Managing Credit Risk Ahead of a Crisis

by Kenneth Proctor, Cadre Strategic Risk Management

Former NBA basketball play Vlade Divac once said; “We all get heavier as we get older because there's a lot more information in our heads”.  Well, I know I’m older and heavier and hopefully smarter.  I can only hope bankers are smarter now about managing credit risk than they were in 2007.  But maybe not, because I’m beginning to see some of the same trends I saw in the run up to the last crisis. 

Loosening Credit Underwriting Standards

The OCC’s Spring 2018 Risk Perspective notes banks are: 1) taking greater credit risk through risk layering, increasing loan policy exceptions, increasing loan-to-value ratios and weaker covenant protection and 2) increasing concentrations of commercial real estate. Regulators are also concerned about low and declining prices for grain, livestock and dairy that have reduced cash flow and increased carryover debt for agricultural borrowers.

The 2018 OCC Annual Survey of Credit Underwriting Practices notes that:

Credit risk has increased over the past five years due to aggressive growth rates, weaknesses in concentration risk management and continued easing of underwriting practices.  

  • Banks continue to move toward more moderate underwriting practices, including increasing approvals of commercial loans with policy exceptions.

  • Signs of Increased Credit Risk in Housing

There are also economic trends driving increased credit risk related to housing, including:

  • The June 2018 Case-Shiller national home price index has risen to an all-time high of 210.17.  Housing bubbles are appearing in Atlanta, Boston, Dallas, Denver, Portland and North Carolina markets where median home prices exceed pre-2010 crisis levels.  

  • Unemployment is historically low, but wages and salaries are growing just ahead of inflation.  Mortgage rates are now over 4%. As a result, the number of potential buyers will decline.

  • Housing starts plunged 12.3% month-over-month in June 2018, the biggest drop since November 2016. It is at the lowest rate since September 2017.

  • More lenders are offering sub-prime loans, including zero-down and stated income loans, to marginal borrowers and self-employed borrowers who have difficulty documenting their income.

 Economic Clouds Gathering

  • While economic news has been positive lately, there are trends that increase credit risk. 

  • Falling oil prices since 2015 have negatively impacted employment and the economies of North Dakota, Wyoming, Alaska, Oklahoma, New Mexico, Colorado, Kansas, Montana and Texas.

  • Farmland prices have declined since 2012 as crop prices and rents on farmland declined.  Foreign tariffs also negatively impact US agriculture and farm land prices not just in the Midwest, but in other areas of the country as well.

  • Metal import tariffs are impacting makers and sellers of farm equipment, from smaller firms to giants like Deere and Caterpillar. 

  • An avalanche of retail store closings has negatively impacted jobs, local economies, businesses and especially commercial real estate values nationwide.

Mitigating Credit Risk

Banks can begin to mitigate increasing credit risk now by taking the following steps:

  1. Review the Bank’s risk appetite statement and loan loss assumptions and projections.  Ensure there will be sufficient earnings, capital and reserves to cover possible future losses and expenses that might result in a downturn.
  2. Identify exposures to specific economic drivers which might impact loans and track them.  
  3. Monitor loans with excessive extensions and renewals or granted as exceptions to loan policy.  
  4. Move potential problem loan relationships out of the Bank through pricing or other means.
  5. Expand the loan review program scope.  Increase loan officer reviews of credits in their portfolio, particularly those with stale risk ratings.
  6. Reduce lending authorities and increase independent reviews of new loan requests and renewals.  
  7. Require Credit Administration to review and analyze more loans and renewals. 
  8. Have Credit Administration review the structure, terms, conditions and collateral coverage of loans as well as the borrower’s financial condition.    
  9. Increase loan reviews and audits to ensure properly executed loan agreements are in file, liens are properly recorded, exceptions are cleared, etc.  
  10. Monitor covenant compliance and ensure the Bank’s rights to enforce then are maintained.
  11. Adopt early stage collection efforts such as notices, letters and calls and shift these activities from lending officers to collectors.
  12. Have workout specialists assist lenders in developing problem loan workout plans.  Include specific goals and track borrowers’ achievement of those goals.  If they aren’t met, transfer the loan to workout.

Credit risk cannot be avoided, but as economic conditions change, it is prudent to evaluate credit risk management practices, procedures and controls. As we’ve seen in the past, the lending engine at some banks continues to run full steam ahead until they run off a curve in the tracks, rather than slowing gracefully to negotiate them.