The Federal Reserve System has established a banking risk framework that consists of six risk factors: credit, market, operational, liquidity, legal, and reputational risks. During examinations, institutions’ risk management structures are reviewed using these risk categories.
Financial Institution Risk Management Programs
The Fed has also identified four key infrastructure components of effective risk management programs:
active board and senior management oversight
adequate policies, procedures, and limits
adequate risk-measurement, monitoring, and management information systems
comprehensive internal controls
Each type of risk, in turn, has its own specific types of risk controls.
Federal Reserve Bank of Chicago Risk Committee Findings
Every quarter, the Chicago Fed’s Risk Committee meets to determine the top banking risks facing Seventh District banks in the upcoming months, and to develop appropriate supervisory responses. The following list of top banking risks incorporates the September 2008 results. Since banking conditions rarely change dramatically from quarter to quarter, the list of top risks tends to change only gradually over time.
We hope you find the Risk Committee’s list useful, providing you with some insight on current concerns of bank supervisors.
Allowance for Loan and Lease Losses (ALLL)
Some firms are failing to maintain an adequate allowance for loan and lease losses (ALLL) and/or are not updating methodologies to reflect the current adverse economic environment. Some Seventh District banks have required significant provisions to restore ALLL adequacy.
Inadequate maintenance of ALLL impacts earnings and capital. Firms may need to incur substantial ALLL expenses. Provisions may result in firms falling below the PCA “Well Capitalized” threshold.
Commercial Real Estate (CRE) Valuations
Firms may be lagging in obtaining appraisals on property that serves as collateral for loans. Some District banks have significant CRE exposure.
Outdated or inaccurate appraisals may make it difficult to assess the health of the credit or the adequacy of the allowance for loan and lease losses (ALLL).
Since most CRE construction and land development (CLD) loans are made with short maturities, the average District bank with CRE concentrations will have significant rollover of CRE portfolios in 2009 and 2010.
Credit availability may be in question as many banks are trying to exit troubled relationships. As a result, banks may encounter significant levels of other real estate owned (OREO) as borrowers are unable to find loans to support projects. Also, banks may see a significant increase in troubled debt restructurings (TDRs) as they are unable or unwilling to take losses on loans and work with borrowers to wait out the recession.
Retail CRE Exposure
Stress in the retail CRE market is starting to show through increases in vacancy rates, slowing absorption and softening in rents.
Banks may have relied on income from traditional income-producing CRE loans to offset stress in CLD portfolios. Problems in the other areas of CRE could significantly impact bank earnings.
Troubled Debt Restructuring (TDR)
Many banks have been modifying terms of loans (particularly CRE-related loans) in attempts to work with borrowers. However, neither levels of TDRs reported nor the number of banks reporting them in the Call Report has increased over the past two quarters.
Failure to report assets as TDRs could misstate the credit risk position of a bank and distorts required disclosures about TDRs. TDRs must be evaluated for impairment under FAS 114, even if the loan type is outside the initial scope of the standard (e.g. residential mortgages).
Other Real Estate Owned (OREO)
OREO levels are increasing at institutions across the District, particularly CRE OREO.
Banks haven’t had to deal with such a volume of OREO in more than 20 years and may not have the experience to handle it. Also, saturation of markets with inventory and lack of buyers may result in significant holding periods for OREO, which may adversely impact bank earnings and liquidity.
Automaker/ Auto Dealer Exposure
Many banks in the District have indirect exposure to the auto industry via dealer financing, supplier financing, and loans to employees of the industry.
Failure or significant cutback in one of the domestic manufacturers could adversely impact the loan portfolios of institutions in areas with significant auto concentrations.
Home Equity Lines of Credit
Delinquency rates on home equity portfolios at District banks have increased over the past year.
Traditionally a lower risk asset, delinquencies in this portfolio could lead to further pressure on earnings and liquidity.
Updates to Government Programs
Firms are preparing for the sunset dates, reduced availability, or more stringent conditions attached to the Federal programs that were designed to address liquidity and capital needs. Some firms are seeking to prove financial independence by extricating themselves from various government commitments such as TARP.
Banks are assessing the potential reputation risk associated with participating in and exiting the Federal programs, as well as the operational risks associated with monitoring and tracking the use of the funds received. Banks should also consider the risk of over-reliance on these programs as a funding source, as the programs will eventually be phased out.