Board on Tuesday instructed its examiners to crack down on banks with weak underwriting standards.
Unpaid and foreclosed loans at the 50 largest bank holding companies increased 13.7%, to $18.8 billion in the 18 months ending June 30, Fed officials told reporters in a conference call. While problem loans are increasing from "fairly low levels," the officials said the trend is troubling because it comes during favorable economic times.
"Although modest thus far, these increases are significant because they have appeared despite the continuing favorable economic and financial climate in the United States," the Fed's director of banking supervision, Richard Spillenkothen, wrote in a Sept. 28 letter to examiners and bankers.
"Credit is being extended to some borrowers based largely on the expectation that the current strong financial performance of these borrowers will continue indefinitely, and with potentially undue reliance on aggressive or optimistic views of their future prospects," he wrote.
The rosy forecasts, he said, are not being challenged with meaningful stress tests at some institutions. Such tests should gauge how borrowers would be affected if interest rates rose, if their collateral fell in value, if expenses increased unexpectedly, or if their access to capital markets became limited.
Even at banks that are measuring how their portfolios might be hurt by adverse economic forces, examiners are finding that the results may not be taken seriously, he said.
"These recent indications of departure from accepted sound-lending standards are troubling because of the near-term effect on credit quality that is already evident, and the greater vulnerability of weakly underwritten credits to future cyclical deterioration in economic conditions," Mr. Spillenkothen wrote.
He told examiners to review enough loans and test enough transactions to determine whether a bank is adequately assessing and monitoring credit risk. Banks that fall short, he said, should receive lower management or asset-quality grades in their overall Camels ratings.
"Plans for remedial actions (should be) discussed with bank management and boards of directors," Mr. Spillenkothen wrote.
Fed Governor Laurence H. Meyer on Monday urged bankers to rigorously test whether borrowers could withstand revenue declines that an economic downturn could bring. Comptroller of the Currency John D. Hawke Jr. raised a similar flag last week, emphasizing that the banking industry's record profits may be disguising the consequences of lax underwriting standards.
The OCC is expected Thursday to release its annual survey of credit underwriting practices, along with a letter from Mr. Hawke on steps banks can take to raise the quality of their loan portfolios.