An inter-agency review of complex loans commonly held by multiple U.S. and foreign financial institutions indicates that improvements in asset quality have stalled year-over-year and underwriting standards have diminished post-crisis, highlighting potential risks for both bank and nonbank lenders going forward. Fitch Ratings sees the review's results as further evidence that competition among lenders is heightening risks in and outside the banking system.

Each year the Fed, the FDIC and the Office of the Comptroller of the Currency (OCC) take part in a review of the major U.S. banks' Shared National Credit (SNC) portfolios to assess risk and underwriting standards relating to large, complex loans shared across the banking system, which total around $3 trillion, or 20% of the U.S. GDP.

Coming off of their 2013 review, the regulators reported on Oct. 10 that "criticized" or high-risk assets remain elevated at $302 billion, or 10% of total SNC commitments. This level was down just 60 bps from 2012 after a 2.1% decline between 2011 and 2012. Actual criticized loan volume increased 2.4% year over year and is about double precrisis levels, highlighting the degree of asset risk remaining in the system four years after the start of the recovery.

Fitch believes the level of criticized assets remaining in SNC portfolios and the observed increase in riskier assets is a concern, given the current fragile state of the U.S. economy, which has a substantial impact on the credit quality of these large loans.

Furthermore, Fitch remains focused on the potential impact on loan quality, particularly in commercial and industrial (C&I) portfolios, once short-term rates begin to rise along with debt payments. We believe that recent C&I loan loss rates, which are below long-term historical averages, are unsustainable and have also been deflated given somewhat higher growth rates in lending activity over recent periods. Fitch observes that the C&I loss rate at second-quarter 2013 for all FDIC insured banks stood at 33 bps compared with a 100 quarter average of 93 bps, thus supporting our view that there will be mean reversion going forward.

The SNC report confirms our view that underwriting, particularly in the C&I space, has weakened since the crisis given market liquidity and intense competition for loan growth.

The report points out that 34% of recently originated leverage loans were cited for weak underwriting due to a combination of high leverage and absence of covenants. This will likely cause C&I loan loss rates to increase over coming quarters.

One potential mitigant to risk in the insured banking system is that nonbank entities are among the primary buyers of these higher risk leveraged loans, and are the largest holders of criticized assets within the SNC portfolio (67%).

In a press release, Fitch noted it will continue to monitor loan portfolio performance within its rating universe, particularly in the C&I space, and could take rating actions if observed loss rates increase outside of its expectations.