Strategic Risk Emerges as Key Issue for Community Banks

Under pressure to increase earnings, some community banks are increasing their risks, and that has regulators concerned. The issue, which was discussed in November during the Chicago Federal Reserve’s 10th annual Community Bankers Symposium, is highlighted in the latest issue of the Chicago Fed Letter.

“Strategic risk continues to be a potential focal point,” the article noted.

Panelists from the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. said they are seeing banks increase their commercial real estate and commercial and industrial concentrations, while weakening credit standards. Many of the community banks that failed after the 2008 recession had high lending concentrations, so examiners said they will pay extra attention now to banks with concentrations, according to the Fed Letter. Regulators expect banks with high CRE concentrations to use stress testing and sensitivity analysis, as well as other risk management practices, according to supervisory guidance. The panelists said supervisors will want to make sure that board-approved limits on concentrations are in place and monitored.

The Chicago Fed reiterated its concern about CRE originations in the first quarter of 2015 issue of Risk Perspectives.  “As financial institutions continue to seek new CRE originations, there remains a critical need for sound underwriting and stress testing practices to address the downside risk embedded within individual transactions and broader loan portfolios. Sound underwriting should include an analysis of the adequacy of borrower equity contributions as well as the ability and willingness of the guarantor to support credits in time of need. Controls around growth plans should be thoroughly vetted, including thresholds and parameters that would signal an increase in downside risk,” the Fed warned.

Supervisors at the November community banking conference said they were seeing signs of lax underwriting that included an increase in the number of commercial loan policy exceptions and lenient terms for consumer auto loans. 

One panelist also said some banks are focusing more on yield than controlling long-term interest rate exposure by increasing the duration of their securities portfolios. Interest rate risk is another examiner concern. Regulators want to make sure that banks have “acceptable risk tolerances in place and that the balance sheet is well positioned for increasing or volatile rate environments,” the Fed Letter said.

Some community banks are trying to generate fee income by entering into new lines of business, such as third-party overdraft protection and prepaid cards. Regulators want banks to conduct proper due diligence before entering into agreements and then make sure they have effective oversight going forward.

Community banks must engage in strategic planning to monitor their strategic risks, especially as they add new lines of business and increase loans to bolster interest rate income, the panelists at the Fed conference said.  A good strategic plan can help banks to make sure they are growing consistent with their strengths, while identifying the risks in their plans, the Fed Letter said.  (For more information on strategic planning, see the October issue of Bank Insights.)