U.S. banking regulators warn of weakening lending standards
01 August 2014
U.S. banking regulators in recent weeks have given sustained attention to brewing problems they observe in banks’ weakening lending standards.
Recently, Janet Yellen, chair of the Board of Governors of the Federal Reserve System (“FRB”), in her semiannual monetary policy report to Congress, described looser lending standards for leveraged loans as a potential source of financial instability and noted ongoing efforts by the banking agencies to ensure bankers’ compliance with underwriting guidance. The centerpiece of this effort, however, is the Office of the Comptroller of the Currency’s (“OCC”) Semiannual Risk Perspective, which praised banks for their improved earnings but warned more forcefully than before of the dangers of weakening lending standards. Citing a growing number of underwriting and policy exceptions in the indirect auto lending market and weakening underwriting standards for syndicated leveraged loans, the OCC indicated it will pay closer attention to these and other loan underwriting practices in bank examinations during the next twelve months. Meanwhile, leveraged lending and sales of securitized leveraged loans continue at a record pace.
A Glass Half-Empty
In its Semiannual Risk Perspective, released on June 25, 2014, the OCC painted a mixed picture of the banking industry’s health. While the OCC reported signs of economic improvement, better credit risk metrics (including a substantial decline in the level of problem assets) and a record level of net income among national banks in 2013, it tempered its enthusiasm by highlighting several warning signs. The new record was only five percent higher than the previous record set seven years earlier; most of the improvement was the result of lower expenses while loan growth remained uneven; and returns on equity and assets were still below pre-recession levels. Furthermore, according to the OCC, banks face limited opportunities to raise revenue and operating profit amidst still weak overall economic growth, low interest rates and other challenging conditions.
The Beginning of a Turn in the Credit Cycle
Echoing bankers’ reported concerns over competitive pressures, the OCC voiced its own concerns over weakening lending standards resulting from such competition in both commercial and retail products, particularly among the largest U.S. banks. The easing of standards appeared across a wide variety of asset categories, including indirect consumer, credit card, large corporate, asset-based, international and leveraged loans. Reduced collateral requirements and looser loan covenants were the primary methods employed to ease standards. Many of these covenant-lite leveraged loans have been securitized as collateralized loan obligations (“CLOs”), with issuance levels in the U.S. having recently been reported to have reached all-time highs.
The urge to improve earnings also introduced strategic and operational risk, according to the OCC. In the absence of growth opportunities, some banks were seeking to lower overhead expenses, often by reducing control functions or outsourcing the activity, in some instances without appropriate due diligence. The OCC is urging senior management and boards of directors to ensure that their banks have “the requisite expertise, management information systems . . . and risk controls for the banks’ business lines and activities,” particularly when introducing new products that are unfamiliar or involve higher risks. Separately, the OCC’s top supervisor of large banks has identified two additional systemic risks. First, unlike typical business cycles in which the need to refinance nonperforming or non-amortizing loans has peaked when business activity and interests rates have dropped, the next round of refinancing may occur in a rising rate environment as the FRB tapers its market support. Second, the record volume of covenant-lite and junk loans being made as banks and investors seeking yield crowd into one of the few asset categories rewarding that search for yield may be difficult to refinance en masse.
What Practices the OCC Will Be Targeting
After a prolonged period of improvements in credit quality and reductions in levels of problem loans, the OCC now sees signs of building credit risk. The OCC is focusing on three issues in particular:
Underwriting standards. The erosion of underwriting standards is of particular concern to the OCC, especially for syndicated leveraged loans, indirect auto lending, commercial loans and asset-based lending.
Exceptions to credit policies. The OCC has stated that in upcoming examinations it will pay closer attention to underwriting standards and will encourage banks to reevaluate their credit risk appetites.
Risk layering. The OCC has also advised national banks “to monitor elevated policy exceptions to established underwriting standards and be alert to the product terms that layer on additional risks.”
Areas of Supervisory Focus
The Semiannual Risk Perspective also highlighted the following, more general points as elements of the OCC’s supervisory strategy over the next twelve months. At large banks, increased supervisory attention will be paid to the following:
Governance in the boardroom. At the 19 largest national banks, examiners will be looking to the boards of directors to demonstrate their ability to set the risk appetite across the institution and to monitor compliance with their direction and their willingness to manage and if necessary challenge senior officers, including through compensation processes.
Enterprise-wide risk management. Similarly, examiners will expect senior management to be able to demonstrate its awareness of the interconnectedness of risks in complex operations and its preparation for an environment of constantly evolving cyber-threats.
Effective corrective actions. Follow-through in implementing mandatory corrective actions in mortgage servicing and foreclosure practices will be examined. Other matters noted during examinations that require attention as well as violations of anti-money laundering laws and consumer protection laws will also be scrutinized.
Compliance culture. Meeting the credit needs of the community, compliance with laws generally, and measures taken to stay abreast of evolving money-laundering threats and new product and service requirements will be reviewed.
Elements of the topics above will also be addressed by examiners at community and mid-sized national banks as appropriate. In addition, OCC examiners will focus on the following:
Strategic planning. Examiners will assess the adequacy of strategic, capital and succession planning processes in light of foreseeable risks and planned business initiatives.
Stress testing. Preparation for stress testing at banks with $10 billion in assets or more will be reviewed.
Interest rate risk. Systems to measure and monitor a bank’s vulnerability to changes in interest rates will be considered, and loan portfolios will be examined for evidence of changes in risk appetite.
Conclusion: The Players Assume Their Positions
The recent emergence of more flexible lending standards is no surprise. Banks now face immense challenges to increase their returns on equity in an environment where low interest rates continue to stifle earnings growth while, at the same time, banks must maintain equity capital at levels higher than ever before. When compounded with a low-growth economic environment more generally, these factors require banks to find new borrowers as well as new lending products that will yield higher returns. Realistically, that can only be achieved with a greater appetite for risk on the part of banks.
The regulatory response also is predictable. The OCC understands this dilemma but has made clear that increased flexibility in lending standards, if taken too far, will bear the brunt of enhanced supervisory scrutiny. FRB officials have acknowledged that its warnings about uncertainties in the path of economic and monetary policy have had limited effect. An additional concern for bank regulators must be investors’ enthusiasm for CLOs as a driver in the lending process, over which they have no direct control and only limited influence without the use of broad monetary policy tools.