OCC warns banks to manage credit risks, asset yields during pandemic

By Covey Son · June 29, 2020

U.S. banks should embrace even greater shocks to earnings from COVID-19 as increased credit risks and low interest rates put an added strain on interest income, the comptroller of the currency said Monday.

Banks’ “strong condition” at the start of 2020 quickly turned sour as financial institutions scrambled to service pandemic relief loans to businesses, the banking regulator noted in a semiannual report of risks facing banks .

At the same time, commercial credit risk is on the rise due to restrictions on businesses, putting bank earnings and liquidity in further jeopardy as more borrowers find trouble making payments on time.

“The onset of the pandemic created an uncertain credit environment testing the resiliency of both commercial and retail loan portfolios,” the regulator said. “Credit risk management practices need to be flexible and proactive to meet the challenges of the current environment.”

Credit risk at U.S. banks grew as banks implemented loan relief programs and evaluated their current and future risk and portfolio resilience, according to the report.

Credit deteriorated across the finance sector and concentrated in certain endangered industries, such as hospitality, retail and energy, which are highly leveraged as firms take out loans or lines of credit to stay afloat during the downturn.

Even as more businesses reopen across the country, the risk of further deteriorating credit remains as the pandemic’s impact on the economy is expected to last through the year’s end, the report said. 

The rise in credit risk amid the pandemic prompted banks to shore up their loan loss provision expenses in the first quarter to withstand an expected increase in loan losses. 

“Second quarter provision expenses are expected to substantially increase as the extent of the economic downturn develops,” the regulator said. 

Bank earnings are constrained by the federal funds rate, which the Federal Reserve lowered by 150 basis points in the first quarter to the record-low range of 0% to 0.25%.

The regulator said three in four banks expected to lose net interest income if the Fed cut rates this year. Most of the banks said they expected to lose less than 5% of net interest income if rates went up just 100 basis points.

“Margins compressed as asset yield declines exceeded interest cost reductions,” regulators said. “Lower rate expectations for the near future will continue to hold yields to lower levels, further stressing earning performance.”

Further complicating already lower earnings is the rise in delinquencies and late payments stemming from the pandemic, the OCC said.

Many banks responded to growing delinquencies by creating new proprietary forbearance and other relief programs in addition to those mandated by federal and state officials.

Such programs allow borrowers to forgo regular payments during the relief period, as the lender continues to make principal and interest payments to support related securities.

Enrollment in these programs “increased sharply,” putting added pressure on banks.

“Such conditions, if required for an extended period, may create liquidity issues for some servicers, particularly nonbank servicers,” regulators said. “During such periods, entities that service loans for themselves or others are expected to continue making collateral protecting insurance and tax payments normally derived from regular payments to escrow accounts.”

The comptroller’s office also raised concerns over the potential for lapses in compliance due to higher volumes of loan applications.

“[These conditions] complicate the compliance responsibilities associated with managing high transaction volumes and various programs of consumer and business lending in a weakened economy,” regulators said. “This could cause breakdowns in controls related to account management, servicing management, flood insurance coverage, credit bureau reporting and complying with applicable laws and regulations.”

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