OCC Shines Light on Auto, Leveraged Loan Risks

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WASHINGTON — The Office of the Comptroller of the Currency sounded the alarm again Wednesday about two key areas in which it sees heightened risks from expanding portfolios: indirect auto lending and leveraged lending.

"The OCC sees signs that credit risk is now building after a period of improving credit quality and problem loan cleanup," the agency said in its Semiannual Risk Perspective, which aims to track potential dangers before they have manifested into losses.

"Examiners have observed erosion in the underwriting standards for syndicated leveraged loans, as well as loosening of standards and increased layering of risk in the indirect auto market."

While the report included the mention of positive signs about the industry's performance - such as net income at federally chartered institutions last year finally returning to pre-crisis levels - the report highlighted other potential warnings for banks and examiners to heed. Among other threats facing the national bank system are interest rate risk, cybersecurity concerns and ever-present anti-money-laundering challenges.

"Operational risk remains high because of the volume and velocity of change to business models and operations as well as continuing cyber-threats," the report said.

The OCC, which had previously raised concerns about leveraged and auto lending in the December risk report, on Wednesday said examinations have revealed banks making certain underwriting exceptions in their commercial loan portfolios, including extending periods that borrowers can make interest-only payments.

"A recent horizontal review of midsize and community bank asset-based lending ... found evidence of gradually loosening credit policies in response to competitive pressures," the report said.

Darrin Benhart, deputy comptroller for credit and market risk, said in a conference call with reporters that institutions still have time to improve their underwriting processes before the weaknesses actually start to hit their balance sheets.

"The risk of weak underwriting doesn't materialize often times for two to three years in some of the traditional metrics," he said. "That's why we continue today to push for sound underwriting, which will benefit the banking system over the long term."

Yet the report also sounded a few positive notes. For example, in 2013, federally chartered banks and thrifts set their first earnings record in seven years, of $108 billion.

Still, the agency said the new nominal record was only 5% higher than the previous mark set in 2006, and revenue streams remain sluggish.

"Return on assets and return on equity remain below pre-recession peaks. Overall, the federal banking system returned almost 10% on equity, but small banks continue to lag behind larger ones," the report said. "Revenue declined modestly as lower net interest income more than offset modestly higher noninterest income."

The risk report said limits on banks' ability to raise revenues and profits - partly as a result of the low-interest rate environment - remain "a key challenge."

"Low interest rates, slow total loan growth, and inconsistent fee income patterns still hinder revenue gains, while lower loan-loss provision expense is a key support to increased profits," the OCC said.

The OCC's concerns about leveraged lending and indirect auto loans echoed warning signs identified in the previous risk perspective report issued in December.

The risks from higher volumes of large syndicated loans, which tend to include leveraged loans, have been on regulators' radar for quite some time now.

In March 2013, the bank regulators issued guidance urging banks to improve underwriting for leveraged loans. Meanwhile, the October Shared National Credits report raised alarms over heightened deterioration in large commercial loans that are shared by at least three lenders, pinning the blame on loan commitments to commercial borrowers with higher-than-average leverage.

The OCC report said that as syndicated leveraged loan issuance reached an all-time high last year, some underwriting structures were relaxed. Newly issued loans with reduced covenants to protect lenders totaled $258 billion in 2013, which was nearly as much as the total issued from 1997 to 2012.

"Accordingly, the quality of underwriting in the syndicated leveraged loan market remains a supervisory concern," the agency's report said.

But the report also said risks in auto lending are emerging across the industry. Some auto lenders are seeking to boost their portfolios with eased credit requirements such as longer payment terms and loan originations for borrowers with low credit scores.

"Loan marketing has become increasingly monthly-payment driven, with loan terms and... [loan-to-value] advance rates easing to make financing more broadly available," the OCC said. "The results have yet to show large-scale deterioration at the portfolio level, but signs of increasing risk are evident."

Benhart said institutions view leveraged commercial loans and auto lending as areas that during the crisis avoided the kinds of losses that hit other types of lending, and are therefore now seen as opportunities.

"The two [loan categories] go together. Banks are looking for asset classes that performed … better during the last crisis and are looking to increase their emphasis in that area to again gain some additional revenue," he said. "So we're seeing competition heat up significantly in both of those areas."

But the "loosening of standards" is "raising our concern," Benhart added. He noted the importance of banks' improving underwriting before credit risk turns into credit losses.

"Oftentimes it's too late when the traditional … delinquencies or losses begin to show up if you haven't addressed the underwriting two to three years ahead of time," Benhart said.

Other risk areas highlighted by the report include continued worries over how banks will be affected when historically low interest rates begin to rise to more normal levels.

"The protracted and prolonged low interest rate environment continues to lay the foundation for future vulnerability," Kevin Walsh, deputy comptroller for market risk, said during the conference call.

The agency said examiners are also monitoring how banks are positioning their business plans to generate returns while economic growth remains slow.

"As banks seek new lines of business, some are bundling products and services or assuming new roles as agents between consumers and merchants that increase cross-channel payment, operational, and compliance risks," the report said.

The agency also included the threats of cyberattacks and banks' susceptibility to money-laundering abuses among risks facing the national bank system.

Anti-money-laundering "risks remain prevalent given changing methods of money laundering and growth in the volume and sophistication of electronic banking fraud," the report said.

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