Accelerating loan growth accompanied by eased underwriting is a leading concern for U.S. banks in the Office of the Comptroller of the Currency's (OCC) semiannual Risk Perspective Report released in late December. The report, a review of key risks facing the banking industry, echoes points of caution expressed by Fitch Ratings in recent outlook reports.
In terms of asset quality and loan growth, the OCC's data paints a mixed perspective of the overall health of U.S. bank balance sheets. Positively, net chargeoffs are running below 25-year averages for all major loan type categories. However, delinquencies in the one-to-four family residential mortgages category remain stubbornly well above historical levels. Furthermore, commercial and industrial (C&I) lending is still growing at nearly 10% per year over the past four years. While this growth trajectory is less aggressive than in 2004-2008, it is a point of concern that Fitch shares with the report.
Loan growth in excess of economic growth, often a result of relaxed underwriting standards, could place greater pressures on banks over time. Consistent with the trends noted in the OCC report, several Fitch-rated community banks in particular have shown outsized growth in multifamily real estate lending, consumer lending and C&I lending in 2014.
While Fitch generally views loan diversification (by both asset class and geography) as a positive, the rating agency has concerns regarding growth in C&I lending. Competition for C&I lending is highly intense and is at times being driven by nonbank lenders with weaker oversight than banks. The low interest rate environment, which is likely to move higher in 2015, is also a factor in Fitch's view. Fitch believes the rate environment has been supporting C&I's better than historical average credit quality.
The OCC's report found that within the C&I segment, loans to real estate and construction sectors, as well as to finance and insurance sectors, led in year-over-year growth in the second quarter of 2014 among the 24 commercial categories tracked by the regulator. Growth in real estate construction likely reflects a reemergence of lending after the deep pullback from construction lending in 2009, while growth in finance and insurance reflects a greater number of funds and financial vehicles, likely related to nonbank and shadow banking financial institutions. Direct lending to banks, a separate category, showed the lowest growth rate among the 24 categories at negative 5.1% in the second quarter.
The trends in C&I loan growth were particularly notable at large community banks, where asset sizes generally range from $1 billion to $10 billion. The overall loan growth rate of 7.6% in second-quarter 2014 was higher than that of banks with greater than $10 billion in assets, at just 3.6% growth, and higher than banks with under $1 billion in assets, with total loan growth of 4.9%. Only the residential real estate category for the group of banks with greater than $10 billion in assets showed negative growth as of the second quarter.
Fitch believes many banks may be buying shared national credits for the purposes of showing growth, a strategy that does not typically strengthen a bank's franchise or long-term financial profile. Banks could also be winning loans by loosening loan terms through removing personal guarantees and lowering debt service coverage ratio requirements, among other means of easing standards.
The OCC noted that the search for yield by investors has been driving more relaxed transaction structures that incorporate fewer, if any, loan covenants and other lender protections. This point, combined with our observations of portfolio durations broadly lengthening across the U.S. banks, heightens not only asset quality risks, but also sensitivity to interest rate risks.