating could be an alternative for banks that have a high volume of small-dollar loans. These types of loans are low risk, monitored through frequent reporting that uses payment performance and require minimal oversight.

Finally, centralizing the portfolio management might be appropriate choice for a bank and can create efficiencies, consistencies in evaluation and reduce overhead expenses.

Credit Quality Reviews
From small borrowers to national corporate clients, there are many creative ways that banks can achieve loan coverage in credit quality reviews while retaining the ability to identify systemic risks.

Banks can accomplish this through a risk-based sampling methodology. Rather than selecting a single risk attribute or a random sample within the loan population, you may be able to get the same portfolio coverage and identify risks with the following selection process. Focus on selecting credits that have multiple risk attributes, such as:

  • Borrowers with large loan commitments, high line usage, unsecured or high loan-to-value, adversely risk rated and high-risk industries.
  • Select credits with a mix of newly originated and existing loans, new underwriters and relationship managers, various loan commitment sizes and property types and collateral.

Consider credits within the Pass range that may have marginal debt service coverage ratios — typically the most common multiple risk attributes for identifying risk rating discrepancies — or are highly leveraged, unsecured or lack guarantor support.

Targeted Review
More targeted reviews can offer banks additional portfolio coverage. These types of reviews require less time to complete, giving institutions the ability to also identify systemic trends. Below are some things to consider when selecting a targeted review.

  • Select a sample of loans with multiple risk attributes and confirm the risk ratings by reviewing the credit write-up for supporting evidence and analysis.
  • Complete a targeted review of issues identified in the previous risk-based sampling reviews.

Finally, for banks that have recently acquired a loan portfolio, review the two banks’ credit policies and procedures and determine where the are differences. Select loans that are outliers or don’t meet the acquirer’s loan risk appetite.

Commercial Real Estate Threatens to Crack Current Calm

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While credit quality at banks remains high, it may not stay there. 

At the end of the year, noncurrent and net charge-off rates at the nation’s banks had “increased modestly,” but they and other credit quality metrics remained below their pre-pandemic levels, according to the Federal Deposit Insurance Corp. However, rising interest rates have made credit more expensive for borrowers with floating rate loans or loans that have a rate reset built into the duration. 

Commercial real estate, or CRE, is of particular focus for banks, given changes to some types of CRE markets since the start of the pandemic, namely office and retail real estate markets. Rising interest rates have increased the monthly debt service costs for some CRE borrowers. An estimated $270.4 billion in commercial mortgages held at banks will mature in 2023, according to a March report from Trepp, a data and analytics firm. 

“If you’ve been able to increase your rents and your cash flow, then you should be able to offset the impact of higher financing costs,” says Jon Winick, CEO of Clark Street Capital, a firm that helps lenders sell loans. “But when the cash flow stays the same or gets worse and there’s a dramatically higher payment, you can run into problems.”

Some buildings are producing less income, in the form of leases or rent, and their values have declined. Office and traditional retail valuations may have fallen up to 40% from their purchase price, creating loan-to-value ratios that exceed 100%, Chris Nichols, director of capital markets for SouthState Bank, pointed out in a recent article. SouthState Bank is a unit of Winter Haven, Florida-based SouthState Corp., which has $44 billion in assets. If rates stay at their mid-April levels, some office building borrowers whose rates renew in the next two years could see interest rates grow 350 to 450 basis points from their initial level, Nichols writes, citing Morgan Stanley data.  

JPMorgan & Co.’s Chairman and CEO Jamie Dimon said during the bank’s first quarter 2023 earnings call that he is advising clients to fix exposure to floating rates or address refinance risk.

“People need to be prepared for the potential of higher rates for longer,” he said.

Banks are the largest category of CRE lenders and made 38.6% of all CRE loans, according to Moody’s Analytics. Within that, 9.6% of those loans are made by community banks with $1 billion to $10 billion in assets. CRE exposure is highest among banks of that size, making up over 24% of total assets at the 829 banks that have between $1 billion and $10 billion in assets. It’s high for smaller banks too, constituting about 18.3% of total assets for banks with $100 million to $1 billion in assets. 

“Not surprisingly, we’re seeing delinquency rates for office loans starting to increase. … [It’s] still moderately low, but you can see the trend has been rising,” says Matthew Anderson, managing director of applied data and research at Trepp, speaking both about year-end bank data and more current info about the commercial mortgage-backed securities market. He’s also seen banks begin increasing their credit risk ratings for CRE segments, notably in the office sector.

Bank boards and management teams will want to avoid credit surprises and be prepared to act to address losses. Anderson recommends directors at banks with meaningful CRE exposure start getting a handle on the portfolio, the borrowers and the different markets where the bank has exposure. They should also make sure their risk ratings on CRE credits are up-to-date so the bank can identify potential problem credits and workout strategies ahead of borrower defaults. 

They will also want to consider their institution’s capacity for working out troubled credits and explore what kind of pricing they could get for loans on the secondary market. While banks may have more capital to absorb losses, Winick says they may not have the staffing to manage a large and rapid increase in troubled credits. 

Working ahead of potential increases in credit losses is especially important for banks with a concentration in the space, which the FDIC defines as CRE that makes up more than 300% of a bank’s total capital or construction loans in excess of 100% of total capital.

“If a bank has a CRE concentration, they’re definitely going to get more scrutiny from the regulators,” Anderson says. “Any regulator worth their salt is going to be asking pointed questions about office exposure, and then beyond that, interest rate exposure and refinancing risk for all forms of real estate.”

Risk issues like these will be covered during Bank Director’s Bank Audit & Risk Conference in Chicago June 12-14, 2023.

Finding Opportunities in a Rising Interest Rate Environment

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Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.

Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.

For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.

Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.

Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.

Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.

So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.

Hazy Outlook for Bank M&A in 2023

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The bank M&A landscape in 2023 will likely be affected by several factors, including concerns about credit quality and turmoil in the stock market, says Rick Childs, partner at Crowe LLP. While sellers will naturally want to get the best price possible, rising interest rates and weak bank stock valuations will impact what buyers are willing to pay. Bankers that do engage in dealmaking will need to exercise careful due diligence to understand a seller’s core deposits and credit risk. Concern about the national economy could prompt bankers to look more closely at in-market M&A, when possible. 

Topics include: 

  • Credit Quality 
  • Customer Communication 
  • Staff Retention
  • Impact of Stock Valuations 

The 2023 Bank M&A Survey examines current growth strategies, including expectations for acquirers and what might drive a bank to sell, and provides an outlook on economic and regulatory matters. The survey results are also explored in the 1st quarter 2023 issue of Bank Director magazine.

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.

Bank Compensation Survey Results: Findings Released

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NASHVILLE, TENN., June 21, 2022 – Bank Director, the leading information resource for directors and officers of financial institutions nationwide, today released the results of its 2022 Compensation Survey, sponsored by Newcleus Compensation Advisors. The findings confirm that intensifying competition for talent is forcing banks to pay up for both new hires and existing employees.

The 2022 Compensation Survey finds that 78% of responding directors, human resources officers, CEOs and other senior executives of U.S. banks say that it was harder in 2021 to attract and keep talent compared to past years. In response to this increased pressure, 98% say their organization raised non-executive pay in 2021, and 85% increased executive compensation. Overall, compensation increased by a median 5%, according to participants.

“Banks are challenged to find specialized talent like commercial lenders and technology personnel, but they’re also struggling to hire branch staff and fill entry-level roles,” says Emily McCormick, Bank Director’s vice president of research. “In this quest for talent, community banks are competing with big banks like Bank of America Corp., which recently raised its minimum wage to $22 an hour. But community banks are also competing against other industries that have been raising pay. How can financial institutions stand out as employers of choice in their markets?”

Asked about specific challenges in attracting talent, respondents cite an insufficient number of qualified applicants (76%) and unwillingness among candidates to commute for at least some of their schedule (28%), in addition to rising wages. Three-quarters indicate that remote or hybrid work options are offered to at least some staff.

“It is obvious from the survey results that talent is the primary focus for community banks,” says Flynt Gallagher, president of Newcleus Compensation Advisors. “Recruiting and retaining talent has become a key focus for most community banks, surpassing other concerns that occupied the top spot in prior surveys — namely tying compensation to performance. It is paramount for community banks to step up their game when it comes to understanding what their employees value and improving their reputation and presence on social media. Otherwise, financial institutions will continue to struggle finding and keeping the people they need to succeed.”

Key Findings Also Include:

Banks Pay Up
Banks almost universally report increased pay for employees and executives. Of these, almost half believe that increased compensation expense has had an overall positive effect on their company’s profitability and performance. Forty-three percent say the impact has been neutral.

Commercial Bankers in Demand
Seventy-one percent expect to add commercial bankers in 2022. Over half of respondents say their bank did not adjust its incentive plan for commercial lenders in 2022, but 34% have adjusted it in anticipation of more demand.

Additional Talent Needs
Banks also plan to add technology talent (39%), risk and compliance personnel (29%) and branch staff (25%) in 2022. Respondents also indicate that commercial lenders, branch and entry-level staff, and technology professionals were the most difficult positions to fill in 2020-21.

Strengthening Reputations as Employers
Forty percent of respondents say their organization monitors its reputation on job-posting platforms such as Indeed or Glassdoor. Further, 59% say they promote their company and brand across social media to build a reputation as an employer of choice, while just 20% use Glassdoor, Indeed or similar platforms in this manner. Banks are more likely to let dollars build their reputation: Almost three-quarters have raised starting pay for entry-level roles.

Low Concerns About CEO Turnover
Sixty-one percent of respondents indicate that they’re not worried about their CEO leaving for a competing financial institution, while a third report low to moderate levels of concern. More than half say their CEO is under the age of 60. Respondents report a median total compensation spend for the CEO at just over $600,000.

Remote Work Persists
Three quarters of respondents say they continue to offer remote work options for at least some of their staff, and the same percentage also believe that remote work options help to retain employees. Thirty-eight percent of respondents believe that remote work hasn’t changed their company’s culture, while 31% each say it has had either a positive or negative impact.

The survey includes the views of 307 independent directors, CEOs, HROs and other senior executives of U.S. banks below $100 billion in assets. Compensation data for directors, non-executive chairs and CEOs was also collected from the proxy statements of 96 publicly traded banks. Full survey results are now available online at BankDirector.com.

About Bank Director
Bank Director reaches the leaders of the institutions that comprise America’s banking industry. Since 1991, Bank Director has provided board-level research, peer-insights and in-depth executive and board services. Built for banks, Bank Director extends into and beyond the boardroom by providing timely and relevant information through Bank Director magazine, board training services and the financial industry’s premier event, Acquire or Be Acquired. For more information, please visit www.BankDirector.com.

About Newcleus
Newcleus powers organizations as the leading designer and administrator of compensation, benefit, investment and finance strategies. The personalized product selections, carrier solutions and talent retention programs are curated to optimize benefits and improve ROI. www.newcleus.com.

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For more information, please contact Bank Director’s Director of Marketing, Deahna Welcher, at [email protected].

Advice to Bank Directors: Don’t Be Reactive on Credit Quality

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With credit quality metrics at generationally stellar levels, concern about credit risk in 2022 may seem unwarranted, making any deployed defensive strategies appear premature.

For decades, banking has evolved into an orientation that takes most of its risk management cues from external stakeholders, including investors, trusted vendors, market conditions — and regulators in particular. Undoubtedly, becoming defensive prematurely can add challenges for management teams at a time when loan growth is still a main strategic objective. But waiting until credit metrics pivot is sure to add risk and potential pain. Banks have four key reasons to be more vigilant in 2022 and the next couple of years. These, and the suggested steps that prudent management teams should take in their wake, are below.

1. The Covid-19 sugar high has turned sour.
All of the government largesse and regulatory respites in response to Covid-19 helped unleash 40-year-high inflation levels. In response, the Federal Reserve has begun ramping up interest rates at potential intervals not experienced in decades. These factors are proven to precede higher credit stress. Continuing supply chain disruptions further contribute and strengthen the insidious inflation psychology that weighs on the economy.

Recommendation: Bankers must be more proactive in identifying borrowers who are particularly vulnerable to growing marketplace pressures by using portfolio analytics to identify credit hotspots, increased stress testing and more robust loan reviews.

2. Post-booking credit servicing is struggling across the industry.
From IntelliCredit’s perspective, garnered through conducting current loan reviews and merger and acquisition due diligence, the post-booking credit servicing area is where most portfolio management deficiencies occur. Reasons include borrowers who lag behind in providing current financials or — even worse — banks experiencing depletions in the credit administration staff that normally performs annual reviews. These talent shortages reflect broader recruitment and retention challenges, and are exacerbated by growing salary inflation.

Recommendation: A new storefront concept may be emerging in community banking. Customer-facing services and products are handled by the bank, and back-shop operational and risk assessment responsibilities are supported in a co-opt style by correspondent banking groups or vendors that are specifically equipped to deliver this type of administrative support.

3. Chasing needed loan growth during a credit cycle shift is risky.
Coming out of the pandemic, community banks have lagged behind larger institutions with regards to robust organic loan growth, net of Paycheck Protection Program loans. Even at the Bank Director 2022 Acquire or Be Acquired Conference, investment bankers reminded commercial bankers of the critical link between sustainable loan growth and their profitability and valuation models. However, the risk-management axiom of “Loans made late in a benign credit cycle are the most toxic” has become a valuable lesson on loan vintages — especially after the credit quality issues that banks experienced during the Great Recession.

Recommendation: Lending, not unlike banking itself, is a balancing game. This should be the time when management teams and boards rededicate themselves to concurrent growth and risk management credit strategies, ensuring that any growth initiatives the bank undertakes are complemented by appropriate risk due diligence.

4. Stakeholders may overreact to any uptick in credit stress.
Given the current risk quality metrics, banker complacency is predictable and understandable. But regulators know, and bankers should understand, that these metrics are trailing indicators, and do not reflect the future impact of emerging, post-pandemic red flags that suggest heightened economic challenges ahead. A second, unexpected consequence resulting from more than a decade of good credit quality is the potential for unwarranted overreactions to a bank’s first signs of credit degradation, no matter how incremental.

Recommendation: It would be better for investors, peers and certainly regulators to temper their instincts to overreact — particularly given the banking industry’s substantial cushion of post Dodd-Frank capital and reserves.

In summary, no one knows the extent of credit challenges to come. Still, respected industry leaders are uttering the word “recession” with increasing frequency. Regarding its two mandates to manage employment and inflation, the Fed right now is clearly biased towards the latter. In the meantime, this strategy could sacrifice banks’ credit quality. With that possibility in mind, my advice is for directors and management teams to position your bank ahead of the curve, and be prepared to write your own credit risk management scripts — before outside stakeholders do it for you.