OCC introduces new Risk Perspective Report

The lingering effects of the weak housing market will continue to challenge banks in late 2012, and revenue growth will be hampered by conditions in a post-recession economy. These are some of the risks discussed in a new report, Semiannual Risk Perspective - Spring 2012 issued by the Office of the Comptroller of the Currency (OCC). Released in July of this year, the report expounds on the primary risks facing national banks and federal savings association (collectively, banks) and reflects data as of Dec. 31, 2011.

This issue marks the first time the report has been released. Intended as a resource for both examiners and banks, the report will be released by the OCC twice a year. Each report will deal with risks faced by banks and will analyze four key topics: (1) the operating environment, (2) the condition and performance of the national banking system, (3) funding, liquidity and interest rate risk and (4) regulatory actions. The report is issued by the OCC's National Risk Committee, which monitors emerging threats to the banking system's safety and soundness.

The new report discusses the continued repercussions of the recessions of 2007 and 2009 upon the U.S. banking system, which has faced significant shifts in the operating and regulatory environments. The shifts have forced banks to make major changes in their risk and profitability profiles. Most notably, levels of capital and allowances for loan losses are more robust and of higher quality than prior to the recession. The higher levels are seen across the industry, but are especially evident at the larger banks.

Attempts to get higher yields may pose a risk

In addition to the risks engendered by a slow-growth economy and the aftereffects of the recession, the report discusses a third major threat – the possibility that banks, in an effort to improve profitability in a lackluster market, may take on excessive risks. Some of these risks are reviewed below:

• New product risk is increasing. In an effort to offset declines in revenues from core lines of business, banks may enter new or less familiar markets and product areas.
• Increased operational risk is a key concern as banks try to economize on systems and processes to enhance income and operating economies. For further insights into this emerging threat, see the May 2012 speech by OCC Comptroller Thomas J. Curry.
• The low interest rate environment continues to make banks vulnerable to rate shocks. In an effort to obtain higher yields, small banks are increasingly adding to investment portfolio positions and increasing durations.
• Underwriting standards are under pressure as banks compete for higher earning assets to improve profitability.
• The exceptional amount of change in the domestic and international regulatory environments is challenging existing business models. These challenges underscore the importance of strategic planning and prudent resource allocation.
• Credit performance overall remains vulnerable to weak economic growth and potential shocks from global financial markets and energy markets.

Community and mid-sized banks

The report offers risk perspectives for different business lines. For community and mid-sized banks, it highlights the following issues:

• The primary concern for community banks will be to implement a strategy that will allow them to thrive in the face of lingering credit stress, historically low margins, competitive pressures from larger banks and uncertainty about future regulatory changes.
• The risks of income-producing commercial real estate (CRE) portfolios continue to raise concerns. Losses from CRE portfolios have been less than expected, but these loans have benefitted from low interest rates. Performance will be adversely affected if net operating income does not improve or if interest rates increase.
• Some of these banks are seeking asset growth by expanding or starting new product lines for which they may lack the appropriate control processes and expertise. Examples include commercial and industrial, indirect auto and oil and gas lending.
• Margins are under pressure in the low interest rate environment due to growth in deposits and weak loan demand. This provides an incentive to increase the duration of the investment portfolio and purchase more complex structured products. Both actions increase exposure to interest rate risk and require heightened risk analysis to fully assess vulnerability.

Other risks

• Non-maturity deposits have experienced significant growth. It remains unclear what fraction of those deposits will be retained when interest rates move higher or when economic activity increases.
• As a significant volume of home equity products reach the end of their draw periods in upcoming years, home equity risk is expected to escalate. The report refers the reader to the January 2012 Federal Financial Institutions Examination Council guidance (Allowance for Loan and Lease Losses - Estimation Practices for Junior Liens on Residential Properties).

Although bankers are familiar with much of what is discussed in the report, it may be an opportune time to evaluate some of your bank's policies, practices and plans, especially prior to your next safety and soundness examination. For more information on this issue, please contact Tim Tiefenthaler, partner, at 702.759.4050.