Solid credit is one of the pillars of strong bank management, as well as one of the two main causes for bank failures (the second being poor interest rate risk management). The year 2023 was a notable exception to the rule, when SVB and others failed due to liquidity concerns. In my opinion, those failures were associated with the same critical principle that causes credit-based failures – concentrations. Diversification of risk is the bedrock of risk management regardless to what risk you are managing. It certainly applies to credit risk, and yet I found it curious that recent conversations on the topic do not use that word – CONCENTRATIONS – as often as they can and should.
Our regulators and management teams have been watching out for, maybe even expecting, a credit crisis. Some might say that expectations started during COVID, when most of us anticipated an economic calamity, likely associated with the collapse of the office space market.
While CRE concentrations continue to be of major concern to all of us, especially the regulators, both the underlying credit performance among most banks as well as the ACL (Allowance for Credit Losses) coverage remained stable for many quarters now. Adversely rated and classified asset trends are rising, as is the ACL in absolute terms. Actual percentage coverage has been declining steadily, though. Some might say this is of concern, but I take comfort in the decelerating rate of new MRAs imposed by the OCC and the declining number of concerns and institutions with outstanding concerns.
One important emerging concerns cited by the regulators, Jamie Dimon and others is the growth in Loans to Nondepository Financial Institutions (NDFI). The OCC now requires banks to>$10B to report specifically on these loans in five categories:
– Mortgage credit
– Business credit
– Private equity funds
– Consumer credit
– Other NDFI
I applaud this new requirement as any unchecked (or unreported) growth could lead to concentrations, and, as we all know, concentrations kill. During recent periods of relative economic softness these categories grew disproportionately, and, with them, bank credit extended to these institutions. A secondary market has been operating for most of these credits, and it is growing as well, reflecting investors’ insatiable thirst for yield. Many of these NDFIs are strong, well-run companies, but clearly not all of them are. As economic uncertainty continues, and CRE values and cash flows remain dependent on shifting employment patterns (WFH), credit risk appears under control and growing. Soft regional loan demand is augmented by ostensibly higher risk loans such as private credits and private equity, both high growth segments.
Now is a good time to return to some basic disciplines as you evaluate your portfolios:
– Overall portfolio management
– Concentration risk management
– Meticulous oversight of loan ratings
– Diligent repricing and refinance risk analyses
– Resisting the temptation to reduce loan review coverage, especially of smaller loans