The report outlines the primary risks banks face, presenting data in four areas: the operating environment; the condition and performance of the banking system; funding, liquidity, and interest rate risk; and regulatory actions.
Analyzing year end 2011 data, the report notes that, although bank profitability increased in 2011, the primary driver of improved earnings was lower provisioning expenses (such as allowances for bad loans and other valuation reserves) rather than higher gross revenues.
Major risk concerns
The report focuses on three key concerns. First, the aftereffects of the recession created significant risks, as banks continued to face severely delinquent residential mortgages. Although small banks didn’t experience the same degree of delinquencies and loss rates as did larger banks, they were improving at a slower pace. CRE performance showed improvement, but high vacancy rates and problem asset levels continued to be a concern.
Revenue growth in a slow economy is the second concern. Loan growth — other than commercial and industrial (C&I) lending — remained sluggish; the low-interest-rate environment continued to squeeze margins and spur growth in nonmaturity deposits, which are vulnerable to runoff; and noninterest income faced increasing regulatory pressure.
The third concern is that banks, in an effort to improve profitability, will likely take on inappropriate levels of risk. For example:
• As banks compete for “higher earning assets,” they’re under pressure to relax underwriting standards.
• Financial institutions that enter new or less familiar markets may create new product risk.
• Banks that economize on systems and processes — particularly by using third-party providers — may increase operational risks.
• Financial institutions that add to investment portfolio positions and increase duration to obtain higher yields may be vulnerable to rate shocks if interest rates rise.
The report also notes that “the unprecedented volume and scope in the domestic and international regulatory environment challenges business models and revenues.”
Challenges for community banks
The OCC report highlights several risks for community and midsize banks:
CRE risk. Although CRE losses have been lower than expected, these loans have benefited from low interest rates. If net operating income doesn’t improve, or if interest rates rise, bank performance will be affected adversely.
New product risk. Some banks are attempting to improve asset growth by expanding or creating product lines “for which they may lack the appropriate control process and expertise,” such as C&I, indirect auto lending, and oil and gas lending.
Interest rate risk. Deposit growth and weak loan demand have put pressure on margins, creating an incentive for banks to increase the duration of their investment portfolios and purchase more complex, structured products, such as asset-backed securities or collateralized debt obligations.
According to the OCC, the main challenge for community banks is developing strategies that 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 first step is to assess your bank’s risks and to implement strategies for managing those risks and allocating resources in a prudent fashion. If you have a high concentration of CRE loans, for example, conduct a sensitivity analysis of your portfolio and develop a workout strategy for distressed CRE loans that minimizes the financial impact on your bank.
Also, if you’re entering unfamiliar markets, evaluate any new products or C&I loan portfolios to ensure that your underwriting and risk management standards and practices are adequate. Finally, evaluate your bank’s interest rate risk and take steps to manage it. (See below “Managing interest rate risk.”)
Review your plans
In light of the many risks your bank faces, now is a good time to review your organization’s policies, practices, procedures and strategic plans. A solid plan for measuring, monitoring and managing risk will help your bank survive — and prosper — as the economy improves.
Managing interest rate risk
It’s critical for you to evaluate the potential impact of interest rate changes on your bank’s earnings and equity. There are four main sources of interest rate risk. Repricing risk is the risk that assets and liabilities will mature or “reprice” at different times. Basis risk arises from a shift in the relationship between rates in different markets or on different financial instruments. Yield Curve risk occurs with variations in the movement of interest rates across the maturity spectrum. And option risk, which can result when customers have the option to prepay loans or withdraw deposits early with little or no penalty. While bank’s often associate this risk with borrowers paying off mortgage loans early, banks must also be aware of this risk with non-maturing deposits as customers may seek higher yields elsewhere when rates rise which can lead to a runoff of deposit accounts.
An Interest Rate Risk model is a valuable tool to help your bank understand and manage risk. Here are a few things you can do to enhance your model’s adherence to regulatory guidance:
• Make certain that the Board is involved to some degree and have some understanding of the Bank’s risk and its interest rate risk model as they retain the ultimate responsibility for managing interest rate risk.
• Review the assumptions that your model uses and understand the ability to adjust those assumptions, especially prepayment speeds and decay rates. Do not just accept the default assumptions built into the model.
• Review the reports produced by the model for reasonableness. If the assumptions are not valid or the inputs are not correct what comes out of the model may not be useful. The old adage still applies, “garbage in – garbage out.”
• Request information concerning how the model was built and that the logic and mathematical calculations have been validated. Your vendor should be able to provide this.
• Make sure you have had an independent party perform a model validation for you. This is in addition to the information that the vendor provides and is something the regulatory agencies are asking for.
• Compare the model projections to the actual results. This “back-testing” is required. Your model may provide some form of back-testing; however, the Bank should be looking at this and documenting it as well.
To manage these risks, use financial modeling or other techniques to assess your risk and, if appropriate, take steps to reduce your exposure, such as:
• Using asset-liability management to ensure the right blend of rates and maturities,
• Reducing option risk by controlling the terms of loans and deposits, and
• Consult your investment advisor regarding potential investment strategies that may help to mitigate interest rate risk.