- Source: occ.gov
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On May 17, 2022, Acting Comptroller of the Currency Michael Hsu spoke at Bloomberg Risk & Regulation Week. Comptroller Hsu began his remarks with a quote from Warren Buffet, “Only when the tide goes out do you discover who’s been swimming naked.” Hsu noted that, despite a long-term positive economic outlook, the short- and medium-term outlook includes significant monetary tightening, inflation, supply chain disruptions, and a European war on top of pandemic recovery, a tech market correction, and uncertainty in China.
For more than a decade, interest rates have been near zero. Typically, long periods of low rate environments have resulted in greater risk-taking in search of better yields. Some researchers have found the low rates to be correlated with asset price bubbles.
Simultaneously with the low rate environment, U. S. lenders have experienced a prolonged period of low levels of delinquencies and charge-offs. Thanks to government interventions, credit quality remained strong and defaults near record lows despite the global pandemic.
Although the timing of change is unclear, these good times will not last forever. The Comptroller reminded his audience that high inflation during the 1970s led to monetary tightening, recessions, and depository institution failures in the 1980s. Although bank capital and liquidity buffers today are solid and substantial, banks that are taking excessive risk are more exposed to tightening monetary policy. Similarly, a greater number of banks with higher risk levels increases the chances of broader instability.
Given the potential uncertainty and volatility, banks should carefully assess their risk of unexpected losses. It may be time for banks to enforce discipline in risk appetites or remediate excessive risk positions. The Comptroller recommended several areas where banks should consider adjustments:
- Counterparty Concentrations: Banks must be able to aggregate counterparty exposures across business units and operating entities to create a holistic assessment of counterparty concentration and risk at the enterprise level. Once a comprehensive view of exposures is developed, banks should carefully consider possible risk layering, such as exceptions to risk limits, margin practices, and client selection and onboarding criteria, especially where consolidated exposures are large. Comptroller Hsu especially warned banks to pay attention to family offices and high wealth clients whose trading strategies and financials may be more sophisticated than the risk management systems of the channels through which they are served.
- Sector Concentrations: The Comptroller reminded banks that sector concentrations can lead to considerable losses when market conditions change. He highlighted two areas of recent loan growth in exposures that may indicate elevated risk – non-depository financial institutions and commercial real estate (CRE). Banks are encouraged to thoroughly review their exposures in these sectors. Concentration management should consider exposures individually, by subsector, and in aggregate. CRE exposures in hospitality, retail, and office space may be particularly stressed due to changing preferences, reduced business travel, sublet, and construction.
- Commercial Underwriting Standards: Hsu mentioned several signs of weakening underwriting standards. First, Shared National Credit (SNC) reviews continue to identify elevated levels of marginal transaction structures, such as weak covenants, in leveraged lending. Second, compounding the risks of the CRE sector, the OCC has noted growth in interest-only, non-recourse loans to institutional real estate investors. If the property was overvalued or income projections were too high, potential asset devaluation could threaten such deals. Third, competition from private lenders and private equity sponsors has placed pressure on underwriting terms and conditions in the middle market and sponsor-backed leveraged buyout transactions.
- Retail Underwriting Standards: In the retail credit market, the OCC has also observed increasing risk appetites and loosening underwriting standards at some banks. Supply chain disruptions have elevated collateral values for homes, cars, and RVs, which increases debt burdens on new borrowers. Inflation has exceeded wage growth, reducing consumers’ abilities to qualify for credit and maintain their ability to repay. This impact is particularly pronounced in lower- and fixed-income households and highly leveraged households. Consumers whose debt repayment moratoria are ending may struggle to resume payments under these conditions.
To manage these risks, banks must understand their risk exposures, manage their concentrations, and enforce risk discipline. When the tide goes out, banks that fail to take these actions may be caught swimming naked.