SRC Insights: Fourth Quarter 2006 - Expanded Year-End Issue

Supervision Spotlight: The Credit Cycle

by Michael E. Collins, Senior Vice President

Credit cycles reflect changes in both loan quantity and loan quality. Credit cycles often occur in tandem with business cycles, which are related to fluctuations in the overall output of goods and services. In recent decades, credit cycles have followed the business cycle fairly closely, although this is not always the case. The current credit cycle includes new factors that were not part of past cycles, such as new products and market entrants, advances in technology, deeper capital markets, and continued advances in risk-based pricing. It remains to be seen how these factors will influence the credit cycle going forward.

Credit cycles are an inherent part of banking due in large part to the way banks compete for borrowers. The U.S. economy is entering a period in which economic activity is expected to moderate. During upturns in the credit cycle, riskier borrowers get credit, while collateralized loansdriven by competitiondecrease along with other loan covenants. Financial institutions are challenged to recognize that as memories of past credit cycle downturns fade, loan officers may become desensitized to the impact of credit problems and may be more willing to lend to high-risk borrowers.

One way to measure a credit cycle is by noting changes in the supply of and the demand for credit. The demand for credit has been strong in the last few years, coinciding with a period of historically low interest rates and extraordinary mortgage lending activity. And the supply of credit has kept up with the demand, proven by strong market competition during this time.

Another way to measure a credit cycle is by examining the quality of credit. Credit quality is often described in terms of delinquency rates and charge-off rates, in addition to other metrics. Credit quality has been very strong over the last several years, as indicated by a stable nonperforming assets ratio, low net charge-off ratio, and strong reserve coverage of nonaccrual loans.

However, examiners continue to see evidence of easing of underwriting standards as financial institutions continue to stretch for loan volume and yield. Price concessions and more liberal repayment terms and loan covenants have been documented by examiners. On the contrary, during downturns in the credit cycle when nonperforming loans are rising, only the banks' best customers get credit. Competition and margin pressure and the desire to drive profitability may be incenting loan officers to increase loan growth at the expense of future loan quality.

There is empirical evidence of more lenient credit standards during boom periods, both in terms of screening borrowers and underwriting and collateral requirements. Bank supervisors and bankers have evidence to suggest that bank lending mistakes are more prevalent in good times when both borrowers and lenders are overconfident about the ability to repay.

Because of the recent extended period of strong credit quality, growing loan demand, and fierce competition, it is not surprising that there is speculation about when there will be a change in the credit cycle and what the impact of that change will be.

Let's take a closer look at a few specific lending areas to gain some insight into current credit conditions. Commercial and industrial lending (C&I) is closely tied to the performance of the business sector. C&I credit quality has continuously improved over the last several years, and C&I loan demand has been steady, while underwriting standards have weakened and loan terms have eased. These trends are not unusual at this stage of the credit cycle. In fact, The Federal Reserve System's October 2006 Senior Loan Officer Opinion Survey on Lending Practices stated that strong competition (from nonblank market participants, in particular) is the main driver of the continued easing of C&I loan terms.¹

Commercial real estate (CRE) lending has received much attention from the regulators as CRE concentrations have reached historic levels. Bank supervisors have focused on CRE because it is typically a highly volatile asset class and CRE was a key factor in the credit problems of the late 1980s and early 1990s. Generally, CRE underwriting has improved over the last 15 years or so, but concentrations of CRE loans as a percentage of capital have continued to grow.

Of particular concern is that CRE lending has grown significantly in the last few years in the community banking sector. In previous credit cycles, large financial institutions typically had the most exposure to CRE loans. At financial institutions with assets between $100 million and $1 billion, average CRE concentrations are approximately 300 percent compared to about 150 percent at the bottom of the last CRE credit cycle in the late 1980s and early 1990s. Consequently, concern has been raised, and proposed guidance has been issued on CRE concentration and risk management practices, which aggregates previously issued guidance with an increased emphasis on portfolio management, strong risk management practices, and CRE concentration monitoring.

Policymakers must balance the focus on prudent risk management while avoiding unintentional consequences, such as creating a credit crunch. Accordingly, the proposed guidance is not intended to disrupt CRE lending that has been prudently underwritten and well managed. Final guidance is expected to be issued by year-end.

As I mentioned earlier, mortgage lending has reached unprecedented levels in the last few years. For several years, the housing market has been strong, with consumer spending driving the economy. A variety of innovative and nontraditional mortgage products has contributed significantly to the rise in mortgage lending.

These products allow borrowers to exchange lower payments during an initial period for higher payments later. Nontraditional mortgage products have also made credit much more available to a greater number of customers who may not otherwise qualify for a similar-size mortgage under traditional terms and underwriting standards. While similar products have been available for many years, the number of institutions offering them has expanded rapidly.

There has been recent evidence at the national level that mortgage delinquencies are on the rise, particularly in geographic markets that have experienced significant home price appreciation over the last several years. In the last few quarters, there has been an increase in delinquencies. In addition, the housing sector has slowed, and certain regional markets have experienced declines in property values.

These nontraditional products are untested across a credit cycle; however, there is anecdotal evidence that delinquencies and foreclosures are rising, particularly in subprime markets affected by higher interest rates and slowing price appreciation. Final guidance to address the risks posed by nontraditional residential mortgages was issued in late September 2006. The final guidance discusses the importance of carefully managing the potential heightened risk levels created by these loans.

Economic conditions over the last several years have supported a period of solid financial performance in the banking industry. However, there is strong evidence that the benign credit environment financial institutions have experienced is changing. Heightened credit risk on bank balance sheets emanating from strong competition and liberal credit policies will increase credit costs going forward and must be managed prudently. In recent years, banks have grown accustomed to spreading risk to investors through various capital markets activities. However, the growing dependence on the transfer of credit risk raises questions about the long-term appetite of investors to fund weaker credits.

Financial institutions must be prudent in managing the risk in their loan portfolios and must strive to be proactive in assessing the effects a change in conditions may have on their portfolio. There is evidence to suggest that the current credit cycle may be shifting, and rising credit costs will present headwinds in 2007. Signs of change include widening spreads on commercial debt issued by noninvestment grade obligors, senior loan officer forecasts that credit conditions will deteriorate in the next 12 months, and rising delinquencies in some retail credit product lines.

So how can banks prepare to weather a downturn in the credit cycle? Some guidelines for management include:

Establishing and reinforcing a strong loan culture
Creating a long-term strategic vision and turning away riskier deals when warranted
Maintaining ongoing awareness of evolving market conditions
Including credit cycle fluctuation scenarios in the management of both credit exposures and lending policies
Focusing on portfolio performance and enhanced stress testing

In the future, credit cycles will continue to occur, although the frequency and severity of the cycles will vary depending on contemporary influences. Management must continue to monitor credit cycles and employ risk management techniques to ensure the safety and soundness of their financial institutions.

¹ The Federal Reserve System's October 2006 Senior Loan Officer Opinion Survey on Bank Lending Practices.

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: Fourth Quarter 2006 - Expanded Year-End Issue

Supervision Spotlight: The Credit Cycle

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