NR 98-70 July 13, 1998 Remarks by Julie L. Williams Acting Comptroller of the Currency before the Robert Morris Associates Consumer Risk Management Conference Chicago, Illinois July 13, 1998 It's a pleasure to be with you for what looks like yet another fine and very timely RMA conference. For nearly a century, RMA has been a focal point for education, exchange of ideas, and exploration of new issues affecting the lending business of our nation's banks. During that time, the banking industry has obviously changed greatly, and has faced many different challenges. Some challenges, such as maintaining sound loan underwriting standards in an evolving economic environment are not new, but they manifest themselves in new ways with changing times. It is this challenge that I want to talk about this afternoon. The OCC has also been doing its job for a long time, too. Since 1863, we have worked toward a safe, sound, and vital national banking system. We too have faced many challenges -- as a supervisor and regulator. And, our responsibilities have always included the critically important but never pleasant task of calling attention to problems developing within the banking system -- problems that, if left unchecked, could undermine the system's long term safety and soundness. Frequently it happens that these warnings must be sounded when standard indicators of banking health are positive -- as most are today. We do this not because we take any pleasure in pulling the punchbowl from the table in the midst of the party, but because 135 years of experience has taught us that the best way to ensure the continued health of the banking system is for bankers -- and regulators -- to exercise vigilance and foresight early on. For the OCC in the current economic cycle, "early on" was three years ago, when, in response to reports of slippage in credit quality and credit terms in both the wholesale and retail loan markets, we formed a National Credit Committee composed of some of OCC's most experienced credit specialists. To get below the surface of the generally rosy aggregate industry statistics and to assess the nature and extent of the problems we were hearing about, the Committee conducted a survey of examiners-in-charge at a sample of our largest banks, and published its findings in November 1995. After that, at roughly yearly intervals, we released two more underwriting surveys, and we have now completed the fourth in the series, to be released later this summer. We now have the results of this latest effort, and they are unsettling. On the retail side, the picture is mixed. Last year, we were able to report that many national banks, in the face of mounting charge-offs, were reassessing their underwriting standards for credit cards, and tightening those standards where appropriate. That trend continues, with ten times as many examiners reporting in the current survey that their banks had tightened credit card and consumer leasing policies as had eased them. But we now find that some of this risk has merely been shifted into other categories of consumer lending. The increase in the number of surveyed banks reported to have tightened credit card standards was nearly matched by the number of banks that had eased underwriting standards in the issuance of home equity loans and home equity lines of credit. This reflects not only the boom in the home equity market generally and an increase in competition among lenders who participate in it, but also the decision of some banks to pursue opportunities in two fast growing segments of that market, the subprime and high LTV segments. There is nothing inherently wrong with these non-traditional home equity loans. Properly underwritten and administered, they can work well for borrowers and lenders. Consumers with a history of financial reverses can use these loans to rebuild their credit and then qualify for better rates on subsequent loans. They can use the proceeds for education, home improvement, or small business formation -- uses that can improve the borrower's long term financial prospects and help them join the financial mainstream. All borrowers deserve the same opportunity to use the equity built up in their homes to reduce their overall credit costs. But the home equity markets, including subprime and high LTV products, also suffer from abusive practices and irresponsibility on both sides of the transaction. Predatory lending, loans made without full disclosure of terms, and loans that cannot possibly be supported by the borrower's cash flow are poor business for both borrowers and lenders over the long run. When loans become financial straitjackets and stop becoming gateways to financial opportunity, neither party benefits. Borrowers run the risk of losing their most important and valuable asset -- their home. Lenders expose themselves to loan losses and damage to their credibility. Some believe that the entry of regulated commercial banks into the subprime and high LTV market will curb abusive lending practices by supplanting certain unscrupulous lenders who prey on the poor and unsophisticated. But competitive pressures must not lead commercial banks to cutthroat, lowest common denominator lending. If bankers are to become successful in these markets, they must be attentive to the peculiar challenges -- both social and financial -- that they pose. They must understand that subprime and high LTV loans are separate products requiring separate marketing, account management, and collections techniques to manage credit exposure. Banks that make and service subprime and high LTV loans as though they were no different from each other and no different from conventional home equity loans are putting their reputations -- as well as their consumer loan portfolios -- at risk. On the commercial side, the picture is even more disturbing. For the fourth year in a row, commercial underwriting standards have slipped. We see this slippage in every category except international lending, where the Asian crisis has prompted lenders to be more cautious. Elsewhere the pattern is consistent. More and more syndicated and middle market loans are becoming leveraged deals. In all categories, heavy competition and a push to increase loan volume has led some lenders to compromise their underwriting standards. The logic of lending is quite simple: the lender accepts a limited return in exchange for manageable downside risk. Unfortunately, more and more lenders are behaving like investors on the downside -- that is, accepting greater risk of loss -- without commensurate potential upside return to compensate for the level of risk assumed. For comparable loans on similar terms, fees and spreads are down. And the downside risk in the commercial loan market seems to be increasing. Across the board, banks are granting broader and more generous concessions to business borrowers. Provisions governing covenants, guarantors, and tenors have become less rigorous for borrowers. Collateral requirements have been relaxed. Even as banks have increased their exposure to risk, they have also reduced their ability to cover potential losses out of existing reserves. Call Report data shows a steady drop in the percentage of loan loss reserves to gross loans and leases over the past 22 quarters. Thus, as we approach a record eighth year of economic expansion, a time when banks should be shoring up their balance sheets, banks seem instead to be increasing their downside exposure in the commercial and consumer loan market. In October of 1997, when we unveiled the results of the last underwriting survey, we also took several steps to respond to the trends we found. We instructed all OCC examiners-in-charge to discuss the results of that survey with senior bank management, with particular emphasis on the relevance of our findings for each specific bank. Furthermore, we instructed examiners to continue to review credit underwriting standards, including sampling new loans, and to discuss the results with senior management of the bank. We began a system-wide study of the capability of national banks to deal with an increase in the volume of problem loans. We accelerated efforts to finalize new interagency guidance governing classification and charge-off policies on retail credit. Finally, we announced the impending release of OCC guidance on loan portfolio management techniques. In the months since we announced this program, we have seen some positive responses. A number of community banks have revised their loan policies. Others have beefed up their collection capabilities, and developed contingency plans to deal with the decline in asset quality that is sure to occur in the event that the economy deteriorates. The OCC's loan portfolio management handbook has been widely hailed as an important contribution in assisting bankers and bank examiners to understand the interrelationships among loans, the importance of analyzing risk across different boundaries, and how the portfolio concept can be used to aid in the management of overall credit risk before it jeopardizes bank solvency. For all that, the disclosures contained in our latest underwriting survey indicate that our previous actions and admonitions have not had the full impact we hoped to achieve. Because banks have not shifted gears to the extent we believe the situation requires, we are shifting gears ourselves to enhance our focus on credit risk issues. In our portfolio management handbook, we emphasized that "the identification and management of risk among groups of loans may be at least as important as the risk inherent in individual loans." Yet our guidance also recognizes that the portfolio is no stronger than the sum of its parts. Where the underwriting and approval processes are flawed, bad loans will result, endangering the whole portfolio. Therefore, we have already begun to supplement our examinations by doing more "drilling down" to assess the adequacy of and adherence to the bank's own underwriting standards, especially in banks with higher risk profiles. We have published or will soon publish new handbooks on large bank supervision, small bank supervision, internal controls, and lending areas, that reflect this emphasis. And we will soon take several new steps that will help focus on credit risk at the individual bank level. In the coming weeks, we will be asking our examiners to identify and report to bank CEOs and Boards of Directors, as appropriate, when, in the course of their examination, they identify specific loans with structural weaknesses that may jeopardize repayment and/or orderly liquidation of the loan at a future date. By "structural weakness" we mean loans underwritten in ways that do not adequately reflect the purpose of the loan, the type of loan, or the source of repayment. These structural weaknesses are most commonly evidenced by inappropriate maturities or amortization schedules, ineffective covenants, and inadequate collateral or guarantor support. This type of lending warrants special attention by bank management and examiners alike. We will also ask our examiners, in the Report of Examination, or other appropriate supervisory communication, to comment on several specific questions. First, is the extent to which underwriting practices are deviating from formal underwriting policies. When loans are made as exceptions to policy, are they so recognized by the bank? Does the bank have systems in place to identify, report, and manage the additional risk associated with those loans? And what are the implications of this category of loans for the bank's overall risk profile? Second, we will ask our examiners to comment on the volume of and trends in loans upon which repayment prospects are heavily dependent upon the realization of projected cash flows, asset values, equity values, and a borrower's so-called "enterprise value." Finally, we will ask our examiners to identify any adverse credit risk trends within category of credits rated as "pass." The purpose of these new steps is not to be punitive. Rather, our objective is to enhance our focus on the quality and quantity of credit risk at the individual bank level and to give bankers the opportunity to make appropriate risk management adjustments. Some will say that the optimistic assumptions underlying much of the lending we see today have never been more warranted. We certainly hope that to be the case. But there are warning signals to the contrary that I would urge you to heed. The problems we are seeing in the banking system today are serious. They could presage the same kinds of problems that afflicted the industry nearly a decade ago. But history does not have to repeat itself. Bankers have the opportunity to take the steps necessary to better contain their credit risk going forward. The time for that action is now. # # # The OCC charters, regulates and examines approximately 2,600 national banks and 66 federal branches of foreign banks in the U.S., accounting for more than 58 percent of the nation's banking assets. Its mission is to ensure a safe and sound and competitive national banking system that supports the citizens, communities and economy of the United States.