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View from the District: Preparing Now to Weather Conditions Ahead
by Bill Spaniel, Senior Vice President & Lending Officer, Federal Reserve Bank of Philadelphia

Prior to becoming the senior officer in charge of supervision at the Federal Reserve Bank of Philadelphia, I spent 25 years at the Board of Governors, where I gained a deep appreciation for developing supervisory policy. I’m looking forward to enhancing that experience by obtaining a firsthand view of supervisory operations from the frontlines. My hope is that combining these two perspectives will provide me with unique insights that I can use when interacting with Third District institutions.

When I moved from Washington, D.C., to Philadelphia in November 2015, I made one particular observation early on. Philadelphia is well prepared to handle a snowstorm! I found out firsthand that 20 inches of snow, which brought the nation’s capital to a halt, can be managed effectively in Philadelphia and the surrounding region. Many cities are simply better prepared for these and other events based on history, planning, or practical experience.

Preparing for severe weather or other adverse events is an important concept for the banking industry. Although the industry has recovered from the depths of the financial crisis, with many financial ratios comparable to precrisis levels, bankers still need to be mindful of the credit cycle. Bank regulators are not at the point of sending off warnings that “a blizzard is coming,” but it is still a good time for both bankers and regulators to remain attentive and prepare for the next storm clouds.

While regulators and bankers have learned important lessons from the previous crisis — especially the importance of having robust risk management — we must continue to monitor evolving financial trends and portfolio concentrations. This will help us better identify emerging risks and negative trends in the credit cycle. We should also be mindful to take necessary actions now, ahead of these risks, before they become credit losses.

Current Performance Trends

Industry banking performance continues to recover after the Great Recession. National unemployment trends have returned to precrisis levels, and house prices have increased in most regions of the country. Problem banking institutions (those with composite CAMELS ratings of 4 or 5) have fallen 79 percent since 2010. The Third District (which covers parts of the Mid-Atlantic region) generally fared better than the nation during the crisis; however, postcrisis loan performance has been lagging the national pace. Loan performance metrics within the Third District did not deteriorate as much as they did across the nation, so the recovery in the Third District was not as well recognized when compared with national improvements.

Financial performance data for Third District institutions with less than $10 billion in assets show clear improvement, with median capital levels that have increased 4.7 percent year over year and 7 percent year over year for the nation since 2010.¹ Third District bank earnings, as measured by the median return on average assets, have increased by 26.7 percent compared with 41.5 percent for the nation over the same period. Further, since 2009, Third District banks have shown consistent improvement in asset-quality metrics.

Sources of Uncertainty

While these market trends are encouraging, there are indications of rising pressure on bank balance sheets, increased operational risk, and volatile capital market trends. Earnings have stabilized since the crisis but remain compressed by historically low net interest margins. Additionally, there are sources of uncertainty that raise concerns for both community bankers and regulators.

Community bankers have voiced concerns over the continued viability of the community bank model. Low interest rates, competition from nonbank sources, and rising compliance costs have affected earnings and led banks to consider mergers and acquisitions in order to find economies of scale. While loan performance metrics, such as charge-off rates, delinquency levels, and nonperforming asset ratios, have almost returned to precrisis levels, asset concentration levels appear to be increasing and underwriting standards appear to be easing.

The substantial rise in commercial real estate (CRE) credit concentrations is a particular area that bank regulators are monitoring. A national commercial property price index from Moody’s Investors Service and Real Capital Analytics rose 12.7 percent in 2015, which is 17.3 percent above the precrisis peak.² Banks have increased their CRE credit concentrations nationwide. As of year-end 2015, 415 community banks, or 8 percent, that meet the regulatory CRE or construction and land development (CLD) concentration levels as discussed in Supervision and Regulation (SR) letter 07-1 were in operation.³ Multifamily credit exposures have also increased, with a growth rate that has outpaced many other asset categories, including CLD loans, commercial and industrial loans, and nonfarm nonresidential lending.

Bankers also need to be aware that the volatility in commodity prices can adversely impact business sectors dependent on a particular commodity. For example, the Federal Reserve Bank of Philadelphia’s state coincident index,⁴ which measures factors such as employment, hours worked in manufacturing, and the change in state gross domestic product growth, shows that historically low oil prices are weighing heavily on the economies of Alaska, Louisiana, North Dakota, Oklahoma, and Wyoming because of their extensive energy reserves and/or oil and gas refining facilities. Similarly, in 2016, low oil prices impacted the earnings of banks with exposure to the energy sector, as noncurrent loans in the oil and gas industry rose sharply.

Applying Lessons Learned from the Last Storm

Against this backdrop, it is a good idea for bankers and bank regulators to take a step back and review the hard-learned lessons from the last storm. For instance, financial institutions, particularly community banks, should pay attention to lending and risk management fundamentals. Community banks that fared well during the crisis focused on the traditional community bank model that emphasized relationship lending tempered by strong credit standards, a robust understanding of products and markets, and an active board of directors that provided oversight.

In the Great Recession, we learned the difficult lesson of not paying full attention to the fundamentals of banking and risk management. Both bankers and bank regulators recognize that strong underwriting practices and well-established risk management processes were central to a bank’s success in weathering the Great Recession. Further, a bank needs a capital buffer appropriate for its risk profile. These actions need to be instituted during relatively benign economic periods so that a bank has a solid foundation to better insulate itself from potential economic downturns and adverse credit cycles. At the same time, a bank needs to thoughtfully assess the amount of risk in its portfolios and ensure that it has the proper tools, management information system reporting, and qualified personnel to face the challenges of the next storm.

Now during the balmy days of summer is the time for bankers and regulators to prepare for winter. Regulators should listen carefully to bankers and other industry experts to glean information that may not yet be present in early warning risk models and examination findings. By taking a thorough and principled approach to bank supervision that includes both quantitative and qualitative analysis of bank practices, risk governance, management, and mitigation, regulators will be able to identify and recommend actions to address these risks at supervised institutions.

Recent interagency guidance shows that bank regulators are watching trends and providing sound direction. In 2015, the Federal Reserve System issued SR letter 15-17 to address the substantial growth in CRE credit concentrations and the easing of underwriting standards.⁵ The guidance was designed to remind financial institutions to maintain underwriting discipline and conduct prudent risk management practices for CRE lending activity.

Similarly, in 2013, the agencies issued SR letter 13-3, which provided interagency guidance on safe-and-sound leveraged lending activities.⁶ The guidance emphasizes the importance of transaction controls in the distribution pipeline and underwriting standards that are commensurate with an institution’s risk appetite. Risk management and risk reporting go hand in hand with this, as higher risk credits require diligent monitoring and provisioning. The best defense from a risk standpoint is to originate loans with a sound business plan, a sustainable capital structure, and a borrower capacity for repayment.

Final Thoughts

Preparation is the key to being ready for the next negative turn in the credit cycle. The steps we take now will determine how well we weather the conditions ahead. Although we are unable to predict the next storm, we can agree that some level of vigilance and preparation is necessary. In addition, it’s important to pay attention to the fundamentals, such as capital planning, strong underwriting standards, and appropriate provisioning, especially as the banking industry looks to continue rebuilding capital and earnings. Collectively, we can begin to prepare to meet the challenges of the next storm.

The author would like to thank Lincy Chacko, Christopher Henderson, and Christopher Hahne of the Federal Reserve Bank of Philadelphia for their contributions to this article.