The first time Comptroller of the Currency Thomas Curry delivered a speech at the Exchequer Club—a Washington, D.C.-based association of bankers and industry consultants—back in 2012 his focus was on operational risk, choosing not to dwell on other well-documented aspects of the financial crisis. “The industry was on the mend, credit quality was improving, loan losses were falling, and capital was building to historically high levels. I thought it was time—in fact, I thought it was long past time—to move beyond the issues that were so prominent during the crisis and turn attention to operational and compliance risk,” he said, speaking once again before the group on Wednesday.
While there is no letting up on the OCC’s focus on operational risk, the economic recovery, slow as it may be, means that credit risk is “now moving to the forefront,” Curry said. As banks reach for loan growth with less creditworthy borrowers, the resulting risk is prompting increased regulatory scrutiny of their auto, home equity, and commercial real estate loan portfolios.
“It’s the point in the [recovery] 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.”
While some financial institutions are now building loan loss reserves and reducing their exposure to higher risk loan products, many face the hazard of overlooking increasing credit risk while asset quality is still strong and lending is profitable. 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. Positive indicators can breed a sense of complacency and mask the risk now embedding itself in bank portfolios, Curry warned.
In response, the OCC and its regulatory colleagues have stepped up monthly monitoring of loan commitments. Auto lending is one area of credit risk that will be watched closely, Curry said. Auto sales are reaching record levels, good news for both automakers and banks supplying the financing that makes it possible. Increasingly, banks are packaging these loans into asset-backed securities rather than holding them in a portfolio. These products garner strong demand from investors, in part because securities backed by auto loans outperformed most other classes of asset-back securities during the financial crisis.
There is a downside to these positive developments.
“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 percent of all new vehicle financing features maturities of more than six years, and it’s fairly easy to obtain a car loan with very low credit scores. With 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’t require great foresight to see that this may not last,” he said. “How these auto loans, and especially the non-prime segment, will perform over their life is a matter of real concern to regulators.”
The OCC and other bank regulators have similarly increased their focus on more on home equity lines of credit, issuing guidance and pressuring banks with sizeable portfolios to strengthen risk management for these products.
“Neither auto loans nor home equity loans are inherently unsafe,” Curry said. “What is inherently unsafe are excessive concentrations of any one kind of loan. You don’t need a very long memory to recall the central role that concentrations—whether in residential real estate, agricultural land, or oil and gas production—have played in individual bank failures and systemic breakdowns.” The OCC, he said, is also “closely watching” growing exposures in commercial real estate loans, especially in the construction and multifamily housing sectors, as well as in loans to non-depository financial institutions.