Credit risk trends for community banks

With lending driving revenue and profitability for most community banks, it comes as no surprise that credit risk problems are at the heart of most matters requiring attention issued by bank regulators. Although credit risk issues are specific to each bank’s particular lending activities, the OCC and FDIC have noted recent trends in credit risk. This post discusses the trends that may be important to community banks and provides guidance for avoiding an MRA related to credit risk.

Recent reports from bank regulators have highlighted credit risk trends and issues that banks should be aware of in order to avoid regulatory issues. In this post, I focus on three particular trends: underwriting standards, loan concentration, and lending to high risk industries.

Underwriting Standards: The most significant credit risk issue for a community bank is its underwriting standards. It goes without saying that poor underwriting standards are likely to lead to bad loans, which will ultimately lead to losses and regulatory problems. As the economy continues to improve, loan growth follows—in fact, the FDIC reported that nearly 33% of banks grew their loan portfolios in excess of 10% in 2016. With loan growth, there is a temptation to loosen underwriting standards, particularly with the increase in competition from marketplace lenders and FinTech companies. Although modest changes in underwriting standards may be appropriate, prudent banks continue to closely monitor their underwriting standards even during economic growth to avoid poor consequences later. This may be particularly important for banks that are lending to higher risk industries (see below). Banks also should rely on data monitoring to determine whether there are certain types of loans or certain industries that call for tighter underwriting standards.

Loan Concentration: Lending concentration has always been an area of focus for community banks, particularly smaller banks and banks located outside of metropolitan areas. In a recent report on credit risk trends, the FDIC noted that “concentrations are not inherently problematic and are a part of doing business for many banks, particularly smaller institutions.” But the FDIC went on to warn that “concentrations add a dimension of risk that management must consider when formulating strategic plans and risk-management policies.” The FDIC recognized that adequate diversification is not always possible and stated that those situations “may require increased oversight; stronger credit- and liquidity-management practices; enhanced management information systems and reporting; more robust loan review and allowance for loan and lease losses (ALLL) policies and practices; and possibly, higher capital levels.”

High Risk Industries: Loan concentration and underwriting standards have heightened significance for banks that lend to higher risk industries. For instance, the FDIC’s recent report noted particular trends in credit risk for the commercial real estate, agriculture, and oil and gas industries. The oil and gas industry, for example, is highly volatile right now due to depressed oil prices. As the chart below illustrates, this has resulted in higher loan charge-off rates for banks located in states with heavy energy lending concentration (Texas, Louisiana, and Oklahoma). Obviously, these are industries that need to be banked, and lending to them can certainly be a profitable business line. However, market volatility and economic conditions require added diligence in lending to these industries. For example, banks should consider tightening their underwriting standards for loans involving these industries (e.g., increased diligence with respect to financials, lower LTV limits, and guaranty requirements).

FDIC Chart