More on Credit Risk
Credit risk arises from potential that a borrower or counter-party to a transaction will fail to perform on an obligation.
An assessment of credit risk is an integral part of the Federal Reserve's examination activities. During the examination process, examiners use a variety of techniques to assess an institution's credit risk, including sampling of institution loans and reviewing an institution's credit risk management processes. A defined system of credit classifications is an important examination tool for assessing credit risk.
Risk Committee Credit Risk Observations
Overall, credit quality at Seventh District banks remains satisfactory but is deteriorating sharply. Past due and nonperforming loans and net charge-offs are increasing, and loan-loss reserves are at record lows relative to nonperforming loans. The Chicago Fed's September 2008 Risk Committee identified the following key credit risks facing District financial institutions:
- Appropriate Adjustments to ALLL Methodology
- Residential Real Estate Lending
Appropriate Adjustments to ALLL (Allowance for Loan and Lease Losses) Methodology
The ALLL represents one of the most significant estimates in an institution's financial statements and regulatory reports. Because of its significance, each institution has a responsibility for developing, maintaining and documenting a comprehensive, systematic, and consistently applied process appropriate to its size and the nature, scope, and risk of its lending activities for determining the amounts of the ALLL and the provision for loan and lease losses. To fulfill this responsibility, each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution's stated policies and procedures, management's best judgment and relevant supervisory guidance.
An assessment of the appropriateness of the ALLL is critical to the safety and soundness of a financial institution, especially in today's highly uncertain economic and financial environment and when concentrations in untested loan products are present. Estimated credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. While historical loss experience provides a reasonable starting point for the institution's analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALLL. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution's existing portfolio to differ from historical loss experience. These include changes in the economic and business environment, changes in lending policies and procedures (such as underwriting standards), and changes in the volume and severity of problem loans.
Changes in the level of the ALLL should be directionally consistent with changes in the factors that may, taken as a whole, provide an indication of credit losses. For example, if declining credit-quality trends relevant to the types of loans in an institution's portfolio are evident, the ALLL level as a percentage of the portfolio should generally increase, barring unusual charge-off activity. Please refer to the 2006 interagency policy statement and supplemental Frequently Asked Questions for more information.
Residential Real Estate Lending
Banks, especially community and regional banks, typically have high levels of real estate-related assets. They continue to hold significant mortgage portfolios. In addition, many banks have high and increasing concentrations in commercial real estate (CRE) lending, including residential construction and development loans.
At Seventh District banks, loans related to residential real estate are being adversely affected by the national housing slowdown and by continuing weakness in the District's auto industry. Nationally, home sales and construction have slowed substantially, and house prices have fallen in many areas. Builders' inventories of unsold homes continue to rise, and construction of new homes continues to fall. In addition, major portions of the District are heavily dependent on auto-related employment. These areas have been severely affected by continuing problems at the "Detroit Three" auto manufacturers and the suppliers associated with them; effects include high unemployment and high mortgage foreclosures. Finally, although most banks have been insulated from direct exposure to the subprime mortgage market, many communities in the District experienced high levels of subprime origination and are seeing severe rates of delinquencies and foreclosures on these loans.
Real estate lending is driving the current asset-quality deterioration at banks. The asset quality of District banks is generally deteriorating faster than the national average. In addition, recent examinations at District banks have revealed significant risk management weaknesses in real estate lending, including:
- Increased interest reserves and other accommodations for residential construction loans, with no credible plan for loan payoff;
- Continued lack of portfolio analysis and stress testing for current and future market conditions; and
- Increased delinquencies, non-performing loans, and write-downs of residential real estate loans of all types.
In response to this deterioration, banks should monitor the performance of residential real estate-related portfolios through concentration analysis, market analysis, and portfolio stress testing. They should also monitor home-equity line use and payment patterns, as well as upcoming interest-rate resets on adjustable-rate mortgages. In addition, they should continue to evaluate the adequacy of the Allowance for Loan and Lease Losses on a quarterly basis and make necessary provisions to ensure adequate coverage of non-performing loans. Finally, banks should review their need for a loan work-out function and proactively make any needed staffing adjustments to the loan area.
Banks should also understand and comply with the agency guidance on risk management of CRE concentrations, as re-emphasized in a supervisory letter by the Federal Deposit Insurance Corporation. To the extent applicable, they should also consult the agency statement on subprime mortgage lending, as well as the statement to lenders and the statement to servicers encouraging them to work with mortgage borrowers who are experiencing difficulties. Finally, the Federal Reserve has published final rules on unfair or deceptive practices in mortgage lending and advertising.