SRC Insights: First Quarter 2003

SVP Commentary on 2002 in Review and Expectations for 2003

by Michael E. Collins

When regulators and bankers in the northeast think back to events of ten years ago, we generally recall the weaknesses in commercial real estate that led to a record number of bank failures. What will we remember about banking ten years from now when we look back on 2002? Interest rate levels not seen since the 1950s and 1960s? Highly publicized failures in corporate governance? The disintegration of one of the Big Five accounting firms? Fraud, both inside and outside the banking industry? Increasing complexity in accounting and reporting requirements? The new legislation, regulations, and guidance as the country prepared to fight money laundering and terrorism through the USA Patriot Act and prepared to crackdown on breakdowns in corporate governance through the Sarbanes-Oxley Act? Or, will we remember that despite all the turbulence, preliminary indications are that 2002 was a year of continued strong earnings for the banking industry?

The Sarbanes-Oxley Act was signed into law on July 30, 2002 in response to the wave of misstatements, incomplete and/or misleading disclosures, and outright defalcations that shook public confidence in the American markets. Among other goals, Sarbanes-Oxley sought to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to securities laws, legislating corporate accountability and responsibility, enhancing oversight of the accounting and auditing industry, ensuring auditor independence, and creating a structure for holding individuals and companies criminally and/or civilly accountable for their actions. The Federal Reserve Board has long endorsed the need for transparency in accounting and disclosures. In addition, the federal banking regulatory agencies recently have proposed disciplinary action rules for accountants and accounting firms performing certain audit services, building off of capabilities in FDICIA related to institution affiliated parties.

While Enron stands out as the epitome of corporate malfeasance, the banking industry did not emerge from 2002 unscathed. While Allied Irish subsidiary Allfirst Financial's loss of $691 million due to fraud captured the headlines, the bank was in sound enough financial condition to absorb the losses. However, ten commercial banks and one thrift did fail in 2002, and one failure in particular was attributed to a multi-million dollar fraud committed by the bank's CEO.

These losses have highlighted the importance of internal controls and operations risk, an area that was once perceived by many as something for the back-office staff to be concerned about. While neither banks nor bank examiners can ignore credit risk, a difficult lesson learned is that operations risk can cripple a bank or a company as easily as credit losses.

Despite the recent strength in banking industry earnings, pockets of weakness remain, with new areas emerging. During the 2002 review of Shared National Credits (SNC)—an interagency loan review program that covers any loan or loan commitment of at least $20 million that is shared by three or more supervised institutions—the dollar amount of classified credits increased for the fifth consecutive year, reaching a level of $157.1 billion, or 8.4 percent of total commitments, up from 5.7 percent in 2001 and 3.2 percent in 2000. At the same time, loans listed for special mention rose to 4.2 percent of total commitments, from 3.7 percent in 2001 and 1.9 percent in 2000. Deterioration was largely driven by the pronounced problems in the telecommunication sector, alleged corporate fraud, weakness from the recent recession, and the after-effects of September 11th. Certain market segments exhibited moderate improvement, including the professional, scientific, financial, insurance, and other service sectors.¹

While the SNC review is of extremely large loan commitments, its findings are symptomatic of weaknesses in smaller credits. In the third quarter of 2002, the percentage of commercial and industrial noncurrent loans to loans was 3.01 percent, the first time this measure crossed the 3.00 percent threshold since 1993. While the severity of the problem was not consistent across banks of all sizes, and was in fact highest at banks greater than $10 billion, this measure was over 1.50 percent in all three categories of banks under $10 billion. The loss rate on credit cards remains high, as charge-offs in the third quarter were above 6.00 percent for the fourth consecutive quarter.² Notwithstanding the high level of charge-offs, noncurrent and delinquent credit card outstandings continued to increase, indicating that a return to lower charge-off levels in the near term is not likely.

While these issues reflect weakness in both the commercial and consumer loan sectors, the weakness is significantly less severe than the profile we faced ten years ago. In addition, implementation of effective risk management practices and lessons learned from the 1990s have served to protect the industry's balance sheets.

A review of recent SR Letters and interagency guidance provides an indication of what was on regulator's minds in 2002. Last year, the Federal Reserve issued five SR Letters related to various aspects of the USA Patriot Act and, as the Treasury Department promulgates additional guidance, even more SR Letters should be forthcoming. Accounting issues were also high on the regulatory radar screen, as three SR Letters and one interagency proposal were released to address accounting and audit issues, and three SR Letters were issued to address securitizations.

A steep yield curve and a return to basic banking activities characterized 2002, driven largely by robust consumer business. This combination of factors has placed the industry in a strong financial position for the future. In fact, strong deposit growth and wider net interest margins will likely produce strong profits for 2002. Nevertheless, concentrations and the potential for weakness in commercial real estate should be watched closely. In addition, high debt levels, delinquencies, and bankruptcies could portend problems in the consumer sector, particularly without employment growth. Banks will likely find that maintaining revenue growth will be challenging, particularly since consumer spending, which has been one area of strength, may begin to slow. Moreover, downward trends in capital markets will likely remain evident in the early part of the year.

Regulators will continue to assess the adequacy of banks' internal and accounting controls and the strength of quality assurance programs. Banks should also ensure that they maintain strong risk management processes around the introduction of new products. While these and other operational risk areas will receive increased attention, credit quality concerns will remain front and center. To mitigate the likelihood of further credit deterioration, banks should know their customers and should understand their business models. Regulators will carefully monitor underwriting practices and will watch closely for one of the newest areas of concern—mortgage fraud involving inflated appraisals.

Finally, regulators and bankers will continue to make progress toward the implementation of a revised Basel Capital Accord, as capital regulation and risk management practices evolve. The ultimate goal of Basel II is to improve safety and soundness in the financial system by placing more emphasis on banks' own internal capital allocation and management, the supervisory review process, and market discipline (the three pillars). This focus would move both regulatory capital requirements and risk management into the future, shedding the prescriptive one-size-fits-all capital levels of the 1988 Basel Capital Accord.

All in all, 2002 was a good year for the banking industry, particularly in the Third District. I hope that we recall the good times when we look back from ten years in the future, and can honestly say that we successfully overcame the challenges that were handed to us in 2002. That is my challenge to you.

¹ See the complete October 8, 2002 press release Bank Regulatory Agencies Find Adversely Rated Syndicated Loans Continue to Increase in 2002, but at Slower Rate than Previous Year .
² See the FDIC's Quarterly Banking Profile , Commercial Bank Performance, Third Quarter 2002.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

SRC Insights: First Quarter 2003

SVP Commentary on 2002 in Review and Expectations for 2003

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