The Office of Comptroller of the Currency has issued a spring 2012 Semiannual Risk Perspective covering national banks and federal savings associations.  The report looks at the risks confronting those institutions and the potential that banks may take excessive risks as they try to improve profitability.

The report says that as the banking industry continues to emerge from the recession and to adjust to shifts in its operating and regulatory environment these shifts are inducing large changes in the risk and profitability profiles.  Levels of capital and allowances for loan losses (ALLL) are robust and a higher quality than prior to the recession.  However OCC has three major risk concerns; the after affects of the recent housing driven credit boom to bust cycle; the challenges to banking industry revenue growth; and the potential that banks may take excessive risks in an effort to improve profitability.

After effects of the housing driven credit boom and bust

• The overhang of severely delinquent and in-process-of-foreclosure residential mortgages continues to challenge large banks with extensive mortgage operations and continues to affect the economic environment for all banks.
• Asset-quality indicators show continued approved improvement across small and large banks. Small bank delinquency and loss rates did not reach the peaks seen at the larger banks, that their pace of improvement has been slower. Housing related loans continue to demonstrate above average rates of delinquencies and charge-offs.
• Commercial real estate (CRE) is improving, but vacancy rates and the level of problem assets continue to be high.

Revenue growth challenges from a slow economy and heightened financial market volatility

• Outside of commercial and industrial lending, loan growth remains tepid which has weighed on the interest income by pressuring asset yields for banks of all sizes.

Large nonbank corporations are extraordinarily liquid and appear likely to remain so.  This has contributed to an increase in deposits in the banking system and while lowering the demand of large nonbank corporations for loans.  It appears that corporate customers will be able to use internal funds to finance investment and expansion and thus that corporate demand for bank credit could remain modest even as the economy recovers

• The persistence of historically low interest rates continues to hamper margin upside by the limiting the ability of many banks to further reduce funding costs.

• Low interest rates have contributed to extraordinary growth in non maturity deposits, especially by businesses. These deposits may be vulnerable to run off and significant upward repricing if businesses start redeploying these funds or interest rates rise rapidly. Rising funding costs because of rising interest rates could limit in the upside to margins from the normal strengthening in loan volumes that would accompany stronger growth.

• As interest income has declined, noninterest income faces ongoing pressure from legislative regulatory and market changes that have depressed the income servicing and securitization income, and may restrain future trading revenue. These pressures are most intense at the largest banks although smaller banks also feel effects.

• European sovereign debt issues and the threat of a breakup of the Euro have led to a sharp slowdown in European economic growth and contributed to worsening credit quality, increased financial market uncertainty, and perceptible weakened global economic activity. This has contributed to an increase in the cost of long-term debt and equity financing for large European and U.S. financial institutions as these issues continue to weigh on market confidence and a recovery.

A potential that search for higher profitability made lead to taking an inappropriate levels of risk

• Underwriting standards are under pressure as bank and banks compete for higher earning assets to improve profitability.

• New product risk is increasing as banks seek to enter new or less for mature markets to offset declines in revenues from other areas.

• Increased operational risk is a key concern as banks try to economize on systems and processes to enhance income and operating economies.

• Credit performance overall remains vulnerable to week at the top economic growth and potential shocks such as from global financial markets or energy markets.

• The low interest rate environment continues to make banks vulnerable to rate shocks. Small banks in particular are increasingly adding to investment portfolio positions an increasing duration to obtain higher yields.

• The unprecedented volume and scope of change in the domestic and international regulatory environment challenges business models and revenues. These challenges increasing importance of strategic planning and prudent resource allocation.

The percentage of unprofitable banks continued to decline in 2011.  The percentage of banks with more than $10 billion in assets that were unprofitable declined 25 percent in 2011 from 39 percent in 2008

In the portions of the report dealing with residential real estate loans, OCC noted that residential mortgages led the decline a consumer credit portfolios continued to contract both because as consumer lending remained slow and banks charged of nonperforming loans.  Outstanding loan balances decreased in 2011 for all major portfolios of loans most notably credit cards and home equity.  All equity portfolios continue to shrink it as banks tightened underwriting standards and old values declined in many parts of the country.

Delinquencies for senior and junior residential liens declined slightly in 2011 but remained above 11%.  Softness in housing markets related to the sluggish recovery combined with the overhang of distressed properties and deficiencies in foreclosure processing has extended the time it takes lenders to dispose of troubled loans.  Fourteen of the largest servicers continued to implement corrective actions imposed by the OCC and the Federal Reserve in April of 2011.  In addition the large mortgage servicers reached a major settlement with Federal agencies and state attorneys general on servicing and foreclosure activities.  These events may help ease the backlog of foreclosures and allow the housing market to find price equilibrium.

Over the next several years a significant volume of home equity products will reach the end of their draw periods.  When these products were originated most contracts required that the outstanding balances would begin a full amortization, usually over 30 years, at the end of the draw period.   End of draw volumes increase significantly beginning in 2014.  Approximately 58% of all HELOC balances are set to start amortizing between between 2014 and 2017.  All equity borrowers face three potential issues; risk from rising interest rates because most HELOCs are adjustable rate; payment shock as loan payments move from an interest only to fully amortizing; and refinancing issues because collateral values have declined significantly since these loans were originated.

Housing the top price declines have led to questions for the banking industry about carrying values and allowances levels that support home equity portfolios.  To further heighten awareness of risk in junior liens the bank regulatory agencies issued ALLL guidance in January 2012.