The Office of the Comptroller of Currency has published its Semiannual Risk Perspective for the spring of 2014. The report is developed by the National Risk Committee and addresses key issues facing banks, such as the operating environment, condition and performance of banks, key risk issues, elevated risk metrics and regulatory actions. This abstract focuses primarily on the key risk issues identified by the National Risk Committee.
Key Risk Issues
The banking industry is continues to operate in a strategically high-risk environment due to competitive pressures from inside the industry and nonbank firms that are expanding into the banking industry, low interest rates, changing business models, and banks outsourcing critical functions to third parties. Operationally, larger banks face increasing risks due to increased legal settlements and regulatory penalties, an increase in sophisticated cyber attacks and greater interconnectedness that increases information security risk.
Underwriting Standards Appear to be Lowering
The National Risk Committee reported that the competitive environment in the banking industry and low interest rates are causing banks to lower their underwriting standards. This is evidenced by a number of factors. For instance, in 2013 the average total-debt-to-EBITD (earnings before interest, taxes, depreciation, and amortization) reached 4.7. This multiple hasn’t been that high since before the financial crisis. This multiple is concerning because leveraged loans are also being issued at a volume greater than in 2007. Covenant-lite loans (loans with less constraints such as collateral and income) have also increased dramatically. They have more than doubled from 2012 to 2013 and are at a level more than twice those seen in 2007.
Auto lenders are lengthening terms, increasing advance rates, and loaning to borrowers with lower credit scores. The average loan-to-value (LTV) for new and used vehicles is over 100% across the board. Because of the loosening of these standards, the auto lenders are being forced to increase their charge-off amounts from 2012 to 2013. The OCC says it will continue to monitor lending practices to determine whether banks manage growth and risk responsibly.
The types of loans that are experiencing an easing in underwriting standards are:
- Large corporate
- Credit cards and
- Consumer loans
However, there are some loans with stricter underwriting standards:
- High Loan-to-Value
- Conventional Home Equity
Risk in Home Equity Line of Credit (HELOC) Declining
HELOC volumes declined at nine of the largest OCC-regulated banks in 2013. However, HELOC volume that is at end-of-draw, which is the period when borrowers will no longer be able to draw on their credit, will reach its peak between 2014 and 2018. The OCC sees improvement as well as future challenges in this area and will monitor the situation and how lenders are managing the risks.
Weaknesses in Interest Rate Risk
Core deposits have increased since the financial crisis because of near zero-interest rates and depositors can have access to cash without incurring much cost. However, banks are using customers’ behaviors before and after the crisis in deposit modeling. Deposits are a major factor in IRR models and there is uncertainty as to whether to the trend will continue. The OCC hopes banks will use other assumptions to determine what effect a change in interest rates will have on earnings and economic capital.
Banks with less the $10 billion have seen this increase in deposits and are managing the pressure that low interest rates have on their Net Interest Margins (NIM). Because of these two factors, smaller banks have increased their investment portfolios centered on Mortgage Backed Securities (MBS). This makes smaller banks more sensitive to IRR fluctuations because they are more exposed to duration extension in a rising rate environment. Banks with less than $1 billion in assets are increasing their extension risk by lengthening their long-term assets in order to increase NIM. These smaller banks have increased their long-term assets from 17% in 2006 to 31% in 2013. Again, these long-term assets are centered in MBS.
It is easy to see why the OCC is concerned with this spring’s perspective. There are trends that mirror those just prior to the financial crisis, new exposures are being identified and large banks are being exposed to legal settlements and regulatory fines. This remains a highly competitive industry, which is being pressured from all angles and could cause the industry over expose itself in the pursuit of greater margins.