As community banks in the Northeast slowly return to pre-recession health, the Office of the Comptroller of the Currency is taking a closer look at how those institutions plan to stay competitive.

Strategic risk is rising, even as credit quality improves for smaller banks in the OCC's Northeast district, which stretches from Maine to South Carolina, agency officials said Tuesday during a quarterly review. The OCC rated 12% of the region's banks as having high strategic risk and 43% as having increasing strategic risk.

Competition in the Northeast "is very strong, largely because of the number of large institutions and the wide variety of products and services offered by many of the banks in the district," said Kristin Kiefer, the OCC's acting deputy comptroller for the Northeastern district.

The OCC is taking a closer look at how Northeastern banks respond to this intense competition, scrutinizing their underwriting terms, internal controls and how they prepare to introduce new products and services.

"Bank management and boards of directors have to be focused on assessing the risk within their institutions and establishing the appropriate controls, especially if they're considering offering new products or services," Kiefer said.

Credit quality is improving, and the number of problem banks is falling. As of June 30, 85% of the 339 community banks and thrifts in the 16-state territory had Camels ratings of 1 or 2, compared to 80% a year earlier, and lending has improved, the OCC reported.

"Overall, the condition of the banks and savings association continues to improve in the Northeastern district, and the level of problem banks continues to decrease," said Kiefer.

Net interest margins have widened and loan-loss provisions are falling, but fee income is declining.

Loan portfolios increased by 4.4% through June 30 this year, compared to 2% in the first half of 2013. Multifamily, commercial-and-industrial and auto loans have accounted for most of the growth, the OCC said. Regulators have previously warned about excess in the markets for C&I and auto loans, but, on Tuesday, agency officials said credit risk is mostly under control in the Northeast.

C&I lending "is increasing, but I don't think it's overheating," Kiefer said. "We're not seeing a dramatic change in the level of risk" banks are taking with auto loans, despite the gradual lengthening of loan terms, added Scott Schainost, the OCC's associate deputy comptroller for New York.

So the agency is turning to strategic risk, which "starts with the challenges in earnings [and] making enough money to satisfy shareholders or pay dividends," Kiefer said. "The other part is finding management expertise … [to] develop and implement strategic plans."

Earnings pressure has been especially pronounced in the tri-state New York metropolitan area, due to the number of big banks competing there.

Loan growth stood at 7% in that region, the fastest rate in the Northeast and among the fastest in the country. Yet 22% of banks in the metro area have less-than-satisfactory CAMELS ratings, compared to 15% across the district, and the return on average assets slipped 3 basis points from a year earlier, to 0.51%.

Earnings for banks in the tri-state region "are worse than they were three or four years ago, toward the height of the recession," mainly due to low interest rates and excessive competition for loans, said Thomas Angstadt, the agency's assistant deputy comptroller for New York.

"So some of our institutions need to reinvent themselves to improve profitability, and that's really the strategic challenge," he said. The agency is "requiring banks to develop sound business plans and risk management for all new activities."

The OCC isn't alone expressing concern about low pricing and strategic decisions around New York. "There are a lot of people slinging money around in New York at cheap prices," John Kanas, chairman and chief executive of BankUnited, said during an Oct. 23 conference call to discuss quarterly results.

"There is a lot of competition in that New York market, especially in the multifamily business," Kanas added. "So, we're watching a lot of these results of these banks that are coming off this quarter and breaking 3% margins. We think that, when you start doing that, you're not leaving a lot of room for mistakes in the future. … People are under pricing and beginning to scale back on loan covenants, and it's a dangerous game."

Still, the OCC is attempting to take an objective look at strategic risk during the examination process. "High [strategic] risk, or increasing risk, isn't necessarily a negative thing for the bank," Schainost said.

"A lot of our banks do have strong capital and excess liquidity, so they're looking at ways to expand their market share," Schainost said. "That just increases, from a regulatory perspective, their strategic risk."

Despite continuing earnings pressure, the number of problem institutions fell in Pennsylvania, New England and the Carolinas. There were 57 problem institutions as of June 30, down from 70 at the end of last year.

The Northeast region comprises Connecticut, Delaware, the District of Columbia, eastern Kentucky, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Rhode Island, South Carolina, Vermont, Virginia and West Virginia.

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