Last week Comptroller of the Currency Eugene A. Ludwig renewed his call to guard against declining credit quality, citing a considerable weakening in underwriting standards in commercial lending over the past year. While noting that banks have tightened credit card lending because of rising delinquencies and losses, Mr. Ludwig stressed that terms for home equity and residential real estate loans have also eased.
The Federal Reserve Board's latest senior loan officer survey on bank lending practices confirms that banks have eased terms on business and commercial real estate loans: 5% relaxed standards for commercial and industrial loans for all firm sizes, and 40% reported narrower spreads. The survey showed that demand for business loans was up a net 15% among large and midsize firms and 20% among small firms. Banks eased standards for commercial real estate loans a net 10% over the past three months-the largest net gain posted since the Fed added the question to the survey in 1990.
Clearly, intense competition within the industry, and from nonbank financial services firms as well, has affected credit quality. To what degree credit quality has been impaired, and the behavior of existing loans and portfolios in a less favorable economic cycle, remain open questions.
As the economy works through its seventh year of expansion, it is important to remember the severe credit problems suffered during the last downturn. However, it is also important to acknowledge that there are a number of new resources now available to the industry to help mitigate cyclical risk. As Mr. Ludwig noted, statutory restrictions on product offerings and geographic distribution have lessened considerably, allowing greater diversification and less concentration. While additional action is necessary to allow banks to fully compete on the product side with other financial services providers, the industry is clearly in a much better position today than it was a decade ago.
The industry also has developed a number of portfolio risk-management techniques that enable it to better measure and manage credit risk. Traditionally, banks maintained credit quality by lending to only the most creditworthy, the so-called "lend and hold" approach. Today, new portfolio management tools allow institutions of all sizes to use a number of grooming techniques, such as loan sales, asset securitization and trading, collateralized loan obligations, and credit derivatives, to effectively manage the risk within their portfolios. Technology also has enhanced greatly the quality of information the industry uses to make credit decisions.
The "State of Play in Credit Portfolio Management," a survey sponsored by Robert Morris Associates and undertaken with First Manhattan Consulting, showed that 59% of a sample of 64 institutions with assets of more than $5 billion practiced some form of active portfolio management. Active portfolio management includes a wide array of both new and old tools and structures, such as advanced risk analysis and classification of individuals loans, loan syndications and trading, use of credit derivatives, and geographic and industry diversification. Hopefully, this research will provide guidance to the industry and regulators alike as they each plan and prepare for the next economic downturn, whenever it might occur.
The principles that have long governed the equities markets are now being applied to credit portfolio management. Indeed, this process is pushing the convergence of the loan and securities markets, driving the homogenization of the commercial and investment banking sectors. To remain competitive, the banking industry has had little choice but to adapt to changing market-driven forces. The most interesting aspect of this entire process, however, is that the industry has turned what many predicted would be its ultimate demise into a profitable transformation. A January 1993 cover of Time magazine asked: Are Banks Obsolete? Today, no one would ask such a question.
Success in the financial services industry is about effectively taking, managing, and pricing risk. Doing so requires that institutions, and regulators, understand the total risk exposure within the various portfolios that an institution may hold. It also requires top-notch talent to staff the diverse portfolios the industry holds today. Now, more than ever, it is important to make the necessary investments in not only technology to run the various business lines efficiently, but also in educating and training for employees managing those businesses so that they clearly understand the principles of risk-adjusted returns.
Mr. Ludwig said that the OCC had detected cutbacks in bank staff experienced in dealing with troubled loans and borrowers, and that examiners will now evaluate a bank's capacity to deal with a potential increase in its work load of problem loans. As earnings continue to hit record levels and losses have remained low, staff in workout groups have had diminished workflow. However, now is clearly the time to ensure that staffing is adequate and properly trained to handle problems when they next occur.
To help identify a lenders' strengths and weaknesses and better build sound lending skills, Robert Morris Associates partnered with 15 member banks to develop its Diagnostic Assessment of Lending Skills and Knowledge. A series of multimedia training courses for lenders was developed to provide needed training flexibly and cost-effectively since employees can use the CD-ROMs at their workstations or at home. Early Detection of Potential Loan Problems is a significant portion of the Diagnostic Assessment and having staff take the exam now may be a simple way to minimize future surprises and problems.
As is often said, it is in the best of times that the most damaging risk-management mistakes are made. It is difficult to exercise prudence and restraint in a euphoric environment. Yet given the new risk-management tools available to the industry, it should be possible to implement effective management systems to detect problems before they become overwhelming and thus lighten the negative impact on bank earnings during the next downturn.