As the economy recovers and banks once again take on the risk of less-creditworthy borrowers, the Office of the Comptroller of the Currency has signaled that its focus is shifting, too — away from the operational and compliance risk it has emphasized since the financial crisis and back to credit risk.
The Comptroller of the Currency, Thomas Curry, talked about the pivot in a speech to the Exchequer Club on Wednesday.
"It’s the point in the cycle where we customarily see an easing of loan underwriting standards, as banks drop or weaken protective covenants, extend maturities, and take other steps to build market share," Curry said.
"It’s also a time in which we see banks develop larger loan concentrations, without concurrent increases in reserves," Curry added. "It’s a natural byproduct of competition during the later stages of the economic cycle, and so it’s a time when supervisors and bank risk officers need to be most vigilant."
Curry said the OCC's annual survey of credit underwriting standards is showing rising credit risk, something that has been confirmed by the OCC's examiners on the ground.
"We are not yet seeing a uniform or comprehensive industry response to these early warning signs," he said "We are encouraged, however, by those institutions that are building loan loss reserves or, in some cases, reducing credit risk by avoiding or reducing their exposure to higher risk loan products."
"It’s all too easy to overlook increasing credit risk and continued loan growth when asset quality is still strong and lending is profitable," Curry added. "In the fourth quarter of 2014, asset quality metrics in OCC-supervised banks nearly matched the historically strong levels achieved in the fourth quarter of 2006, right before the start of the financial crisis. Those numbers have basically stabilized, but at levels that can easily breed a sense of complacency."
Curry also cited commercial loan growth, which has increased for 18 straight quarters, and loan growth in community banking, which he characterized as "particularly strong."
"These facts are impressive," Curry said. "But they can also be a misleading indicator of the fundamental health of the banking system. Credit quality, after all, reflects the outcome of decisions made when loans are originated, perhaps months or years earlier, possibly under tougher standards than those in effect today.
"So the indicators that many are looking at most closely actually say little or nothing about the risk now embedding itself in bank portfolios. We won’t see the results of those decisions for many months to come," Curry said.
Curry gave credit to banks and regulators for some "noteworthy improvements" in risk management over the past few years, especially in large leveraged loans and home equity lines of credit.
"Many banks enhanced their reporting systems to provide more detailed metrics on HELOC performance. So while the risk remains, it is being better managed today," Curry said.
While recognizing progress in some areas, Curry highlighted the rising risk he sees in the way banks are handling auto loans.
Curry said that the current state of auto lending looks a lot like the housing market, before the crash.
"But what is happening in this space today reminds me of what happened in mortgage-backed securities in the run up to the crisis," Curry said. "At that time, lenders fed investor demand for more loans by relaxing underwriting standards and extending maturities. Today, 30% of all new vehicle financing features maturities of more than six years, and it’s entirely possible to obtain a car loan even with very low credit scores.
"With these longer terms, borrowers remain in a negative equity position much longer, exposing lenders and investors to higher potential losses. Although delinquency and losses are currently low, it doesn’t require great foresight to see that this may not last. How these auto loans, and especially the non-prime segment, will perform over their life is a matter of real concern to regulators. It should be a real concern to the industry."