CREDIT STRESS CONTINGENCIES Why Wait Until It Comes? BY DAVID RUFFIN PRINCIPAL, INTELLICREDIT® Credit cycle shifts tend to be abrupt; thus, banks should assess credit risk degradation now to avoid trouble later. Over the past five years, persistent uncertainty has dominated industry surveys on the outlook for credit quality and loan growth. This is hardly surprising given the aftermath of a global pandemic, the sharp rise in interest rates from historic lows to decade highs and ongoing shifts in political and policy landscapes — all of which have contributed to a widespread sense that, at best, the credit environment remains challenging. While the trailing quarter-to-quarter public call report data remains generally benign, unmistakable signs of stress are emerging. Delinquencies and non-performing loans are on the rise, while reserve coverage ratios are declining, particularly among community financial institutions. At the same time, banks with assets under $10 billion continue to hold a disproportionate slice of commercial real estate (CRE) loans — a segment facing significant challenges related to property use and obsolescence. Since the high-profile, liquidity-induced bank failures of 2023, bank finance chieftains have been under constant investor and regulatory scrutiny regarding contingency funding plans. However, the credit function itself, beyond reliance on the allowance for credit losses (ACL), has not yet faced the same level of inquiry. It has now been nearly a generation since the Great Recession, with its massive loan losses and bank failures. While the industry has subsequently adopted more robust risk management practices, many current bankers have only known periods of benign credit performance. Credit cycle shifts tend to be abrupt and contagious, so why wait until credit stress becomes palpable? Now is the time for banks to take inventory of their credit stress contingency plans. Assuming a bank’s underwriting standards are delivering sound loans on the front-end, best practice credit stress contingencies should focus on several critical areas, including: • Updating Loan Policies: Regulators frequently use banks’ loan policies as tripwires for criticism, whether due to exception levels or relevance to current lending environments. For example, a bank touting a three-year, interest-only inducement for CRE loans would be out of step with today’s CRE risk environment. • Assessing Industry Risk: Technology shifts and changing public policy have elevated industry risk to a level of importance comparable to traditional borrower or entity underwriting. Modern credit assessments must give industry risk equal weight alongside traditional repayment capacity analyses. • Quantifying CRE Market Supply and Demand: A common thread in recent regulatory orders has been criticism of inadequate supply and demand assessments in markets where CRE products are financed. Because real estate characteristics are inherently local, it’s essential to understand marketplace absorption potential — specifically for the CRE subset being financed (e.g., hospitality, multifamily or industrial) — regardless of borrower or project risk profile. • Planning for Workout Capacity: The long period since the last major credit downturn has resulted in a shortage of experienced credit workout specialists. Now is the time to identify where the bank can obtain this expertise — by developing talent internally or by partnering with external specialists. 18
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