The $700 Billion Credit Question for Banks

It’s the $700 billion question: How bad could it get for banks?

That’s the maximum amount of losses that the Federal Reserve modeled in a special sensitivity analysis in June for the nation’s 34 largest banks over nine quarters as part of its annual stress testing exercise.

Proportional losses could be devastating for community banks, which also tend to lack the sophisticated stress testing models of their bigger peers and employ a more straight-forward approach to risk management. Experts say that community banks should draw inspiration from the Fed’s analysis and broad stress-testing practices to address potential balance sheet risk, even if they don’t undergo a full stress analysis.

“It’s always good to understand your downsides,” says Steve Turner, managing director at Empyrean Solutions, an asset and liability tool for financial institutions. “Economic environments do two things: They tend to trend and then they tend to change abruptly. Most people are really good at predicting trends, very few are good at forecasting the abrupt changes. Stress testing provides you with insight into what could be the abrupt changes.”

For the most part, stress testing, an exercise that subjects existing and historical balance sheet data to a variety of adverse macroeconomic outlooks to create a range of potential outcomes, has been the domain of the largest banks. But considering worst-case scenarios and working backward to mitigate those outcomes — one of the main takeaways and advantages of stress testing — is “unequivocally” part of prudent risk and profitability management for banks, says Ed Young, senior director and capital planning strategist at Moody’s Analytics.

Capital & Liquidity
The results of the Fed’s sensitivity analysis underpinned the regulator’s decision to alter planned capital actions at large banks, capping dividend levels and ceasing most stock repurchase activity. Young says bank boards should look at the analysis and conclusion before revisiting their comfort levels with “how much capital you’re letting exit from your firm today” through planned distributions.

Share repurchases are relatively easy to turn on and off; pausing or cutting a dividend could have more significant consequences. Boards should also revisit the strategic plan and assess the capital intensity of certain planned projects. They may need to pause anticipated acquisitions, business line additions and branch expansions that could expend valuable capital. They also need to be realistic about the likelihood of raising new capital — what form and at what cost — should they need to bolster their ratios.

Boards need to frequently assess their liquidity position too, Young says. Exercises that demonstrate the bank can maintain adequate capital for 12 months mean little if sufficient liquidity runs out after six months.

When it comes to credit, community banks may want to start by comparing the distribution of the loan portfolios of the banks involved in the exercise to their own. These players are active lenders in many of the same areas that community banks are, with sizable commercial and industrial, commercial real estate and mortgage portfolios.

“You can essentially take those results and translate them, to a certain degree, into your bank’s size and risk profile,” says Frank Manahan, a managing director in KPMG’s financial services practice. “It’s not going to be highly mathematical or highly quantitative, but it is a data point to show you how severe these other institutions expect it to be for them. Then, on a pro-rated basis, you can extract information down to your size.”

Turner says many community banks could “reverse stress test” their loan portfolios to produce useful insights and potential ways to proceed as well as identify emerging weaknesses or risks.

They should try to calculate their loss-absorbing capacity if credit takes a nosedive, or use a tiered approach to imagine if something “bad, really bad and cataclysmic” happens in their market. Credit and loan teams can leverage their knowledge of customers to come up with potential worst-case scenarios for individual borrowers or groups, as well as what it would mean for the bank.

“Rather than say, ‘I project that a worst-case scenarios is X,’ turn it around and say, ‘If I get this level of losses in my owner-occupied commercial real estate portfolio, then I have a capital problem,’” Turner says. “I’ll have a sense of what actions I need to take after that stress test process.”

A key driver of credit problems in the past has been the unemployment rate, Manahan says. Unemployment is at record highs, but banks can still leverage their historical experience of credit performance when unemployment hit 9.5% in June 2009.

“If you’ve done scenarios that show you that an increase in unemployment from 10% to 15% will have this dollar impact on the balance sheet — that is a hugely useful data point,” he says. “That’s essentially a sensitivity analysis, to say that a 1 basis point increase in unemployment translates into … an increase in losses or a decrease in revenue perspective to the balance sheet.”

After identifying the worst-case scenarios, banks should then tackle changing or refining the data or information that will serve as early-warning indicators. That could be a drawdown of deposit accounts, additional requests for deferrals or changes in customer cash flow — anything that may indicate eventual erosion of credit quality. They should then look for those indicators in the borrowers or asset classes that could create the biggest problems for the bank and act accordingly.

Additional insights

  • Experts and executives report that banks are having stress testing conversations monthly, given the heightened risk environment. In normal times, Turner says they can happen semi-annual.
  • Sophisticated models are useful but have their limits, including a lack of historical data for a pandemic. Young points out that the Fed’s sensitivity analysis discussed how big banks are incorporating detailed management judgement on top of their loss models.
  • Vendors exist to help firms do one-time or sporadic stress tests of loan portfolios against a range of potential economic forecasts and can use publicly available information or internal data. This could be an option for firms that want a formal analysis but don’t have the time or money to implement a system internally.
  • Experts recommend taking advantage of opportunities, like the pandemic, to enhance risk management and the processes and procedures around it.

Delinquency rates tick upward: Blame the Government

pastdue.jpgConsumer delinquencies on loans moved higher in the second quarter of this year, as high unemployment continues to hurt the loan portfolios of banks, according to the latest analysis of the American Bankers Association.

As if you hadn’t heard the refrain enough lately: the country needs more jobs.

“The most important factor in whether or not someone can repay their debt is whether or not they have a job,’’ says ABA Chief Economist James Chessen, in the understatement of the year.

It hasn’t helped matters, as Chessen points out, that the national unemployment rate ticked upward from 9 percent to 9.2 percent during the second quarter. (The latest unemployment rate for September, released by the U.S. Department of Labor today, shows a 9.1 percent unemployment rate.)

The ABA survey of 300 commercial banks about their auto, personal, home equity and credit card portfolios found that nine out of 11 categories of loans had higher delinquency rates in the second quarter than the quarter before.  The exception was a slight improvement in credit card portfolios and mobile home loans.

The overall, seasonally adjusted, composite index rose 17 basis points to 2.88 percent from 2.71 percent in the first quarter. The ABA defines its delinquency rate as the percent of loans that are 30 days or more past due.

Interestingly enough, the private sector has been adding jobs quarter-to-quarter since 2010. It’s the public sector, pressured by low tax revenues, that has been shedding jobs this year and through much of last year. (The latest figures for September show this trend continuing.)

In an ABA chart that uses its own loan survey data and data from the Bureau of Labor Statistics, the delinquency rate starts to drop as jobs pick up in the private sector. But you can almost see the delinquency rate on consumer loans begin to climb slightly after a series of layoffs in the public sector.


“(Governments) spent a lot (of money) and thought revenue coming from property taxes or income and sales taxes were going to continue at that level,’’ Chessen says. “But when property taxes started to fall relating to home prices and when income fell, and sales were off, their revenue fell quickly but their expenses were locked in. To get expenses back in line has meant layoffs.” 

Unlike the federal government, most states must balance their operating budgets and not spend more than they collect in taxes, so the layoffs seem almost inevitable.

It appears that this time around, the public sector is a real drag on the economy, keeping unemployment high even as the private sector tries to get its footing.