In early 2016, the then-Comptroller of the Currency, Thomas Curry, issued a strongly worded report. “In the area of credit risk, the warning lights are flashing yellow,” he wrote in the OCC’s Semi-Annual Risk Perspective. “We can’t wait until the warning lights turn red.”
According to the OCC, 2016 marked the fourth straight year that underwriting practices had loosened. Curry noted that banks were making too many concessions on pricing, loan agreements and maturities. He urged bankers to remember that “the worst loans are made in the best of times, and the growing credit risk in their banks should be managed very closely.”
That was 2016. In 2019, the lights have not stopped flashing. In its latest report, the OCC noted, “Increased risk is evident through eased underwriting, a higher tolerance for policy exceptions, and high concentrations in commercial real estate (CRE) lending, particularly in smaller banks.”
It is not hard to understand why financial institutions have taken on more risk. Twelve years after the near-collapse of financial markets worldwide, and ten-plus years along into the current economic expansion, the Great Recession seems like a distant memory to many. Banks have largely worked through many of the problem loans that marked that debacle. Even the OCC, for all its warnings, has noted that credit quality “remains strong as measured by historical performance metrics.”
Moreover, interest rates have remained low, and competition for borrowers has increased among financial institutions. A worldwide slowdown in growth and signs of weakness in the U.S. economy, most notably a contraction in manufacturing, has shrunk the lending market.
End of the Boom Cycle
In spite of the rosy credit picture, well-managed banks are heeding the OCC’s message. These financial institutions understand that the end of the prolonged boom cycle is inevitable, and that a healthy asset could quickly become a special asset in a sudden downturn. They also realize that increasing their resilience and weathering the next storm depends on their abilities to identify, monitor, measure and control risks. Among the measures they are considering are the following:
- Staffing up with troubled assets personnel
- Honing their systems to identify problem loans quickly
- Reviewing policies and procedures to ensure the timely involvement of the Special Assets Group (SAG), including transfer of management of troubled loans where applicable
- Focusing the staff’s attention on regulatory requirements, while maximizing collections
- Setting up a robust system to ensure adequate reserves in a sudden downturn
For its part, the OCC has set out a number of recommendations in its Handbook for Loan Portfolio Management. In general, the OCC suggests that a financial institution ingrain the handling of special assets throughout its credit policy, procedures and review. It notes that an experienced SAG can provide valuable guidance during initial underwriting, and that the SAG can help maximize returns on defaulted loans.
Beware of Inertia
Despite the signs and warnings, many financial institutions remain in a wait-and-see mode. Much of their stance can be attributed to inertia. After all, it’s difficult, if not costly, to prepare for an environment starkly different from the one we are in. And a volatile economy and evolving regulatory and reporting requirements on consumer and commercial loans have made early identification of problem assets difficult, contributing to the inaction.
Unfortunately, recent history has shown that a bide-your-time approach is fraught with danger. Many financial institutions were blindsided by the last meltdown. And the risk of being blindsided remains, given the multitude of potential drivers of a downturn. For that reason, it is essential for banks to go beyond identifying the obvious problem assets in their portfolios. They also must take a close look at borrowers with structural or operational issues, including those that have kept current with payments through interest reserves or payments from other sources. By identifying such assets, management can establish appropriate measures to strengthen these credits and enhance resilience by initiating a collection strategy that minimizes exposure.
An additional challenge institutions face is the advent of the Current Expected Credit Losses (CECL) standard for credit loss accounting. The regulation, which requires banks to estimate losses under the “life of loan” concept, creates a whole new layer of complexity. To deal with it, special assets departments should ensure they have a robust framework in place and establish effective processes to report their potential exposure under CECL guidelines.
At Protiviti, we’ve found that troubled asset tracking and reporting is a great tool for senior management, lenders and the board of directors. It supports lender performance programs and ensures timely and open communication between management and the board, which can greatly enhance a bank’s ability to identify and manage borderline loans. Executive and board involvement should not be limited to loan approvals; it can also contribute to successful collection strategies for large non-performing credit relationships.
Even with all the foregoing precautions, our view is that that independent loan review is one of the quickest and most cost‐effective ways to identify asset quality issues. For such reviews to be effective, however, the board of directors must insist that the reviewers are experienced and independent. As a testament to the efficacy of this measure, many banks have increased the frequency of these reviews from once a year to semi‐annually or more often. We believe it is an excellent example to follow.
Present Value
In a period of compressed margins, institutions must make difficult decisions on where and how to spend resources. We believe a focus today on special assets management and independent loan review will help institutions position themselves to be resilient in a cycle downturn. Such efforts will provide stakeholders value through the mitigation of credit risk exposure, less effort required in future periods to resolve problem credits, and better determination of the allowance under CECL.
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