The regional bank executives spoke during a Risk Management Association (RMA) audioconference in November.
Philadelphia, Pa. (January 7, 2005)—The 18-month outlook for credit portfolios is good, according to executives at three large regional banks, but they are urging their institutions to be prudent. “It’s that time of the season to be most cautious,” said Karl G. Grunawalt, executive vice president of the $88.6 billion-asset Key Bank, during a recent RMA audioconference.
He and fellow panelists H. Lynn Harton, chief credit officer of the $84.1 billion-asset Regions Financial Corp., and W. Kendall Chalk, senior executive vice president of the $99.7 billion-asset BB&T Corporation, agreed credit quality and performance are excellent, but they are closely monitoring rapid growth in some portfolios, particularly in the acquisition and development (A&D) portfolio and the condo and home equity loan portfolios. They also noted that institutions are also under continuing pressure to please the analysts by generating growth.
“It's the age-old challenge: don’t let the drive for short-term results overwhelm our need for long-term discipline,” said Chalk.
Although the bankers expect the strong performances to continue for 12 to 18 months, they are less certain about the long-term outlook for some market segments. During the hour-long audioconference they also discussed the cost and difficulties of compliance in the post 9/11 environment.
Commercial Real Estate
Few portfolios garner as much attention as commercial real estate (CRE), which has been performing well across the industry. All three panelists reported exceptional performance in their banks’ CRE portfolios, and they say this performance is no accident.
“After the difficulties institutions experienced with commercial real estate in the 1980s, banks learned to do a much better job of mitigating risk,” said Chalk. “We've avoided the speculation that took place 15 years ago. We typically require more equity now; we're more conservative on appraisals. The capital markets have also played a role by bringing more discipline to commercial real estate. There's also a lot of liquidity in the marketplace now, and most importantly, interest rates are low.”
CRE is definitely not a safe haven, agreed the panelists. “There's still significant risk, particularly in specific markets,” said Chalk. “Offices may be doing well throughout our portfolio, but in some very specific markets we see excess building and high vacancy rates. We zero in on the risk by considering property types within a very localized market, and we are more selective in areas where we see increasing risk.”
Grunawalt noted that competition is increasing in some market segments while underwriting standards are loosening somewhat. “We're seeing less equity going into deals and less recourse going into deal structures. We’re paying very close attention in some segments, such as apartments, but we don't have any issues. It'll be very interesting to see how conditions change as interest rates increase.”
It’s multi-family construction that has Harton’s attention, even though he expects the market to continue doing well for 18 months. “What we're seeing is a little out of line with fundamentals, particularly in the condo market.
“Regions Bank is reinforcing its project hold limits. We've got exceptional geographic distribution and great product distribution. But we're looking at how much we want to hold on a per-project basis, and we're investing in our syndication abilities to better manage that project risk and maybe hold a little less of each individual transaction on our books.”
Single-Family Home Construction
The panelists agreed that the near-term outlook for single-family home construction is very good, with a healthy balance between supply and demand. It’s the longer-term acquisition and development projects that concern them. “The national homebuilders are pushing off the land loan to developers that follow them from market to market,” said Harton. “It’s a plus, however, that the national builders bring market expertise and discipline that we have not always had in the past.”
It’s the speculators who believe the good times will go on forever that concern Chalk. “They buy property hoping to develop it in a year or two or three or four,” said Chalk. “If rates increase, the housing market will slow down.”
Grunawalt says there will be a silver lining for lenders if interest rates continue to go up. “There might be a decrease in activity in the single-family market, but that might actually be good for the multi-family market,” he said.
Leveraged Lending
Many banks are finding opportunities in leveraged transactions today, but again the panelists urged caution.
Chalk said the industry is losing discipline in leveraged lending. “Maybe it's because there's so much money relative to the very little demand in the commercial and industry (C&I) world right now. There's just very limited demand relative to the amount of dollars chasing the deals.
“Investment banks are coming into the upper middle market and even the lower middle market, which is unusual. So that's providing more liquidity. Some of the covenants are getting waived or reduced. I worry about the discipline in the C&I lending arena, particularly around leveraged lending.
BB&T tracks leveraged lending. If debt to EBITDA is above four-and-a-half, we consider it to be leveraged lending. We've set some criteria for these deals and if we see troubling characteristics, we don't lend.”
Troubling characteristics are:
- No tangible equity.
- Poor collateral coverage.
- No historical cash flow.
Consumer Lending
Consumer portfolios are making up an increasingly larger share of banks’ earnings, but there are some clouds on the horizon. The consumer debt burden is rising and in some states, bankruptcy levels and defaults are elevated. The panelists agreed that consumer portfolios will continue to do well for the next 18 months largely because of low interest rates and the value in the housing markets that consumers access through home equity loans. The bankers’ outlook for the consumer portfolio in the long term is not as optimistic.
Chalk compared the fast growth in the consumer portfolio to high leverage that existed in the real estate and LBO transactions in the 1980s and to the high leverage and fast growth in the corporate market in the 1990s. “The consumer is where we’re getting most of our growth now, but some years down the road, the leverage and faster growth rates could be the source of our problems.”
Key Bank is watching its consumer portfolio, but doesn’t see it as a big challenge now or in the future because it’s so predictable. “We can allocate capital pretty accurately against it,” said Grunawalt. “There are areas of expected volatility, such as second mortgages.”
Regulatory Efforts
The panelists agreed that regulators would focus on anti-money laundering, corporate governance and consumer privacy issues in the near term. “Since asset quality has improved dramatically across the industry in the past two years, other concerns, such as Basel II, are likely to be pushed to the back burner,” said Grunawalt.
Pushed back, but not forgotten. “Through the credit cycle, we’ll see a resurgence of discussion around Basel II issues, regardless of whether banks are going to be disclosing more information about how they manage the risk in their portfolios. All banks are likely to develop systems that will enable them to discuss the risk in their portfolios,” said Grunawalt.
Chalk noted that regulators are also discussing economic capital. “BB&T has not yet made a decision on opting in to Basel II, but the regulators are asking what we’re doing to make sure we’re allocating the appropriate level of capital to the riskier businesses,” he said. “They want to see models.”
Regions Bank is documenting its processes and developing a statistical backup that verifies the accuracy of those processes. “We want mediation plans in place ahead of time if we find errors,” said Harton.
Overall, the outlook for the industry looks very good for the next 12 to 18 months, but institutions must be mindful of their credit quality. It is during good times that underwriting mistakes are most often made.
About RMA
Founded in 1914, RMA is a nonprofit, member-driven professional association whose sole purpose is to advance the use of sound risk principles in the financial services industry. RMA promotes an enterprise-wide approach to risk management that focuses on credit risk, market risk and operational risk.
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