Swelling corporate debt could come back to bite banks: OCC
WASHINGTON — Banks' heavy involvement in the corporate debt markets could make them more vulnerable in a sudden downturn, the Office of the Comptroller of the Currency said Monday.
The agency's semiannual report on looming risks in the industry placed a heavy focus on the high volume of commercial loans as well as banks' exposure to nonfinancial corporate debt, which is near a record share of GDP. The OCC also repeated concerns about the growth of lending to highly leveraged companies.
In a conference call accompanying the release of the Semiannual Risk Perspective, Comptroller Joseph Otting said a bigger risk with leveraged lending is occurring outside the banking industry, but he said banks should be vigilant about underwriting commercial borrowers.
“I think that in this environment where there are very high and elevated leverage levels being done outside the banking industry, that it’s important for banks to look at a company’s suppliers or a company’s distribution network and understanding the leverage levels that are important partners in executing their business plan,” Otting said.
About 60% of banks’ outstanding loans are in commercial loans, marking the highest level in 30 years, the report noted. Commercial and industrial loans, which includes corporate loans made to nonbanks, make up 43% of the total commercial portfolios. The current report reflects industry data as of June 30.
“A deterioration in corporate bond and loan markets may affect supervised institutions more profoundly than in previous periods,” the OCC said in its report. “Favorable markets can turn quickly and unpredictably.”
The report included a special section on corporate debt as well as a supplement on credit underwriting. The OCC said it is still seeing a loosening of credit standards, especially in leverage lending.
“Growth in the leveraged lending market continues with near-record issuance through the first half of 2018, partly driven by investor rotation from fixed-rate bonds to floating-rate loans due to the rising interest rate environment,” the report said. “The OCC remains focused on transactions with increasing leverage, weaker capital structures, and looser credit agreements.”
The OCC also continued to raise concerns about a more competitive lending market; operational risks such as cyber threats; risks associated with rising interest rates; and compliance risk as banks adopt new technology to streamline processes.
“The highly competitive environment with nonbanks, particularly in the residential mortgage market, results in banks seeking to improve operating efficiency and considering introducing new consumer products,” the report said.
OCC staff during the call Monday said they were not against banks using AI or fintech partnerships, but they should be aware of compliance concerns related to digital undewriting procedures.
“Fair lending risk may increase as banks attempt to increase efficiency and effectiveness of underwriting through the use of artificial intelligence or alternative data," the report said.
During the OCC conference call, a member of the agency's staff said "there certainly would seem to be ways that they can” apply machine learning “in a compliant manner.”
Examiners “need to see how loans are being underwritten and ... how different groups of borrowers are being impacted by the use of particular criteria, and the extent to which the banks can demonstrate links between those criteria and credit performance,” the staff member said.
The OCC’s warnings come at a time when banks' return on their equity and lending growth have enjoyed steady growth.
However, that growth also raises concerns for examiners about banks getting too competitive, especially with nonbanks.
OCC-regulated banks reported more than 12% ROE in the first half of 2018, surpassing 10% for the first time since 2008. The net interest margin also reached its highest level in six years, the OCC said.