By Darrin Benhart
The current operating environment of historically low interest rates, slow economic growth and increasing competition from nonbank firms is one of the most challenging many of us have ever experienced. Adding the rapidly evolving risks associated with operations and compliance to the mix only compounds the complexity of this challenge. Many banks are finding it increasingly difficult to meet already-lower target rates of return. Accordingly, many banks are re-evaluating their business models and risk appetites in the search for acceptable rates of return on their capital.
Make no mistake: the banking business is about managing risk. This is what bankers do on a daily basis. Banks should seek out new business opportunities that provide products and services that meet the needs of their communities, provided they do so safely and soundly. However, when adding new products or reevaluating business models that stretch risk appetite by expanding into less familiar products the key challenge is doing so while maintaining adequate due diligence, appropriate risk management and controls.
Bank management should focus on fundamental risk management principles to address this challenge—managing correlation risk, resisting the temptation to rely too heavily on historical performance and protecting against concentration risk. Three recent developments illustrate the importance of these basic tenets of risk management: the decline in oil prices, changes in auto lending and the valuation of the Swiss franc.
Correlation risk and oil prices
Correlation risk management involves risks to industries and investments affected by events in another industry.
Toward the end of June 2014, the price of Brent crude, a major world oil price benchmark, peaked at $107.48 per barrel. Since then, the price has fallen dramatically, by as much as 60 percent from last year.
This may be good news for consumers and many businesses, but if oil prices remain low for an extended period it can present a number of concerns for the industries and communities directly involved in energy production. It could also raise concerns for businesses that indirectly support the oil and gas extraction, refinement and distribution. Accordingly, while much of the recent discussion has rightfully focused on oil producers and concentrations to those borrowers, it is also important to consider potential effect to the correlated service industries.
The impact on correlated industries is much more difficult to capture—but it is potentially more meaningful. Exposures to commercial real estate such as office space or hotels and residential real estate built to support the expansion of the oil industry could be affected. Commercial loan exposures to trucking companies, restaurants or equipment companies may feel the effects as oil producers reduce operations, slow or stop new exploration or lay off workers.
It is easy to focus on the up-front risk, but sound risk management also needs to think broadly about other, sometimes more nuanced correlated risks. These risks are often more difficult to measure and understand. When looking at concentrations in the energy sector, for example, consider the effect on hotels, restaurants, residential real estate, office space and other local businesses.
To understand these risks, risk managers need to use data systems that can help determine exposure levels. They need to actively monitor these exposures and reach out to borrowers early. This allows for a better understanding of the risk and a chance to work out a plan to manage the exposures, rather than a reaction after negative financial results or missed payments that may not occur for another three to twelve months. Options for dealing with a late payment are often more limited for the borrower and the bank than risk-mitigating actions in advance.
Auto lending: past performance does not guarantee future results
The past, while providing us with good information, will not predict the future. This inherent limitation is where risk management needs to provide perspective by looking more broadly at how the environment has changed to protect against an overreliance on historical data. Learning from the past is an important part of risk management, but risk managers must take care not to rely too much on history. Things change. Risk management needs to provide perspective by looking broadly at how an environment changes over time, sometimes rapidly.
Auto lending is a good example. The OCC’s Semiannual Risk Perspective illustrates how auto lending has changed significantly and rapidly over the last few years, yet much of the justification for entering or expanding this product line is based on historical performance and consumer behaviors. Competition and the reach for revenue and yield have lowered underwriting standards and introduced new product features that may adversely affect the performance of these loans over time.
Rather than lending over the traditional 60 months, lenders are extending repayment periods of up to 84 months on new and used vehicles. In the past three years, the share of 73- to 84-month loans increased as a percentage of the total market for new cars—from almost 16 percent to 29 percent and for used vehicles from almost 10 percent to 16 percent. Lenders also are making loans with higher loan-to-value ratios and to borrowers with lower overall credit scores.
Under those terms, a family with subprime credit who buys a used car when their daughter celebrates her ninth birthday will still be paying for it when she takes it for her first drive on her 16th birthday.
At an individual loan and consumer level, the weaker underwriting of lower payments, higher loan to value, bundling add-on products and longer terms creates loans that focus on payment affordability rather than long-term sustainability. With lower payments during periods of economic stress, the lender and borrower have even less room to manage credit difficulties in the event of delinquency caused by short-term credit impairment. When borrowers experience difficulties, they are more likely to default and the loss will likely be greater for the lender and investors.
We are starting to see deterioration in auto lending portfolios, and banks reporting the average dollar losses per vehicle rise. Sixty-day auto loan delinquencies rose 11 percent in the second quarter of 2015 compared with a year earlier, according to Experian. So far, rapid growth in auto loan volume and low payments have offset the full impact of the risk by masking delinquency and loss rates as a percentage of total volume. How those investments perform over time is an outstanding question. But institutions should take care to manage these risks carefully and weakening underwriting standards or risk layering.
Concentration risk and the Swiss franc
On January 15, 2015, the Swiss National Bank ended its three-year cap on the value of the franc. While the SNB action was in response to developments in the euro, the action shook equities and currency markets around the world. The franc appreciated 41 percent in intraday trading, and the Swiss benchmark market index declined 9 percent.
Major Swiss companies that depend on stable foreign exchange and exporting goods felt the weight of the decision. The stock value of the watchmaker Swatch plunged 16 percent, and Holcim Ltd., the world’s biggest cement maker, dropped 10 percent. Both companies attributed volatility created by the SNB policy. Shockwaves rippled across borders, stressing the $5.3 trillion-a-day foreign-exchange market. Even the giant Deutsche Bank suffered disruptions to its trading.
While this was an extreme occurrence for a single day, the policy change shows the need to understand concentrations. From 2008 to 2010, a number of banks and thrifts in the United States failed because of concentrations related to residential real estate. Even seemingly stable values can change by 20, 30, or even 40 percent quickly. Managing concentrations has long been a focus of sound risk management. Concentrations can introduce a variety of risks including credit risk, interest rate risk because of maturity concentrations, liquidity risk from funding concentrations, or operational risks associated with concentrations of certain lines of business. That is why the OCC’s Handbook on Concentrations of Credit stresses continuous monitoring and setting risk limits for concentrations relative to capital or earnings.
Bank directors need to make sure their institution has adequate capital relative to all of its risks, and stress testing can help. All institutions can conduct stress testing at an individual portfolio or product line level. To be clear, the requirements for stress testing in Dodd-Frank do not apply to community banks and thrifts with less than $10 billion in total assets. However, federal banking agencies have emphasized that all banking organizations, regardless of size, should be able to analyze the potential effects of adverse events on their financial condition as part of sound risk management practices. This type of stress testing can help management and boards understand the risks associated with concentrations.
Weathering the storm through sound risk management
Risk managers have a lot to pay attention to every day. Many banks are re-evaluating business models in the search for additional sources of revenue. It is important for banks to establish and follow appropriate risk management processes as they explore new products and services.
Risk managers should consider the potential impact of concentration risk, correlation risk and the risk of relying too heavily on history in assessing emerging risks. As volatility returns after an extended hiatus, the dangers of these risks grow, but rigorous monitoring and early mitigation can help managers weather the storm—even in a sea filled with Swiss franc shocks, oil-price drops and shifting auto lending practices.
Darrin Benhart is deputy comptroller for supervision risk management at the Office of the Comptroller of the Currency.