The financial crisis of 2008 may well be in everybody’s rear view mirror by now, but in a recent report, regulators warned banks against getting too comfortable – and taking too much risk.
The Office of the Comptroller of the Currency (OCC) recently outlined several potential areas of risk in its aptly titled “Semiannual Risk Perspective,” released June 25.
First, the good news. The OCC noted substantial improvements in the American banking landscape since the recession in the executive summary of its report.
“Traditional credit risk metrics improved significantly in 2013,” the report’s authors wrote. “The level of problem assets declined as economic conditions improved. The level of nonperforming assets and net charge-offs declined substantially and are now back near or below pre-recession levels. Allowance for loan and lease losses (ALLL) releases were a common practice for many banks in 2013, driven by the improvement in loan quality and moderate portfolio growth. Median loan growth remains below average. Commercial loan growth, however, has been stronger, particularly for larger banks, but the pace of loan growth varies widely at small banks.”
Traditional credit risk metrics improved, while problem assets, nonperforming assets and net charge-offs declined. Motivated by improvements in loan quality and moderate portfolio growth, many banks released funds from their allowance for loan and lease losses. And while median loan growth is still below average, commercial loan growth strengthened last year, the report’s authors noted.
Risk In Auto Lending
But the federal agency also expressed a number of concerns where risk could lie with some of the nation’s largest banks. One area of concern the OCC highlighted was in auto lending.
Lenders are increasing term lengths and loosening underwriting standards, the agency notes. Furthermore, loan-to-value rates have been increasing and now top 100 percent for both new and used cars across all major lender categories, including banks, credit unions and finance companies.
Bill Loftus, director of credit risk at the Risk Management Association, said that the high loan-to-value ratio is somewhat typical of auto lending, according to many of the bankers he works with.
In some ways, it’s simply the nature of the business: Once you drive the car off the lot, it starts depreciating in value, so at some point, the borrower will probably be underwater on his or her car.
“I think the bigger issue, if there is an issue, is the length of terms for these loans that they’re doing,” he said.
Loftus cited OCC data demonstrating that in the second quarter of 2013, just 38 percent of loans made for new cars were for loan terms of 60 months or less, meaning the remaining 62 percent of loans would be for five or more years.
The split was closer to 50/50 for used cars, he said, and 61 percent of those used cars were 2009 models or older, meaning there are some rather expensive used cars out on the road today. Or that banks feel fine taking more risks, while consumers are just dandy increasing their leverage on a rapidly depreciating asset.
It’s not the first time auto lending has drawn scrutiny from regulators. Early in 2013, the Consumer Financial Protection Bureau indicated it would be taking a closer look at auto lending, when it released a bulletin outlining fair lending guidance for financial institutions that provide indirect auto financing, and late last year, Ally Financial paid $98 million to settle charges that it discriminated against minority borrowers who were charged more than white customers for auto loans from car dealers.
More generally, the OCC fretted that banks are easing underwriting standards in both commercial and retail products, citing data from its own recent “Survey of Credit Underwriting Practices,” released Jan. 30 and based on data from mid-year 2013.
Other Risks
In its report, the OCC noted other potential risks, too. The agency made note of home equity lines of credit end-of-draw risk on the horizon, as millions of HELOCs are scheduled to reset over the next four years.
The agency also warned of the potential for deposit flight when interest rates rise. Presently, the OCC noted, it’s inexpensive for depositors to keep their funds liquid in traditional bank savings accounts with near-zero interest rates, since they’re not likely to get a much better rate elsewhere.
But as the OCC writes in its report, “Segments of a bank’s core depositors may react differently in an increasing interest rate environment than they have in a low rate environment. Accordingly, the OCC will emphasize the need to analyze core deposits carefully, as some are potentially more sensitive to rising interest rates than historical relationships may suggest.”
The potential exodus of deposits could have implications for liquidity strain further down the road, and community banks dealing with that problem might consider replacing those runaway deposits with purchase funds, or increasing their rates to stay more competitive, but as interest rates rise, that could change.
While asset-liability management could be a challenge for some banks in a rising rate environment, John Carusone, president of the Hartford, Conn.-based Bank Analysis Center, doesn’t anticipate a mass exodus of deposits from community banking institutions to Wall Street.
“To be sure, these banks will have to adjust upwards their CD and money market rates, as well as other rates, to remain competitive with other bank and non-bank financial institutions, so there will likely be some compression in margins which will trim the rising profitability. But a deposit exodus en masse from the banking industry I don’t think is in the cards,” he told Banker & Tradesman.
He added, “If liability-sensitive banks cannot keep up with the competition in adjusting deposit rates upward, they will lose market share and it could impact their competitive position and long-term viability.”
Email: lalix@thewarrengroup.com
