WASHINGTON — In an effort to squeeze out profits in a low-interest rate environment, banks are under increasing pressure to lower underwriting standards, offer new, potentially dangerous products and ignore operational risk, a federal banking regulator warned Thursday.
The Office of the Comptroller of the Currency, in its first Semiannual Risk Review, offered a rare distillation of what agency officials see as the greatest safety and soundness threats facing national banks.
Though the agency noted that the industry overall appears to be slowly improving, the report focused squarely on potential pitfalls, particularly as banks attempt to make up for lost profitability.
"This is probably the biggest emerging risk area that we try to emphasize," said Darrin Benhart, deputy comptroller for credit and market risk at the OCC, in a conference call with reporters. "Banks are looking for ways to have higher earnings. How do you get that? Oftentimes you have to go out on the risk curve."
Chief among problem areas are how small and midsize banks are handling historically low interest rates, which have squeezed margins and - combined with continued weak loan growth -- forced institutions to look elsewhere for profit opportunities.
"The low interest rate environment continues to make banks vulnerable to rate shocks. Small banks, in particular, are increasingly adding to investment portfolio positions and increasing duration to obtain higher yields," the report said.
As a result, some banks are pursuing new business lines – such as indirect auto, asset-backed and oil and gas lending, for which they might not be fully prepared, OCC officials said.
"These are products with some demand – but some banks may not have level of expertise to deal with these products," Benhart said. "We aren’t seeing huge concentrations yet – but once there is a huge concentration, it might be too late."
While the problem of boosting earnings is widespread, OCC officials said, it’s most severe at smaller banks, which are far less diversified than their larger counterparts.
"The fact is the large banks have a much more diverse revenue stream," Marty Pfinsgraff, deputy comptroller for credit and market risk at the OCC, said on the conference call. "The megabanks are benefiting from some extent to some of the problems in Europe by picking up various businesses. …The problem is probably more acute for those institutions that have less diverse revenue streams and less ability to find more diverse sources of revenue."
Large banks, meanwhile, face ongoing problems because of "legal, operational and reputational costs stemming from" mortgage underwriting and servicing deficiencies, the report said.
"They face fundamental changes in their business models that are dampening revenue growth, including shifts in the role of trading, securitization and consumer fee income," the report said. "Operational risk is heightened during this period of transition."
Comptroller of the Currency Thomas Curry warned banks in May about heightened operational risks, saying that for the first time they have eclipsed credit risks as the top safety and soundness concern.
"Operational risk is a key concern as banks try to economize on systems and processes to enhance income and operating economies," the report said. "This risk may be amplified by the use of third-party products or distribution systems."
In particular, the report highlighted the growing danger posed by home equity lines of credit. Many were offered between 2003 and 2007 as interest-only loans, with the outstanding balance due to begin amortizing after a 10-year period. Those borrowers now face potential payment shock as they must begin making principal payments in addition to interest, and potentially be charged at a higher interest rate. Those that try to refinance the loan may be unable to because of housing price declines.
"Our rough analysis was the actual payments would go up by two to three times – it can be significant," Pfinsgraff said.
OCC officials said they offered the report to give the market and industry observers a better sense of what problems may emerge over the next several years. The report also details what steps regulators are taking to address these concerns, including new guidelines and enforcement actions.
"We envision as a way to be more transparent on our concerns on emerging systemic threats …and what actions we are taking to confront those," Pfinsgraff said.
Other key findings included:
• As banks compete for higher earning assets to boost profitability, underwriting standards are under pressure. "We are hearing a lot more about competition increasing significantly in the credit area for those few good loans," Benhart said.
• Some banks that previously built up concentrated exposures to commercial real estate loans are transitioning to positions in commercial and industrial lending "without appropriate control processes."
• With the exception of commercial and industrial lending, loan growth "remains tepid, which has weighed on net interest income by pressuring asset yields for banks of all sizes."
• Banks remain vulnerable to potential runoff of non-maturity deposits, which have swelled in a low-interest rate environment but would rapidly change if interest rates increased.
• Long-term debt and equity financing for large banks are likely to rise because of ongoing fiscal problems in Europe.
• Cybersecurity remains a big problem mainly for large banks, as criminals continue to try and find weaknesses in banks' systems.
• "The unprecedented volume and scope of change in the domestic and international regulatory environment challenges business models and revenues."