Yogi Berra is famous for having said, “it’s Déjà vu all over again”. During my career, I’ve seen banking “crises” caused by REITs, third-world debt, oil embargoes, variable deposit vs fixed mortgage interest rates, changes in tax laws on passive real estate investments, oil price collapses and varying economic recessions, including the 2008-2010 recessions. Well, it’s Déjà vu all over again, because I’m starting to see signs that remind me of the run up to the 2008-2010 crisis.
Loosening Credit Underwriting Standards
The OCC’s Spring 2017 Semiannual Risk Perspective notes that the banking industry is at the point in the cycle where lending is highly competitive, resulting in not only pricing concessions, the loosening of credit terms and conditions and increasing concentrations in commercial real estate (CRE). As the report notes:
• Credit underwriting standards and practices across commercial and retail portfolios remain an area of OCC emphasis. Over the past two years, commercial and retail credit underwriting has loosened, showing a transition from a conservative to an increasing risk appetite as banks strive to achieve loan growth and maintain or grow market share.
• Strong CRE loan growth has resulted in increasing credit concentrations. Regulators are concerned about the quality of CRE risk and concentration management.
To boost loan volume and respond to competitive pressures, banks are: 1) taking greater credit risk through risk layering, increasing number of loan policy exceptions, increasing loan-to-value ratios, and weaker covenant protection and 2) increasing their exposure to commercial real estate.
In addition to the Risk Perspectives, the OCC publishes an annual Survey of Credit Underwriting Practices. Recent Survey conclusions are similar to those in the recent Risk Perspective. For example:
• The 2015 Survey noted an easing of commercial underwriting standards, reflecting trends similar to those seen just prior to the most recent financial crisis. The Survey noted:
o A trend of increasing policy exceptions, predominantly centered in commercial products.
o Competitive pressures, abundant liquidity, and the desire for yield in a low interest-rate environment resulted in eased underwriting standards and increasing credit-risk concerns.
• In 2016, the Survey found that:
o Banks continue to ease underwriting practices in response to competitive pressures, expanding credit risk appetites, and a desire for loan growth.
o While overall underwriting practices remain satisfactory, an increasing tolerance for looser underwriting has resulted in continued movement from more conservative underwriting practices to more moderate underwriting practices, a trend consistent with past credit cycles.
o Credit risk has increased since the 2015 survey in commercial and retail lending activities, and examiners expect the levels of credit risk in these areas to increase over the next 12 months. Primary areas of concern are aggressive growth rates, weaknesses in concentration risk management, deterioration in energy related portfolios, and the continued general easing of underwriting practices.
Déjà vue, these recent trends and comments echo many of regulator’s concerns in the run up to the 2008-2010 financial crisis. For example:
• In 2005, the OCC Survey noted a pronounced trend toward easing commercial credit standards, with significantly more banks easing underwriting standards than tightening standards, beginning in 2004. Examiners most recently reported more banks easing credit standards than tightening standards in 1998, three years before the 2001 recession.
• The 2006 Survey reflected a pronounced trend toward easing commercial credit underwriting standards and the volume of loans approved with exceptions to lending policies. Of particular concern was the increasing volume of term loans with nominal amortization required during the initial years of the credit. The survey also found that the banks were easing underwriting standards for residential mortgages and home equity lending, including reduced documentation requirements and more relaxed underwriting criteria.
• In 2007, the OCC noted easing underwriting standards and increasing loan volume. Banks’ increasing risk appetite and greater market liquidity were factors that contributed to easing standards. Examiners continued to report weakening of loan structures, including minimal amortization requirements and less frequent meaningful financial covenants to monitor borrower performance.
After several years of increasingly accommodating credit terms, the majority of banks tightened underwriting standards for both commercial and retail loans in 2008. Primary reasons for these tightened standards included the overall economic outlook, the downturn in residential real estate, a changing risk appetite and a decrease in market liquidity. Unfortunately, the barn door could not be closed quickly enough, and the rest, as they say, is history.
Housing Market Tightening
The Case-Shiller national home price index reached an all-time high in July 2006 at 184.62. By 2009, the gains from 2004 to 2006 were almost entirely erased. After seven consecutive monthly increases, the June 2017 index has risen again to a new, all-time high of 192.60. In the Boston, Dallas, Denver, Portland and North Carolina markets, median home prices exceed their pre-2010 crisis levels.
Case Shiller data indicates that increasing prices are the result of a tight housing market. Both the number of homes for sale and the number of days a house is on the market have declined over the last five years. Currently the months-supply of existing homes for sale is low, at 4.2 months. Housing starts remain below their pre-financial crisis peak as new home sales have not recovered as fast as existing home sales.
Prices are rising, but other drivers of affordability are more favorable. For example, the unemployment rate is below 5% nationally. Employment continues to grow at a rate of approximately 200,000 per month. Wages and salaries are growing at a rate a just ahead of inflation. While up slightly from 2016, mortgage rates are under 4%. Consequently, it is unlikely that current home price trends will reverse quickly.
Return of the Sub-prime Loan
In 2015 the President of a sub-prime lender was quoted in American Banker as saying he had reviewed a number of rejected mortgage loan applications and he would have approved all of them as sub-primes. Sub-prime mortgage loans were instrumental in driving the increase in housing prices during the 2004-2007 time period, peaking in 2005 at roughly 23% of total loan originations.
According to the Wall Street Journal, nonbank lenders accounted for about half the mortgages originated in the U.S. during the first quarter of 2017. Referencing data from Inside Mortgage Finance, the Journal said “Lenders say there is an untapped market among borrowers with good credit scores like self-employed workers who don’t have proper income documentation, or for responsibly made loans to borrowers with credit problems that have had bankruptcies in the past or had to sell their home for less than it was worth. If they are successful in recruiting brokers, lenders believe the market potential for both types of loans could reach $200 billion annually.”
Rising interest rates and borrowers with impaired credit are expected to increase the demand for sub-prime mortgages, and originations did increase in 2015 and 2016. More lenders are entering the market for sub-prime loans. Even zero down mortgages are being offered by Lending Tree and major financial institutions.
Admittedly, subprime loans today are not the same as subprime loans in 2006, but the implications are pretty clear. As lenders seek more borrowers, they will resort to more innovative loans. At the moment, as Case-Shiller points out, the supply of housing is low and housing starts are below pre-crisis levels. Eventually, bankers will step in with developers to fill the gap with increasing levels of residential acquisition, development and construction lending. This generally leads to a follow-on expansion of loans for retail shopping space and then commercial office space. And the cycle
Economic Clouds Gathering
In addition to risk associated with residential lending and loosening of commercial loan underwriting standards, there are other areas where credit risk, driven by unique economic trends, is increasing. For example:
• Shale oil in western North Dakota’s Bakken field brought a flood of new workers to Minot and Williston. Tents and shipping containers were used as housing. In July 2015, there were 204 oil rigs operating in North Dakota. A year later, as oil prices slumped dramatically, there were 30. Oil prices remain low and have impacted economies in the southwest as well as North Dakota. Falling oil prices have negatively impacted the economies of other states, including Wyoming, Alaska, Oklahoma, New Mexico, Colorado, Kansas, Montana and Texas.
• After a significant run-up since 2004, farmland prices have declined since 2012 as a result of declining crop prices and cash rents on farmland. Declining crop prices from negatively impact states in the region, including Iowa, Illinois, Indiana and Wisconsin.
• There has been an avalanche of retail store closings over the last 18 months. Stores closing locations include Sears, Sports Authority (bankruptcy), Office depot/Office Max, Macy’s and the GAP. Some 7,000 store locations have been closed in 2016 and through mid-2017. Closures have been nationwide, negatively impacting jobs, local economies and businesses and commercial real estate values.
Responding to Increasing Credit Risk
Banks can begin to mitigate increasing credit risk by taking the following steps:
• Evaluate Risk Appetite – A great deal of the expansion of lending is the result of the reversal of conservative risk appetites adopted during the crisis. Given the economic issues that have arisen since 2015, it is a good time to review the credit risk components of the Bank’s risk appetite statement, including types of loans, concentrations of loan types to capital and estimates of potential losses. Revise financial forecasts based on the review of the Risk Appetite to determine if management remains confident the Bank will have sufficient earnings and capital to cover possible future losses and expenses of problem credits.
• Review Loan Portfolio – Analyze the composition of the loan portfolio and identify exposures to significant local and nation-wide economic drivers. Identify risk trends in the portfolio, such as concentrations with declining aggregate risk grades and other potential problem areas, such as loans with excessive extensions and renewals. Expand the coverage ratio of the independent loan review program, whether internal or external, and increase the level of loan officer reviews of credits in their portfolio.
• Enhance Loan Approval Process – Increasing the level of review on new loan requests. Expand the use of “pre-flight” reviews, discussions of potential loans between lenders and Credit Administration prior to offering terms and conditions to a borrower. Have Credit Administration review and comment on the structure, terms, conditions and collateral coverage of proposed loans as well as the financial condition of the borrower. Adjust lending limits to include increased review of new loans in areas of emerging risk by experienced lenders and Credit Administration. Consider adopting a concurring loan approval scheme where lenders and Credit Administration must approve the loan together and significantly reduce the loan committee approach to approving loans.
• Strengthen Credit Analysis – Adopt guidelines requiring more loans be submitted to Credit Administration for preparation of financial analyses, global debt identification and global cash flow analyses. Review staffing of Credit Administration to ensure they are qualified, capable and sufficient to support lenders and any increase in work volumes.
• Review Risk Ratings – Revisit the credit risk rating systems. The risk rating system should form the foundation for credit risk measurement and monitoring, but many rating systems are too general in nature to be fully effective. Many I look at are so general that it is impossible to distinguish between good, acceptable and pass rated loans. Take time now to review rating criteria and include more objective measures like specific ratios for capital adequacy, debt service coverage ratios, earnings ratios, etc. Consider also who has the last word on ratings. In a well managed credit risk environment, Loan Review or Credit Administration should have the last word on ratings assigned to loans.
• Increase Collection Activities – Increase early stage collection efforts such as notices, letters and calls. Shift responsibility for these activities from lending officers to dedicated collectors.
• Manage Problem Assets – Many banks leave the collection and work-out of problem loans to lending officers for too long. Adopt guidelines for involving an experienced loan workout officer with the lender in developing a plan to improve the credit. Ensure that specific objectives are included in any plan agreed to with the borrower. If those objectives are not met, transfer the loan to the workout team. Develop problem asset plans, again with specific goals and objectives and track borrowers’ compliance with any related commitments. Review these action plans regularly with the loan committee.
• Review Loan Documentation – Now is a good time to step up loan quality reviews and audits. Review loan documentation to ensure properly executed loan agreements are in file, liens are properly recorded, exceptions are cleared, etc., and ensure the bank has an enforceable claim for repayment or to cease and liquidate collateral. Review covenant compliance and take care to ensure the Bank’s rights to enforce these covenants are maintained. Even if the borrower does not meet all covenant requirements, notify them that the Bank recognizes they have not and has not waived the future enforceability of its rights.
• Evaluate Loan Loss Reserve – Maintaining a sufficient reserve for loan losses is critical to managing credit risk. Make sure procedures for identifying and accounting for impaired credits are in place and effective. Review the qualitative factors used to adjust the reserve. In my experience, banks often adopt economic and other qualitative adjustment factors that allow them to manipulate the balance in the reserve. The 2006 Interagency Policy Statement on the ALLL recommended nine qualitative factors.
Credit risk cannot be avoided entirely, but as economic conditions change, it is prudent to evaluate the bank’s 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 the tracks end abruptly, and badly, rather than slowing to a stop.
As many CEOs and Directors learned over the last few years, just having strong net worth and earnings doesn’t mean you’ve managed risk carefully. Earnings and capital can evaporate quickly in a severely down turning economy. Many financial institutions that overly concentrated in acquisition, development and construction loans and buying loan participations learned this from 2008 to 2010.
And yet, risk management at most financial institutions continues to be fragmented, expensive and inefficient. Even as the concept of enterprise risk management becomes more widely accepted across the industry, many banks and credit unions are creating silos of analytical information and a hodgepodge of different solutions. While each database of information may be high in quality, they often lack the capability to interact with other solutions to provide a true picture of risk across the enterprise. Additionally, they are often inaccessible to management.
To address the risk management issue, banks and credit unions are increasingly are turning to Enterprise Risk Management (ERM).
Implementing an Enterprise Risk Management System in a Bank or Credit Union
A number of approaches to implementing an enterprise risk management system have been proposed, with two, the COSO model and the new BASEL III model rolling out in 2013. In my opinion, Basel III is not the best enterprise risk management model. At its heart, it is primarily a capital adequacy model. That was the intent of its design. Its methods are complex and confusing, and consequently, its results are difficult for management to interpret, making it difficult to for them to communicate to others at the financial institution and to respond to changing risk conditions in a timely manner.
The COSO model offers a more comprehensive “strategic focused” framework for the effective management of risk.
The COSO model consists of 5 key elements:
- Understanding of Strategic Business Objectives,
- Establishment of an effective general control environment,
- Development of systems to identify and measure risk exposures,
- Implementation of appropriate controls and strategies to mitigate risk and
- Maintenance of on-going information systems to track the changing nature of risk and effectiveness of risk management controls.
While a lot of people are talking about risk and risk management, there is no commonly accepted definition of risk management, or comprehensive framework outlining how the process should work.
We have developed an enterprise-wide approach to managing risk that provides management and directors a comprehensive model. The Enterprise Risk Solution Framework, addresses regulatory requirements for risk management – to identify, measure, monitor and control risk, while focusing the financial institution on a strategic approach to risk management.
More importantly, the model clarifies the definition of risk. If you speak with an auditor about risk, they will likely view it as something negative, to be managed and controlled. There is a tendency to think of risk only as the downside, or negative consequence, of a certain action or event. It is just as important to consider risk as an opportunity, or not taking risk as an opportunity lost.
The objectives of the Enterprise Risk Solution Framework are to:
- Aid the Board and management in determining the risk, at a broad level, that is acceptable in the pursuit of the financial institution’s strategic objectives
- Help management align strategic objectives and risk appetite
- Define risk tolerances and ensure that risks taken are consistent with the level of risk the institution desires
- Provide sufficient, appropriate information about risk positions and trends to aid management in making effective risk management decisions
- Ensure that risk management strategies and controls employed are both appropriate and cost-effective
The ERS Framework:
- Considers risk as a critical component in strategy formulation
- Recognizes the interdependencies of risks and risk management practices among business units throughout the financial institution
- Improves the financial institution’s ability to identify and take advantage of future opportunities
- Facilitates and improves communication about and understanding of risk and
- Applies risk management techniques throughout the financial institution’s business units and to its products, services and delivery channels.
Key elements of the ERS Framework include:
- Strategic Goal and Objective Setting– The strategic direction, and specifically its goals and objectives, are critical in determining how much risk the financial institution can, or even must, take. Clearly, the setting of objectives implies the financial institution desires to move from its current position or state to a future, improved state. Objectives calling for significant growth or improvements in ROA/ROE and efficiency will require the institution to do something different than it has in the past. Management must make critical decisions about how the institution will build value. Likely, these decisions will result in a changed, and perhaps increased, risk profile. It is vital that management and the board consider the effect of risk on the financial institution’s risk management and control systems and capital requirements in setting strategy. The potential effects of strategic decisions should be evaluated as part of the institution’s “risk appetite” setting process and formally documented in a Risk Appetite Statement.
- Risk Identification and Risk Measurement– As tactical decisions are made to implement the chosen strategies of the bank or credit union, you must be aware of the events that might impair its ability to successfully implement strategy and achieve its business objectives. Again, these decisions may result in exposure to new or increased events with negative, downside potential. Similarly, decisions may be made in the name of risk that preclude significant opportunities. Without a clear understanding of the risks, potential exposures and potential benefits resulting from a decision, informed decision-making is not possible. More importantly, effective decisions about risk management strategies and controls cannot be formed.
- Risk Monitoring– Risk does not exist in a static environment. It is constantly changing and the impact of events, both within and outside the financial institution’s control, significantly impact the identification and assessment of risk and exposure. Consequently, management must have a clear understanding of the current risk environment, as well as the position of the institution in relation to the risk environment. Reports of key risk indicators, both leading indicators and trailing indicators, is vital to this process.
- Risk Control– General risk strategies to be employed, such as retention, transfer, avoidance and control, or specific decisions about risk controls, must be consistent with the level of risk desired, and information about the changing nature of the risk environment.
- Risk Governance– There is an old saying that the fish rots from the head. If a financial institution has not established a strong general control environment, the presence of other controls really doesn’t matter. Their effectiveness is already fatally compromised. It is vital that the financial institution employ knowledgeable, engaged and informed directors, experienced management with a strong sense of business ethics and adequate staff. Further, steps should be taken to build a strong risk management base by developing comprehensive policies and ensuring adequate segregation of functional responsibilities within the organization.
If this most recent banking crisis has pointed up the need for anything, it is that financial institution executives must understand the potential future risk consequences of strategic business decisions they make today. When many made the decision in 2004 and 2005 to grow, funding speculative acquisition, development and construction loans with wholesale funds, did they actually understand whether the institution could survive effects of a severe downturn in the real estate market and a prolonged recession?
To survive and thrive in the future, financial institutions must consider the future risks of strategic decisions made today. In short, they must be able to define the institution’s “risk appetite”.
On the face of it, this seems easy to do. Isn’t it simply the institution’s capital structure and solvency needs which determines its ability to withstand shocks and therefore represents its risk appetite? For some smaller firms this approach may well be enough, but for others risk appetite is a more complicated affair at the heart of risk management strategy and indeed the business strategy.
But defining a financial institution’s risk appetite goes beyond just considering the potential future losses of a single strategic decision. Other issues must be considered as well. How, for example, would the planned growth be funded, for example? What were the implications of the chosen funding strategy.
Beyond consideration of the growth and funding issues, did the institution manage risk effectively? Did Directors and management believe credit underwriting and risk management practices were sufficient to protect the institution if the real estate market turned against them with a vengeance? Did they develop appropriate contingency funding plans?
The risk appetite statement goes beyond a simple projection of losses and assessment of capital adequacy. Properly crafted, a financial institution’s risk appetite statement sets the boundaries between strategic decision-making, day-to-day business decisions and risk management.