Q&A on Agency Action


Anticipating safety and soundness exam issues in 2016

As in past years, community bankers will have a dynamic regulatory environment to contend with in 2016. Safety and soundness concerns will remain a prominent driver of that supervisory dynamic for community banks.

Karen Thomas, ICBA’s senior executive vice president–government relations and public policy, talked with Independent Banker about safety and soundness examination issues community bankers are likely to encounter in the year ahead. In particular, she discussed the strategic, credit and interest rate risks that the regulatory agencies have signaled they intend to evaluate closely this year.

IB: What safety and soundness issues are the regulators watching out for this year?

Thomas: Some of the most heightened concerns center on credit risks, interest rate risks, cyber- and third-party risks, and Bank Secrecy Act monitoring for criminal and terrorist money laundering activities. Regulators also have been mentioning strategic operational risks more frequently, those risks associated with pursuing new business relationships, activities or models.

IB: What are their concerns?

Thomas: Because banks have been introducing more new products and services or introducing new business lines, in part to simply serve their customers and in part to generate new revenues, the regulators want to evaluate how well banks are managing the risks associated with such new activities. Here, these risks could involve pursuing a new lending business line such as commercial leasing, expanding into a new marketplace, or rolling out mobile banking or remote check deposit capture.

Here’s also where their growing interest in third-party risks also come into play, where banks use outside service partners, as do cybersecurity risks related to technology services.

IB: This covers a broad area. What should community banks anticipate here?

Thomas: Any new activity that your community bank is involved in since its last safety and soundness exam is likely to receive close scrutiny. Regulators want to make sure banks are not only fully considering the risks before getting involved with something new or a new vendor relationship, but they also want to see that a strong process is in place to continually monitor those risks, including layers of new risks. They want to see well-documented decision-making oversight that extends all the way through the bank as is necessary, including up to the board of directors.

This isn’t new territory for safety and soundness exams. What’s new are the expanding number of the new and increasingly complex activities community banks are getting involved in that have tripped off the warning lights at the banking agencies.

IB: Lately, some of the agencies are sounding off about softening underwriting throughout the banking industry. Will underwriting receive greater scrutiny?

Thomas: Regulators are always cautious about financial institutions becoming complacent about warding off rising credit risks and drifting underwriting standards. However, regulators recently have said they remain concerned that intense and persistent competitive pressures in the lending markets—an ongoing challenge since the Wall Street financial credit crisis—are causing more banks to ease their underwriting standards and increase their credit risks beyond what they intend.

Regulators believe that many banks are still finding it difficult to lend to as many creditworthy borrowers as they have in the past. And consequently they say more banks, whether consciously or not, appear to be stretching their credit standards to serve more borrowers they would not have considered in the past.

IB: The Office of the Comptroller of the Currency has been citing a survey of national banks in relation to its most recent warnings about rising credit risks.

Thomas: That’s right. The OCC in particular has found as part of the periodic surveys it conducts that, for the third year in a row, more banks had been easing rather than tightening their underwriting standards. The trends apply to commercial and retail lending. In particular, the agency says it found more banks increasing their underwriting exceptions or adopting weaker protective covenants. It says loan maturities are growing longer, too.

Regulators issued a statement with reminders about prudent risk-practices related to concentrations in commercial real estate lending. They are seeing an easing of commercial real estate underwriting standards. Banks are expected to implement risk-management practices and maintain capital levels commensurate with the level and nature of their commercial real estate concentration risk. The OCC and other agencies also have cited increasing loan portfolio concentrations—particularly in auto lending, leverage lending and multifamily rental real estate projects—that may not be sufficiently offset with loan-loss reserves.

All of this cautionary talk from the regulators adds up to safety and soundness examiners taking a closer look this year at how banks are monitoring and modeling their credit risks, as well as how banks are maintaining their loan-loss reserves. Commercial real estate loan portfolios and loan participations could receive the greatest scrutiny. With the big drop in fuel prices, banks serving oil and natural gas industries will surely receive closer reviews for their credit risk management.

IB: Now that Federal Reserve has begun a series of gradual, if tentative, steps to raise the federal funds target rate over the next few years, what will examiners be looking for in terms of community banks’ interest rate risk management?

Thomas: Of course, interest rate risk has been an ongoing concern voiced by federal regulators for years since the Federal Reserve dropped its target federal funds rate to the historic low of a quarter percent during the Wall Street Financial crisis. Community bankers certainly have known that interest rates would eventually rise, and they have kept this in mind in managing their lending and investment positions. The Fed’s first quarter-point interest-rate increase wasn’t really a surprise to anyone.

Nevertheless, this is the first interest rate change in seven years, so the prudential regulators have renewed their concerns that some banks still might have liability-sensitive portfolios and have difficulty repricing their loan portfolios quickly enough to offset rising deposit rates.

IB: So what should community banks anticipate here?

Thomas: For the most part, that examiners will continue to monitor how well community banks are assessing and managing their exposures to rising rates. Community banks should be prepared to show that they are actively modeling their assets and liabilities for interest rate risks under different rising-rate scenarios. Such modeling, in the agencies’ views, should include realistic assumptions for various scenarios in which competition for deposits could become more aggressive. Examiners will be interested in what impact rising interest rates might have on earnings and capital.

So believe it or not, community banks should get ready for more scrutiny over their interest rate risk monitoring and management. It’s more of the same.