Garnet Capital Advisors Blog

In a recent report, the Office of the Comptroller of the Currency warned banks about the credit risk that is steadily accumulating because of their willingness to provide loans easily.

Banks face challenging conditions
The government agency recognized the harsh environment these lenders face, noting that they are struggling to cope with steep competition and low interest rates, according to The Wall Street Journal.

The Spring 2014 Semiannual Risk Perspective, which culled data from the second half of last year, maintained that financial institutions are having a hard time increasing their revenue and operating profit.

Efforts to boost profits struggle
Last year, the industry generated net profits of $108 billion. This figure was 12 percent higher than in 2012, and represented an all-time high. However, it took the sector seven years to rise above its previous figure for profitability. In addition, reaching this new level required total assets held by lenders to increase $1.5 trillion, or 20 percent.

It is also worth noting that while banks with more than $1 billion in assets saw their net income rise 12 percent in 2013, those with less than $1 billion only experienced a 3 percent gain. All these shortcomings showed how weak the banking recovery has been.

In an effort to cope with this situation, many of these financial institutions have turned to providing higher-yielding loans to borrowers who are at greater risk of default, the media outlet reported. Lenders have also started extending the maturities of many of their financial products in an effort to bolster revenue.

Banks loosening credit standards
The report stated that banks are now lowering their lending standards amid the challenging business conditions. This is happening after the industry enjoyed a long period of improving credit quality and troubled loans being cleaned up.

In addition to granting credit more easily, financial institutions are extending maturities in an effort to bolster current yields, according to Bloomberg. Doing this in the current environment of continued low interest rates is generating additional risk.

OCC to scrutinize underwriting
Given the delicate situation, the government agency has indicated it will focus on how financial institutions evaluate potential loans, the media outlet reported.

"Given these trends, the OCC will increase its attention on underwriting standards and encourage banks to diligently assess their credit risk appetite in this stage of the credit cycle," the report stated.

Government agencies are interested in more than just what is owed to banks, and generally focus on "the company's ability to repay the debt over a reasonable period," Darrin Benhart, deputy comptroller for Credit and Market Risk at the Federal Deposit Insurance Corp, recently told members of the media, according to Bloomberg.

While the OCC's warning may seem troubling, many have criticized financial institutions over the last several years for keeping lending conditions too tight. Loosening these standards a bit will provide a stimulative effect to the economy, and could potentially increase the number of loans defaults. However, there are very few nonperforming loans right now, and the figure is far below the historical average.

While any increase in the amount of low-quality debt could affect loan sales, the impact that looser credit has on loan sales will likely be modest.