The Federal Deposit Insurance Corporation this week published its 2019 Risk Review, an annual publication highlighting emerging risks and exposures that could affect the banking system in the months ahead.
The Risk Review provides a summary of conditions in the U.S. economy, financial markets, and banking industry. It also presents key risks to banks in two broad categories: credit risk and market risk.
Concerns about reduced underwriting standards escalated with an increase in the “prevalence of loans with weak covenants and less rigorous documentation standards,” the report says. The stock market was adversely affected by price volatility in 2018, and several indices ended the year with negative annual returns. Despite strong earnings reports, bank stocks were volatile and underperformed relative to broader indices as interest rate expectations dampened the market outlook.
The role of geography
Past banking crises have been frequently associated with economic activity related to a specific sector or geographic area. “While the discussion of risks in this report is organized by topic, it is important to bear in mind that the confluence of risks facing institutions exposed to multiple sectors or geographies may present challenges that are difficult to foresee and therefore warrant attention,” the report says.
After 10 years of economic growth, loan performance metrics at FDIC-insured banks remain strong. Competition among lenders, however, has increased as loan growth has slowed, posing risk management challenges. Market demand for higher-yielding leveraged loan and corporate bond products has resulted in looser underwriting standards.
A slowdown in the agricultural economy is an important risk to the FDIC because farm banks are a large source of financing for the agriculture industry and represent about one-fourth of banks in the United States. Farm bank liquidity has declined as farmers have shifted from being net depositors to net borrowers.
Commercial real estate
Commercial real estate market fundamentals remain favorable as the economic cycle matures. Outstanding CRE loan balances are rising, however, and competition among lenders to maintain market share in the face of slowing loan growth is increasing. Vacancy rates are low, and property prices and rents continue to grow for CRE in general. But overbuilding in some multifamily and industrial segments and oversupply of outdated retail properties may weigh on CRE fundamentals going forward.
The housing market began to slow in 2018 as concerns about affordability intensified. “Banks with concentrations in this portfolio could be vulnerable to the slowdown, but credit quality has been resilient so far. Rising home prices, low inventory, and rising mortgage rates reduced affordability in many markets and led to a decline in home sales in 2018,” the report says.
Leveraged lending and corporate debt
Nonfinancial corporate debt as a share of gross domestic product has reached a record high level. The report suspects the increase has been driven by growth in corporate bonds and leveraged loans, which have become increasingly risky as the share of low-rated bonds has grown and lender protections in leveraged loans have deteriorated.
Partly in response to low interest rates, corporate debt levels reached a record-high 46.9 percent of GDP in 2018. Investors reaching for yield increasingly funded leveraged loans to highly indebted companies that lacked traditional lender protections. Direct bank exposure to corporate debt is concentrated in revolving leveraged loans, traditional commercial and industrial loans, and commercial mortgages. In contrast, indirect exposures are opaque and could transmit corporate sector stress into the banking system.
Banks have enjoyed several years of abundant low-cost deposit funding, but they could be challenged if deposit competition intensifies, the FDIC says. Nearly one-third of banks have seen a decline in their net interest margin since fourth quarter 2015, generally due to an increase in funding costs but also partly because of a decline in asset yields at some banks. Many rural community banks face added deposit retention challenges associated with long-term demographic shifts and the recent downturn in the agriculture industry.