For community banks, fear of loan losses intensifies

Credit quality is a top worry for community banks in 2023, given the looming threat of recession.

Of more than 100 lenders polled by the Risk Management Association, 84% ranked potential loan losses as a major challenge for the year ahead. That fear trailed only cybersecurity, which was cited by 85% of respondents. The RMA surveyed more than 100 bankers in the second half of 2022, focusing on executives at banks with $10 billion of assets or less.

"Community banks continue to face unprecedented risks and extraordinary demands on their time, attention and resources," said Nancy Foster, the RMA's president and CEO.

At issue: Following multiple Federal Reserve interest rate hikes in 2022 — the latest a 50-basis-point boost in December — borrowing costs are spiking and spending is beginning to ease. This is the Fed's strategy to tame inflation that hit a 40-year high last year in the wake of pandemic-induced supply chain problems.

Historically, however, recessions follow pullbacks in spending, stifling loan demand. During economic downturns, loan losses also tend to rise, driving up banks' credit costs and cutting into profits.

"You inevitably get the real potential for credit issues with a slowdown in the economy," said Michael Jamesson, a principal at the community bank consulting firm Jamesson Associates. Small, locally focused banks are often concentrated on commercial real estate lending, financing the properties of their bread-and-butter small-business clients. "And areas of CRE are potentially vulnerable if we do get a recession" in 2023, Jamesson said.

Analysts say small businesses are more exposed to soaring inflation and rapidly rising interest rates than larger companies because they typically have leaner savings to tap during difficult times. As such, if their customers pull back on spending in a downturn, it could make it more challenging for these businesses to turn profits and, by extension, to make loan payments.

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Office properties, too, are particularly susceptible in the pandemic era. Expiring office leases and an enduring shift to remote work could pinch landlords in the year ahead.

More than 10% of U.S. office leases expired in 2022, according to estimates from the real estate services company Jones Lang LaSalle. With more Americans working from home following the coronavirus outbreaks of recent years, employers this year are expected to decide against renewing office leases and others could downsize to smaller spaces. Both developments could hamstring landlords, leaving them with partially empty buildings and dwindling revenue. Loan defaults could follow.

"Fears about a turn in the credit cycle create a more challenging backdrop for bank stock investing in 2023," Stephens Inc. analysts said in a report.

Beyond credit quality, cybersecurity expectedly ranked atop community bankers' concerns, the RMA said. Most lenders this decade hastened their efforts to provide the digital services that customers are embracing as technology advances. However, as this happens, hackers are increasingly active, necessitating that banks both invest more in cybersecurity and brace for greater risk of criminals exploiting digital platforms to rob lenders or steal customers' private information.

"Every bank is hyperaware of cybersecurity — or should be," Charles Wendel, the president of Financial Institutions Consulting, said in a recent interview.

The RMA poll found several other areas of trepidation. Survey respondents also ranked operational risk (65%) information-technology challenges (62%), interest rate risk (57%) and regulatory compliance hurdles (50%) as leading worries.