By Tyler Mondres
ABA Senior Manager, Economic Research
Even good times have their risks. That’s the central message of the OCC’s Semiannual Annual Risk Perspective report released May 20. The study noted that, in keeping with a robust economy, bank asset quality is strong and stable, capital and liquidity remains at or near historic highs, and earnings have improved. These are strong signals of a healthy banking sector, provided the risks associated with them are well managed. To that end, OCC’s report reminds banks of the underlying credit and liquidity risks that can come with the current point in the economic cycle.
Building on the health of the economy…
Banks continue to build on the health of the economy, reporting strong financial conditions in 2018. Banks have invested significant time and resources addressing supervisory concerns, the report noted, and have improved quantitative metrics to levels that have not been seen in many years in asset quality, capital and liquidity. While U.S. economic growth is widely expected to slow in 2019, the economic environment is expected to support loan growth and bank profitability for the remainder of the year.
Banks’ asset quality remains strong and stable. Delinquent and nonperforming loans in the federal banking system remained below their long-term average in 2018. The total of 30-day-plus past-due loans plus nonaccrual loans continued to decline, reaching the lowest level since 2005 for banks with total assets less than $1 billion. Similarly, banks with total assets of $1 billion or more touched the lowest level of delinquencies since 2006 as of the end of 2018.
Banks have increased their risk-based capital ratios to all-time highs. Similarly, leverage capital ratios increased since 2008. Banks with $10 billion or more in total assets show an upward trend since 2010. The tier 1 ratio’s upward trend from 2008 to 2012 has slightly reversed for banks with less than $10 billion in assets as lending has increased during the economic recovery. These higher ratios are noteworthy given the increase in the quality of regulatory capital and the increase in risk sensitivity in the calculation of risk-weighted assets in the post-crisis reforms.
Liquidity remains strong across banks. Banks with total assets above $1 billion are operating with high levels of liquid asset across all categories. Banks with total assets below $1 billion continue to redeploy into somewhat less liquid assets. Cash levels remain heightened across all banks in aggregate, as reductions in total liquidity are primarily a function of changes in the securities portfolio.
Profitability benefited from strong underlying performance and tax reform in 2018. Pretax return on equity increased to 14.8 percent, indicating the strength in fundamental financial performance driven by increases in net interest income and well-managed expenses. Pre-tax income rose 14 percent to $204 billion, reflecting strong revenue growth. Net interest income grew at an 8 percent pace, spurred by margin expansion at banks of all sizes. Noninterest income growth rose 5 percent from a nearly flat performance in 2017.
…but watching for emerging risks
While banks have had a strong year contributing to the health of the economy, the OCC noted several risks worth managing. The agency warned that imbalances like inflation can emerge when the economy operates above its full potential. “Successive years of growth, incremental easing in underwriting, risk layering, and building credit concentrations result in accumulated risk in loan portfolios,” it said.
Though credit quality remains strong as measured by historical performance metrics, credit risk remains a top concern for the OCC. The report noted that banks and nonbanks have continued the recent trend of easing underwriting standards as they compete for quality loans. The dollar volume of adversely risk rated loans, as a percentage of total loans, remains elevated compared with levels experienced at a similar point in the prior economic cycle. However, the report noted that most of the credit risk associated with leveraged loans is outside the federal banking system. More leveraged lending is being transferred to nonbank entities with much less transparency, making it difficult to monitor.
The report also observed that commercial real estate lending remains highly concentrated in some banks. CRE loans grew 7.8% at community banks in 2018, compared to 1.4% industry-wide, and represent about 70 percent of commercial loans and 42 percent of all loans. While growth in CRE exposure continues, the number of banks with CRE exposure over 300% of capital or construction and development loans of over 100% of capital declined.
Finally, while deposits have risen, the OCC cautioned that an uncertain rate environment and technological advances in moving funds “could result in markedly different depositor behavior than in previous economic cycles.” The OCC also noted that strategic risk—driven by the need for banks to invest in innovative technologies, transition from legacy systems and achieve greater efficiencies—is elevated. Consistent with previous reports, cyber threats result in elevated operational risk, and Bank Secrecy Act compliance risk remains high.