By Kenneth Cline

While banks generally seem better prepared to handle this credit downturn than the last one, credit professionals are taking a cautious stance.

If you believe the politicians and economic prognosticators, the U.S. economy is slowly emerging from its recent bout of weakness. That won't spell instant relief for bank credit officers and risk-management specialists, however.

U.S. commercial banks suffered a 28% increase in non-current loans during 2001, according to the Federal Deposit Insurance Corp., and more pain is in store.

Federal regulators have warned of continued deterioration in commercial and industrial loans, for several more quarters at least. They have also reported weakness in commercial real estate and consumer loans in some parts of the country. Are today's bankers well equipped to deal with these challenges from a risk-management and problem-resolution point of view?

Participants in a recent Banking Strategies roundtable discussion answer in the affirmative, pointing to strong capital ratios and improvements in the early identification of problem credits, particularly through the introduction of a more robust loan-grading system. Compared with the banking industry's last credit downturn in the early '90s, systems for resolving bad loans are also much improved.

In this latter area, however, the regulators themselves have created uncertainties. In the wake of the Enron Corp. scandal, examiners are sharply scrutinizing "off-balance sheet" structures used by some banks to dispose of bad assets. Most notably, Pittsburgh-based PNC Financial Services Group had to take back some bad loans and restate its 2001 earnings under pressure from the Federal Reserve.

It all adds up to a dicey time for bank credit experts. "We'll be working out of these problems over the next couple of years," says Martin J. "Dev" Strischek, managing director, commercial and corporate credit policy, for SunTrust Banks Inc. in Atlanta. He was joined in the discussion by John F. Carter, regional director of the Federal Deposit Insurance Corp. in Dallas, and Walter L. Smith, vice president, risk support services, with Wachovia Corp. in Charlotte.

During the session, conducted in March at BAI's National Loan Review conference in San Antonio, Texas, the three participants cited commercial real estate, agriculture, and small business loans as areas of particular concern. They also saw little prospect of improved loan origination volume until later this year.

FDIC statistics bear out their concerns for the banking industry at large. While overall concentrations of troubled credits are not at crisis levels, problems have risen rapidly in many lending sectors. In 2001, non-current construction and development loans rose 59%; commercial and industrial loans 35%; and loans secured by real estate 27%. Non-current home equity lines of credit increased by 27%, as did other types of non-current consumer loans (outside of credit cards).

Banking Strategies: What are the top issues on the minds of bank credit officers and regulators? What keeps you awake at night?

Smith: At Wachovia, we still have a high sense of concern over maintaining asset quality. Even though we see signs of the recession ending and the economy picking up, the marketplace is still marked by high corporate defaults. So for the next few quarters, the key for us is maintaining asset quality in our portfolios.

Carter: From a regulatory standpoint in Texas and some other parts of the Southwest, we're very concerned with some commercial real estate markets and agriculture.

In terms of the former, both vacancy rates and lending are on the rise. There probably isn't going to be a quick turnaround in certain markets, like Houston, where you have a lot of factors in play. In addition to the overall economy, for example, there's the Enron bankruptcy, layoffs at Continental Airlines Inc., and the uncertainties of the Compaq Computer Corp./Hewlett-Packard Co. merger.

We also have two metro markets, Oklahoma City and Dallas, where vacancy rates are among the highest in the nation. And we're monitoring the rapid rise in vacancy rates that occurred in Austin and, to a lesser extent, in Denver last year.

The agricultural industry, meanwhile, has been facing several years of depressed prices because of record global production and trade imbalances facilitated by a strong U.S. dollar. Additionally, the uncertainty surrounding the 2002 farm bill is causing many agricultural producers and their lenders to wonder about future government payments and producer profitability.

Strischek: I'd echo the concern about commercial real estate.

We addressed a lot of our underwriting problems coming out of the last recession by requiring pre-leasing and pre-sales before loans were issued. But that doesn't solve all the problems. For example, some movie theatre chains recently declared bankruptcy and have been renegotiating their shopping mall leases.

Now, if you were a lender on that mall, or lent to operations within the mall that depend upon theatre traffic, you face a real dilemma. If you don't go ahead and accept the lower lease, you lose the foot traffic from the theatre, which is so important to the other merchants. But then, the shopping center itself ends up with a much lower debt-service coverage ratio.

So the notion that we solved the real estate underwriting problem by requiring pre-leasing didn't take into account the possibility of people breaking those leases.

This is also going to be the recession where we finally get to test the credit models for small business banking, which was a big growth area for banks during the '90s. We all hope those models worked. But this is one group of loans where the time elapsed from past due to default to collection to chargeoff is pretty short. Typically, you go out on day 16 to find out why they haven't paid and discover a "gone out of business" sign on the door.

Banking Strategies: So do you all anticipate credit quality worsening this year, in general?

Smith: I'm not sure it's going to worsen. But it's likely going to be a few quarters before we see improvement. Corporate bankruptcies reached record highs in 2001. Corporate and small company bankruptcies are expected to remain high this year as well.

Carter: I wouldn't try to predict when the turnaround will come. But we certainly expect, for the first quarter of 2002, that the numbers will show an increase in problem commercial loans.

Some perspective is important here. While commercial and industrial loans are a big problem right now in Texas, for example, the nonperforming levels are still well below where they were back in the late '80s. Total past dues in December nationwide were 2.63%, which compares with a high of 5.14% in 1987.

Smith: That's a good point. 2001 was actually a record year for bank earnings. And capital levels are much stronger than they were in the last recession. So banks are much better prepared to deal with this downturn.

Strischek: On the other hand, there's a lag effect to these recessions. Right now, it doesn't look so bad. But we'll be working out of these problems over the next couple of years. And that can be a dreary process, like it was in 1991 and 1992.

The good news is the banking industry's strong capital base. We also have capable workout units for problem credits, which weren't as prevalent in the last recession. Even at the community bank level, there's a core of people who have had special-assets experience. Therefore, you could argue that the overall infrastructure for handling problem loans is much better than it was 10 years ago.

Banking Strategies: What are the top issues in terms of resolving problem assets?

Smith: For one thing, we're seeing changes in the accounting for assets held for sale. Regulators are more focused on the mark-to-market adjustments made on those assets and how they're accounted for. The first lower-of-cost-or-market — or LOCOM — adjustment is a charge against loan-loss reserves and creates a ceiling for that asset's value until sold.

The bulk-sale strategy worked pretty well for a while as secondary markets opened up and investors purchased the loans. But we're now seeing the tail end of that cycle. It's not really the most cost-effective or efficient way to move those assets from the books. With the expected upturn in the economy, improving conditions could breathe new life into some of our problem assets.

Strischek: The regulatory attention now being paid to special-purpose entities, or off-balance sheet vehicles, because of Enron Corp.'s demise and PNC's accounting issues is probably going to curtail that bulk-sale business, or limit it as an alternative, if the market itself doesn't just back away from it. Ultimately, no matter where you push the dirt, somebody's got to sweep it up.

Smith: At our institution, we're trying to approach this issue in a more proactive way, through early identification of problems. We're hopeful that we can identify problems early enough in the process so that we have some better alternatives, such as rehabilitating the credit or having another institution finance us out of the situation. We don't want to wait until it gets to that critical point where there aren't really any good options.

Strischek: The whole point of early identification is to catch the problem while it's still recoverable. It gets back to the improvements in the risk-management infrastructure. Risk ratings pick up problems more quickly now so you can deal with them faster, which allows banks to do a better job of monitoring their asset-quality ratios.

Everyone wants to get this stuff off the balance sheet as soon as possible. Ten years ago, the industry might have let a problem loan stay 60 days with the line lender before sending it to the special assets division; today, it will be gone in 30 days. There's far less tolerance of that kind of lassitude than a decade ago.

The right people to handle problem loans are not the sales people, by the way. For the sales/credit division of labor to work, you have to be quick about moving problem loans into the functional specialty that's best equipped to handle them.

Smith: In our bank, we apply higher capital costs to problem assets. The sales team then realizes, no, this is not an asset they want to spend time with. They're much more willing to let someone else start working the credit if it's pulling down their portfolio return.

Strischek: Cost accounting for problem loans has certainly improved. Every bank now has some kind of loan-loss reserve calculation to estimate the amount of provision to be set aside for loan losses. There are consequent credit premiums being assessed in calculating a loan's profitability. People don't realize how much a problem loan costs, even if it's still accruing interest.

We're also seeing better screening of credits at the front end. There's been an evolution of pre-screening techniques. The idea of cold calling, of just hopping into a car and driving down to the nearest industrial park to prospect for loans, is passé.

Instead, most institutions are now compiling "hit lists," or lists of prospects that have already been pre-screened. There's always somebody our screens didn't pick up who turns out to be a good credit, and that's fine. But for the most part, the process is far more systemized, which is one of the great benefits of the information revolution. People have learned how to use Dun & Bradstreet and some of the other databases to mine the gems.

Carter: From an ongoing bank supervision standpoint, my division does not deal directly with disposing of problem assets. But over the past several years, we have emphasized to our examiners the need to take a close look at a bank's practices, as opposed to its existing condition. By that I mean we try to assess risk levels before they become problems that require some type of intervention by the regulators.

One of the things we do look at is the bank's internal procedures for early identification of the problem assets. Are they willing to be aggressive and address issues early, or are they just sitting back and waiting, hoping that things work out?

Banking Strategies: We've been focusing here on improvements that banks have made since the last round of troubles. What areas of risk management technique still need improving?

Smith: We continue to enhance our credit-grading system. We've gone from just four or five grades to about 21 or 22. This allows us to monitor migration in the portfolio and more precisely identify where our potential problems are — by portfolio, by industry, by type of account, and by region. So we continue to work on enhancing those tools to give us some better early warning signs.

Strischek: Same with us. The Basel II Accords, expected to be implemented in 2005, call for a two-dimensional risk rating system, which rates the obligor, or borrower, on one axis and the facility, or transaction, on the other. We find that this matrix provides a much better picture of where our risks are.

Under this system, the bank estimates the probability that the borrower might default and multiplies that times the probability of loss on the transaction given the default. Banks with one-dimensional ratings of obligors typically have eight to 10 grades that lump together these two probabilities. If facility ratings, say lettered A for fully secured and D for unsecured, are added as a second dimension, you now have potentially 32 to 40 alphanumeric grades.

So if you double the granularity of the obligor ratings to approximate the bond ratings, those 20 obligor ratings times the four facility ratings create up to 80 grades. This allows the bank to differentiate between the small business proprietor with a loan secured by a certificate of deposit and a Fortune 500 corporation with an unsecured facility. Under the old approach, both loans might have been rated the same.

In adopting this system, many banks are being held back by old accounting systems, which were set up for just one dimension. In our case, we have had to add a second alpha character and also convert to alphanumeric recognition. That doesn't sound like a big problem until you talk to your programming people. But you get there eventually.

Carter: I don't disagree with anything that's been said about credit analysis. But when you ask where banks can improve, I would offer internal controls and due diligence as two areas.

Several of the most recent bank failures were attributed to internal fraud. The environment for embezzlement and misappropriation of assets is fostered where there is a lack of effective internal controls.

In regards to due diligence, banks that acquire loans or investment-type products either directly or through third-party vendors should perform due diligence to ensure they understand what they're buying and verify the reputation and stability of the seller.

Strischek: We're working with our operations people on the internal controls issue.

At SunTrust, we picked up a lot of legacy systems through acquisitions. The accounting systems are not always comparable, so things fall through the cracks when you're dealing with basic tasks such as documentation, follow-up to documentation, policy exceptions, and regular monitoring of financial statements and covenants.

This kind of housekeeping should really be done in the back room. It's not the kind of work a sales force likes to bother with. But you need a degree of teamwork between the two areas to avoid problems. Even if a system is able to track documentation exceptions and policy exceptions, you still have to make sure the right person actually acts on the information.

Banking Strategies: What are the prime opportunities for lending over the next year, and what will it take to capitalize on those opportunities?

Smith: A strong capital base allows us to position ourselves for when the economy does rebound. We can be out there aggressively looking for those stronger accounts. Hopefully, opportunities are going to come back as capital spending starts picking up, both in terms of direct loans and leasing products for capital investment. At the moment, consumer and residential lending remain strong.

Strischek: If you believe the statistics, the recovery is on its way. One of the first signs of that will be higher levels of inventory and receivables. The receivables will go up simply because one way to sell through a downturn is to extend easier credit terms. Inventories will pick up because the economic data seems to show a lot of companies have run their inventory levels down.

That means there's potential for more asset-based lending to finance the rebuilding of inventories and the rebound in sales receivables. After that will come the stage that Walter referred to: the inevitable capital expenditures. Companies will buy a better piece of equipment, for example, or upgrade existing equipment.

Banking Strategies: What do you expect, then, in terms of origination volume this year?

Smith: We're still seeing weak commercial loan demand and don't expect that to pick up until the second half of the year.

Strischek: Industry-wide, you won't see institutions planning for the same growth rates in their portfolios as they saw in 1999 and 2000. We hope to grow some at SunTrust, but not as much as we did the last couple of years.

Banking Strategies: What do you anticipate this year, industry-wide, in terms of increases in loan-loss reserves and the subsequent effect on bank earnings?

Smith: My sense is we've seen the worst of it. I think banks today are pretty well reserved and able to cope with any contingency that might occur over the next several quarters. But the strength of this recovery remains to be seen. And we'll likely see some new non-performers emerge from the tail end of this period of economic weakness.

Strischek: Non-performers will increase, but without all the drama and terror you saw 10 years ago. Basically, we have fewer banks. The weaker players have largely disappeared. So you're just not going to see the same kind of earnings volatility we had in the early '90s.

Regardless of what the economy does, institutions need to keep their internal credit systems well oiled — everything from the risk rating systems to the credit evaluation process. So regardless of what particular artillery shell hits you, the good ship "Bank" continues to sail onward.

Smith: Improved risk-management infrastructure has definitely gotten the industry through the current downturn. We need to remember that lesson as we go through another expansion, and then possibly another downturn at some point in the future.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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