As we emerge, from the global pandemic, the good news is that we are not in the middle of a credit crisis, as some had foreseen. However, there are some cautionary signals for banks to heed as they manage their commercial credit portfolios.
Prudential bank regulators have made it clear that risk remains high as credit standards have become more relaxed. In another sign of the times, they have also restated the critical importance of the role of credit risk review systems in banks’ overall risk management programs. The upshot is that credit risk officers and heads of credit review need to put robust capabilities in place to head off potential risks while commercial portfolios continue to perform.
‘Risk Remains High’
Specifically, while credit quality improved slightly for large, syndicated loans in the past year, “risk remains high”, according to the Shared National Credit Review (SNC) Report for 2021. Released in February 2022 by the Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, this interagency review included 5,764 borrowers, totaling $5.2 trillion in outstanding and unused commitments comprised of syndicated loans, loan leases, letters of credit and acceptances, and other forms of credit extensions. It focused on five industries impacted by the pandemic: entertainment and recreation, oil and gas, commercial real estate, retail, and transportation services, which represent about one-fifth of total SNC commitments.
On a positive note, the review cited fewer “non-pass loans” than the previous year. Such loans, which are classified as substandard, doubtful, a loss, or otherwise meriting special mention, decreased from 12.4% to 10.6% year over year.
Nearly half of the total SNC commitments are leveraged loans, provided by groups of lenders. One of the more auspicious numbers in the report, as a reflection of pandemic related trends, is that for leveraged borrowers operating in COVID affected industries, non-pass loans decreased slightly to 25.7%. However, the number still remains significantly above the 13.5% in 2019. Some relief was provided to oil and gas by the recovery of commodity prices, but stress remains in the hotel, office, and retail subsectors of the commercial real estate portfolio.
Sources of Potential Stress
In the U.S. all eyes are on the Federal Reserve as it unwinds loose monetary policy; concerns abound as to whether policymakers can engineer a soft landing for the economy in the near term. A period of higher interest rates can have mixed results for banks. Higher rates can improve net interest margins but can induce more stress for borrowers in the form of higher borrowing costs. In addition, U.S. equity markets have shown signs of volatility this year, which can impact wealth levels, consumer confidence, and the cost of capital. Inflation is at a 40-year high, fueled in part by geopolitical issues that have elevated commodity prices. Gross Domestic Product (GDP) declined at a 1.4% annualized pace in the first quarter of 2022, another sign of a potential weakening economy.
Signs of stress in the commercial real estate (CRE) industry are evident, although some improvement is noted as we emerge from the pandemic. The demand for commercial real estate had declined (as noted in a third quarter Investors Service), with the net absorption rate (the difference between space occupied vs. vacated) turning negative during the pandemic. Fourth quarter 2021 was positive, however—the first time since 2020. But levels still remain below pre-pandemic values. This is not surprising as employers will likely need less office space as the country moves toward a hybrid work environment. As expected, office vacancy rates are elevated to levels not seen since the late 1980s and early 1990s, with the national vacancy rate at about 15.7 as of January 2022. Required cash flow coverage for operations and debt service potentially cannot be sustained at these vacancy levels.
A recent Chicago Fed Letter, No. 463, from November 2021, supports the view that bank credit risk exposure to commercial real estate remains uncertain following the COVID-19 pandemic. CRE loan delinquencies rose soon after the start of the pandemic and remained high throughout 2021. These delinquencies are obvious threats to a bank’s overall safety and soundness—in particular for smaller banks, which tend to have higher concentrations of CRE exposure. In addition, bank regulators are challenged in their data collection of discrete types of CRE exposures at smaller banks.
What Can Be Done?
Now is the time to scale up resources in support of credit risk functions both from a second and third line of defense (LOD) perspective. Banks should also review their three-to five-year credit strategy and implementation plan including limits, portfolio controls, and expected loss calculations. The review would be comprehensive to include the bank’s capital plan, its stress testing results, and scenarios in the context of emerging risk factors.
This is where the federal regulators’ credit risk review guidance comes into play. In 2020, the federal regulatory agencies involved in the SNC review process underscored the role of credit risk review systems in risk management.
The guidance is principles based and articulates expectations for either a dedicated credit review function or a set of independent reviewers comprising a credit risk review system. Focused on the internal resourcing of an institution, it does not preclude, however, the opportunity to outsource such a function or activities to a qualified independent third party. Of course, the bank can cede the review of credits, but not the responsibility for such an activity, as any outcome is owned and managed by the bank.
This guidance falls short of explicitly calling out the function of credit review as a third line of defense but implicitly states it as it should be independent and separate from internal audit. It maintains banks need to “… include a system of independent, ongoing credit risk review and appropriate communication to management and the board of directors regarding the performance of the institution's loan portfolio …”
Credit review is very different from other credit risk functions that monitor, manage, or report on credit risk. It reviews the integrity of the underwriting quality consistent with bank policy, procedure, and regulatory requirements and expectations. It is important that credit review be conducted by experienced and balanced professionals. Lenders need to be effectively challenged as lenders are intrinsically biased towards their own portfolios. The bank requires a balanced challenge methodology if they are to stay ahead of the credit cycle.
The independence of this function allows it to prevail in instances of credit risk rating and regulatory classification discrepancies between the business whose loans are reviewed and the independent reviewer who reviews them. It also empowers the function to review workout plans to understand the reasonableness of collection assumptions and the strategy for capital preservation or asset sale.
Principles within this guidance are common sense and intrinsic to good credit risk management. Key take-aways include a reminder of what is needed for such a function to execute successfully:
- Requisite qualifications and independence of credit risk review personnel;
- Frequency, scope, and depth of reviews commensurate with the complexity of the portfolio; and
- The review follow–up, communication, and distribution of results, and how those results are actioned by the relevant parties.
Bottom line, it is unclear how bank credit portfolios will perform, especially those impacted by the pandemic and current geopolitical issues. But an opportunity exists for banks to actively review and hone their credit capabilities to ensure policies, standards, and practices are in place and properly leveraged by their credit originators, approvers, and portfolio managers to ensure the safety and soundness of the bank, its assets, and capital preservation. To this end, rigorous credit reviews can support adherence to a bank’s risk appetite by independently reviewing and providing constructive criticism that can be actioned for future successful underwritings.
TOM FREEMAN, Senior Advisor at Treliant, manages the firm’s Credit Risk services for banking, FinTech, and mortgage clients. Tom has over 30 years of experience in both the industry and as a consultant.
PETER REYNOLDS is a senior advisor with Treliant, a regulatory risk and compliance management consultancy. He is a global transformational risk and compliance executive with over 30 years of experience holding C-suite roles at Fortune 100 multinational financial services companies and Big 4 accounting firms.