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Publications by Type: Survey of Credit Underwriting Practices, June 2005
The Office of the Comptroller of the Currency (OCC) conducted its eleventh annual survey of credit underwriting practices during the first quarter of 2005. The survey identified trends in lending standards and credit risk for the most common types of commercial and retail credit offered by national banks.
The 2005 survey included the 71 largest national banks and covered the 12-month period ending March 31, 2005. Although mergers and acquisitions have altered the survey population, the surveys covered substantially the same group of banks for the last 10 years. All companies in the 2005 survey have assets of $2 billion or greater. The aggregate loan portfolio of banks included in the 2005 survey was approximately $2.9 trillion as of December 31, 2004. This represents over 90 percent of all outstanding loans in national banks.
The OCC examiners-in-charge of the surveyed banks were asked a series of questions concerning overall credit trends for 18 types of commercial and retail credit. Commercial credit for purposes of this survey included 10 categories of loans: syndicated/national loans, structured finance (leveraged finance), asset-based loans, middle market loans, small business loans, international credits, agricultural loans, residential construction, commercial construction, and other commercial real estate. Retail credit consisted of eight categories of loans: residential real estate mortgages, affordable housing, credit cards, other direct consumer loans, indirect consumer paper (loans originated by others, such as car dealers), consumer leasing, conventional home equity, and high loan-to-value (HLTV) home equity loans.
The term "underwriting standards," as used in this report, refers to requirements, such as ones related to collateral, loan maturities, pricing, and covenants, that banks establish when originating and structuring loans. Conclusions about "easing" or "tightening" of underwriting standards are drawn from OCC examiners' observations since the 2004 survey. A conclusion that the underwriting standards for a particular loan category have eased or tightened does not indicate that all the standards for that particular category have been adjusted. It indicates that the adjustments that did occur had the net effect of easing or tightening such underwriting criteria.
Part I of this report discusses the overall results of the survey. Part II depicts the survey results in graphs and tables.
Part I - Overall Results
Commercial Underwriting Standards
In 2005, there is a pronounced trend toward easing commercial credit standards, with significantly more banks easing underwriting standards than tightening standards. Examiners reported that 34 percent of banks eased, 12 percent tightened, and 54 percent made no change to commercial underwriting standards. The easing trend began modestly in 2004 when examiners reported that 13 percent of banks eased, 12 percent tightened, and 75 percent did not change their commercial underwriting standards. From 1999 until 2004, more banks tightened than eased credit standards. The last time examiners reported more banks easing credit standards than tightening standards was in 1998, when 44 percent of the banks eased commercial standards.
Commercial underwriting trends at the product level confirm the shift toward easing. Examiners noted eased standards for all of the commercial products except agriculture loans. Easing is most prevalent in syndicated/national, structured finance, asset-based, and international loans. However, fewer banks are involved in these lending activities. Significant easing also was reported for commercial real estate and middle market loans, products which most banks offer and, therefore, have a potentially greater impact on credit quality. Examiners noted that this is the second year of net easing for structured finance, asset-based lending, and middle market products.
Once again, examiners cited competition as the primary reason for easing commercial credit standards, followed by risk appetite and market strategy. As in prior years, the most common method of easing standards is pricing. Banks also continue to ease standards by adjusting covenants, increasing the amount of the credit line, lengthening maturity, and changing collateral requirements. For those banks that tightened standards, the primary reasons were a change in risk appetite and product performance. When tightening standards, banks commonly relied on adjustments to collateral requirements.
Examiners reported that credit risk trends in commercial portfolios have increased slightly and are expected to continue to increase during the next 12 months. The percentage of banks with increased commercial credit risk slightly exceeds those banks with decreased risk. The shift in risk is attributed to increased competition and the change in banks' risk appetite. Examiners reported the greatest increase in risk is centered in commercial real estate products-including residential construction lending-frequently citing the high growth rates of these products as well as easing standards.
Retail Underwriting Standards
While underwriting standards for retail credit traditionally have been more stable, examiners noted easing of retail underwriting standards in over one-quarter of the banks surveyed. Specifically, 28 percent of the banks eased standards, 10 percent tightened, and 62 percent made no change. This is up considerably from 2004 when the number of banks easing retail credit standards (13 percent) equaled the number of banks tightening (13 percent). Notably, this is the first time in the survey's 11-year history that examiners reported net easing of retail underwriting standards.
The easing of retail credit standards is primarily concentrated in home equity products and residential real estate lending. Indirect consumer loans and affordable housing loans also experienced some easing. Among the retail products, only credit cards and other direct consumer loans (e.g., auto loans or personal loans) exhibited net tightening.
According to examiners, banks continue to ease retail standards primarily because of increased competition, while tightening results primarily from a decreased risk appetite. Regulatory expectations also played a role in the tightening of credit card standards. Banks reduced debt service requirements, extended amortization schedules and lowered collateral requirements when easing credit standards. To tighten underwriting standards, examiners reported banks primarily adjusted scorecard cutoffs and pricing.
Examiners reported that nearly 75 percent of the banks surveyed had no change in the overall level of retail credit risk during the past 12 months. However, examiners expect retail credit risk to increase in 28 percent of banks and decrease in only 6 percent of the banks over the next 12 months. Examiners reported that credit risk increased in most products in the past 12 months, but this was particularly evident in home equity and residential real estate products. Examiners cited the high growth rates coupled with the potential for higher interest rates and continued competition as the primary factors contributing to the increased risk in the these products.
With our eleventh annual survey of credit underwriting practices, we see a clear trend toward easing of underwriting standards as banks stretch for volume and yield. While the performance of commercial and retail portfolios remains satisfactory, credit risk is increasing and expected to continue to increase over the next twelve months.
Ambitious growth goals in a highly competitive market can create an environment that fosters imprudent credit decisions. As the adage goes, "the worst of loans are made in the best of times." Banks should be diligent to ensure risk management practices keep pace with new products, changing risk selection practices and underwriting standards, and emerging concentrations. Exceptions to underwriting standards need to be carefully controlled and monitored, and relationship and line of business managers must be held accountable for loan quality as well as loan volume.
Commercial and residential real estate secured loans have experienced high growth rates resulting in growing concentration levels. For all residential portfolios, rapid appreciation of housing values has raised concerns about price volatility and over-valued markets, while for commercial portfolios, certain property types and markets continue to exhibit weaknesses. These portfolios are particularly vulnerable to interest rate increases. Banks should ensure these portfolios receive appropriate oversight.
Easing of commercial credit standards is not unusual after five years of tightening, improved credit quality, and several quarters of healthy corporate profits. Nonetheless, given the competitive environment and liquid market conditions, banks should approach further easing with caution.
Retail lending has undergone a dramatic transformation in recent years as banks have aggressively moved into the retail arena to solidify market positions and gain market share. Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations - have introduced more risk to retail portfolios. While performance remains sound, banks should be wary of the unseasoned nature of many of these portfolios and approach further easing with caution.
Because reduced payment requirements and extended amortization arrangements can mask credit risk, bankers need to develop broader, more discerning, and more forward looking approaches to measuring and monitoring risk in retail portfolios. Bankers should refer to the guidelines contained in OCC Bulletin 2005-3, "Standards for National Banks' Residential Mortgage Lending Practices;" OCC Bulletin 2005-22, "Home Equity Lending—Credit Risk Management Guidance;" and the updated "Retail Lending Examination Procedures" in the Comptroller's Handbook series issued in December 2004. For commercial portfolios, bankers are directed to OCC Advisory Letter 1999-4, "Leveraged Lending."
The OCC will continue to focus supervisory attention and resources to ensuring that credit risk in national banks is appropriately identified and effectively managed.