Credit quality has been very strong recently and, as a result, many financial institutions have seen their watch list almost disappear. FORVIS performs loan reviews for approximately 150 institutions each year and their current average classified to capital ratio is hovering around 10%. For comparison, that number was almost 40% in 2009 coming out of the Great Recession and peaked in 2012 at just below 50%.
Prior to COVID-19, the U.S. experienced its longest consecutive economic expansion in history. After a sharp one-month drop in March 2020, the expansion continued for another 24 consecutive months until April 2022. A growing economy can hide a lot of potential risks in a portfolio. Similar to the economy, credit quality tends to be cyclical. FORVIS’ proactive and collaborative approach helps identify and manage potential drivers of credit risk to help our clients be prepared for a possible downturn.
One of the primary drivers of credit risk is the economy. On a macro level, it appears out of an institution’s control. However, there are strategies that can be implemented to prepare and coach borrowers through economic headwinds. One of the hottest topics regarding the economy is inflation and the government’s response to quell the rapidly growing inflation rate.
The Federal Reserve has increased interest rates by more than 450 basis points in the past 12 months. While the sizable increases appear to have slowed, there is growing sentiment that the Fed is not finished. An additional 25 basis point increase is expected at the upcoming May meeting. The continued rate increases will have a negative impact on your borrowers' cash flow unless the borrowers are tactfully managing their income and expenses to adjust for the increase in debt service.
For example, an institution has made a $10 million loan secured by a commercial real estate property with net operating income of $903,000. Based on a 20-year amortization, if all other variables remain constant, the table below illustrates the impact on the debt service coverage ratio as the interest rate increases.
| Interest Rate | 4.0% | 4.5% | 5.0% | 5.5% | 6.0% | 6.5% | 7.0% |
|---|---|---|---|---|---|---|---|
| DSCR | 1.25 | 1.20 | 1.15 | 1.10 | 1.06 | 1.02 | 0.98 |
A second illustration considers how increased interest rates for lines of credit will impact debt service coverage ratios. If a borrower were to have a $1 million line of credit, assuming $40,000 in cash available for debt service, and all other variables equal, a 300-basis point increase would have an adverse impact on their cash flow as depicted below.
| Time Frame | Rate | DSCR |
|---|---|---|
| Q4 2021 | 3.25% | 1.23 |
| Q4 2022 | 6.25% | 0.64 |
Borrowers of this type of loan are often commercial and industrial operations. Compounding their increased interest expense, these entities have faced increases in cost of goods sold, supply chain issues, and rising costs of transportation and raw materials. If the borrower is unable to pass any of these additional costs on to the consumer, the impact on cash flow could be even more extreme.
Early identification of the borrowers who will be most impacted by interest rate risk can provide an opportunity to coach them through potential shortcomings and allow the institution to actively supervise weaker credits.
There are additional drivers of credit risk that the bank can manage internally such as concentrations, credit administration, loan structure, and underwriting. The advisory team at FORVIS can work with clients to help them better understand how deficiencies in these areas can be improved to help prevent losses.
For assistance on how to better manage credit risk within your control or learn to be proactive instead of reactive to risk in your portfolio, reach out to a professional at FORVIS or submit the Contact Us form below.