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Large Loan Review Finds Higher Risk Persists

Federal regulators say the credit risk of large, shared loans remains elevated in large part because of challenged oil and gas sector borrowers. On a positive note, regulators also found improved underwriting practices.

The credit risk of loans totaling $20 million or more and made by 3 or more federally regulated financial institutions remained elevated in the first quarter of 2016, 7 years after the recession ended. But underwriting of such credits did improve.

Those are the core findings of the Shared National Credits Program (SNC) examination released in July 2016. Federal regulators found that the percentages of adversely rated credits have climbed since the last review.

The percentages of classified credits—those rated substandard, doubtful, or loss—and non-pass credits—those rated special mention, substandard, or doubtful—climbed to 6.9 percent and 10.3 percent, respectively. In 2015, the percentage of classified credits was 5.8 percent, and the percentage of non-pass credits was 9.5 percent.

“Normally—and we have data going back decades—during a recovery period, the percentages of classified assets and of non-pass assets decline, and they decline to a relatively low level,” explains John C. Shackelford, a senior examiner with the Federal Reserve Bank of Cleveland.

“During this recovery, percentages are still quite elevated, and, in fact, as a result of challenged oil and gas credits, they’ve actually started ticking back up somewhat,” explains Shackelford, who for more than a decade has worked with SNCs and is currently assigned to the national program in Washington DC.

In fact, the asset ratios of special mention credits, or those with potential weaknesses meriting close attention, and classified credits continue to be double those of the precrisis period, according to the examination.

“Rather than using a period of low rates to de-lever their balance sheets as has been typical in past cycles, borrowers have taken on additional debt” that, notes the review, “may be more difficult to service in the years ahead.”

The review explains that the “agencies remain concerned about the overall level of special mention and classified commitments, as they have not recovered to the same level as previous periods of economic expansion in the mid-1990s and in the 2003–2007 period.”

In conducting the Shared National Credits examination, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation assess a sample of the large, shared (or syndicated) loans.

Banks in the Fourth Federal Reserve District, which comprises Ohio, western Pennsylvania, the northern panhandle of West Virginia, and eastern Kentucky, are among those participating in such loans.

‘A better job of underwriting’

The incidences of non-pass originations, or newly lent credits that don’t pass muster from the beginning, “were very, very low this time.”

Though higher risk persisted, this year’s review uncovered good news, too: Underwriting and risk management practices had improved.

“I can see, looking at transactions and the underwriting, that bankers are doing things differently,” Shackelford says. “They have changed and improved some of their practices.”

The incidences of non-pass originations, or newly lent credits that don’t pass muster from the beginning, “were very, very low this time.”

Bankers “are doing a better job of underwriting,” Shackelford explains. “We like to see that. We hope it continues. I think good underwriting foretells the ability to withstand unknown economic events and over time should allow banks to mitigate the reserves that they have to build.”

Said another way, when institutions’ underwriting of the loans they make is such that they may appropriately reserve less money for losses, those institutions have more earnings to distribute in the form of dividends.

If underwriting and risk management have improved, when might that improvement translate to declines in adversely rated credits?

It’ll take time, Shackelford says, to work through older leveraged loans, which are those that have high debt levels relative to their equity. In order to see improvement in the performance of leveraged loans, highly levered borrowers need stronger earnings growth. As for loans made to the oil and gas sector, asset quality will improve as oil prices rise, he explains, enabling that sector’s borrowers to increase operating activity and enhance profits, which can be used to reduce their debt loads.

The Shared National Credits review noted, however, that “some gaps between industry practices and the guidance remain [that] require continued attention by the agencies.”

John C. Shackelford
John C. Shackelford

Bankers need to continue to be diligent in their administration of loans, particularly through distressed economic times such as those presently for the oil and gas industry.

These gaps, according to Shackelford, included weakness observed in some institutions’ risk-rating of their credits and in slow updating of price decks, which track commodity price changes. In addition, several institutions could improve the frequency of redeterminations of borrowing bases, or the amount a borrower can borrow based on current economic conditions. Institutions, he adds, are extending more credit than they normally do as a result of weak borrowing base determinations.

Eyes on oil

As they did in the prior year’s Shared National Credits review, the regulatory agencies paid special attention to leveraged lending, often borrowed for merger and acquisition purposes, and on credits extended to the oil and gas sector, whose borrowers’ capacity to repay loans has been weakened by the decline in oil prices that began in mid-2014.

A number of energy sector companies have laid off workers and filed bankruptcies. Fourth District banks’ exposure to the oil and gas industry is “modest,” Shackelford says.

“Bankers need to continue to be diligent in their administration of loans, particularly through distressed economic times such as those presently for the oil and gas industry,” he says. “We expect bankers to work with their borrowers and to do so in a prudent fashion.”

The Shared National Credits review dates back to 1977. The next findings will be published following the first quarter 2017 examination.

Sum and substance: The early 2016 Shared National Credits examination found that credit risk remained higher than it has been in other economic recoveries, but federal regulators also found a positive: Bankers had improved their underwriting.

Read more

For the full Shared National Credits review, definitions of the various types of credit ratings, and a breakdown by industry of loans, download the PDF.


Forefront’sState of Banking, 2016” report also touches on underwriting practices, the energy sector’s role in increased projected losses, and more.

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