Increased risk in credit portfolios continues to be an area of concern as interest rates rise and stressors are placed on the economy. Credit quality has been very strong in recent years, and as a result, many financial institutions have seen their watch list continue to decline. FORVIS performs loan reviews for approximately 250 institutions each year, and we have observed the current average classified-to-capital ratio 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%.
The Federal Reserve’s benchmark lending rate is at its highest level in 22 years.1 Fed officials are estimating one more rate hike this year, according to their latest set of projections. Inflation’s steady slowdown in recent months has been encouraging for American consumers and businesses, but officials reiterated in their post-meeting statement that “inflation remains elevated” and the Fed “remains highly attentive to inflation risks,” suggesting that another rate hike remains on the table.
As interest rates have increased, concerns have been raised on the credit quality of loan portfolios at financial institutions. The Office of the Comptroller of the Currency’s (OCC) Spring 2023 Semiannual Risk Perspective indicates that “credit risk remains moderate in the aggregate, but signs of stress are increasing, for instance in certain segments of commercial real estate. Overall, credit markets and loan portfolios remain resilient, and problem loan levels remain manageable. The persistent drag from high inflation and rising interest rates, however, is causing credit conditions to deteriorate.”
The OCC continues, “It is important for banks to remain vigilant in identifying, monitoring, and managing weaker portfolio segments. Specific actions may include stress testing vulnerable segments, vintages, and geographies, and then adjusting underwriting standards and utilizing loss mitigation and collection strategies based on stress-testing results. Additional actions may include implementing increased portfolio monitoring and appropriately allocating for risk in the allowance for credit losses. Sound governance, transparency, and documentation of assumptions and judgments, including those for scenario selection and weighting, are critical to an adequate allowance for credit losses.”
Prudent underwriting and effective portfolio management can help reduce the impact of economic volatility. It is important for banks to closely guard against complacency. Robust analysis of borrowers’ repayment abilities and reliable valuations of collateral remains critical to effective risk selection. With considerable uncertainty in current economic conditions, bank management teams should consider monitoring the potential impacts on credit quality from changing unemployment levels, declining asset values, inflation impacts on disposable income, changes in payment rates, and consumers’ payment prioritization in this increasing interest rate environment.
As economic challenges persist, it is important that banks continue to emphasize sound risk management and loss mitigation practices. Loss mitigation strategies, including forbearance and modification programs, offer meaningful, affordable, and sustainable payment assistance to borrowers while minimizing loss exposure to the bank.
As a financial manager, your team will want to look beyond the basics of traditional cash flow measures to help your institution detect potential problems before they hit your criticized loan list. A detailed analysis of your operation will help provide an objective snapshot as well as peer comparison data and guidance for immediate and long-term improvements.
How FORVIS Can Help
We offer outsourced Loan Review programs, skill sets to complement your staff, a one-time assessment of your processes and procedures, or assistance in completing due diligence or reverse due diligence. Our Restructuring and Turnaround team has experience consulting with financial institutions to help assess problem loans and create action plans to rehabilitate borrowers and improve recoveries.
If you have any questions or need assistance, please reach out to a professional at FORVIS.
- 1“Federal Reserve Minutes: Officials Signal Cautious Approach to Rates Amid Heightened Uncertainty,” apnews.com, October 11, 2023.