Bracing for the "Ripple Effect"
Critical Risk Management Action Items for Asset Quality, Earnings, & Capital
In recent weeks, regulators have signaled concern at levels not seen since the onset of the pandemic about the potential for credit deterioration.
As stated in the August 2022 FDIC Supervisory Insights: “It is important for bank management to understand how risk in a bank’s loan portfolio can affect its financial condition. A common way to do this is through portfolio stress testing and sensitivity analyses.” This heightened focus on the impact of credit deterioration on asset quality, earnings, and capital has already markedly increased the number of institutions planning to enhance their stress testing and capital planning processes. Among Darling Consulting Group bank and credit union clients, Q3 has already seen a significant spike in inquiries for assistance with risk management strategies in the face of increased regulatory scrutiny.
The ripple effect
The United States has just experienced one of the most extreme economic environments in its history; one in which the economy shut down and restarted with the proverbial flick of a switch. Significant fiscal and monetary stimulus have created a “ripple effect” across the industry in the form of unpredictable inflation levels coupled with extreme market volatility, resulting in elevated uncertainty. While it remains to be seen just how far into this ripple effect we are, one thing is for certain: it is not over.
Is history a predictor of the future?
Think back to the Great Recession. In hindsight, the factors that contributed to the severe economic downturn, such as loose underwriting, subprime lending, and deregulation – which ultimately resulted in unemployment levels rising to 10% in October of 2009 – were obvious. However, on the eve of that economic disaster, no one could have predicted the full extent of what was about to happen.
Today we have a similar situation. We’re not suggesting that the U.S. is going to experience another Great Recession; however, the recent economic stimulus initiatives taken to avoid a credit crisis during the COVID-19 pandemic are contributing to ripples today that have not been seen in over 40 years. Among these are:
Unexpectedly high sustained inflation
Dramatic decrease in consumer sentiment
Changing spending habits
S&P 500 entering bear market territory
Declines in Q1 & Q2 GDP
Almost 70% of senior-level bankers responding to a recent DCG poll answered ‘Yes’ when asked if they expect a recession over the next year. Another 27% said there is a 50/50 chance.
Source: Darling Consulting Group Annual Conference Poll, June 2022
Status of the banking industry
Banks and Credit Unions on average are highly capitalized and most characterize credit as being “strong.” Earnings are also strong as interest rates rise, and most (up until the writing of this article, at least) have been able to lag their deposit cost increases. But what happens when the next ripple comes, potentially resulting in higher funding costs, weakening loan demand, and pressure on the ability of consumers and businesses to service their debt? What if there is a flight to safety as the Fed pendulum swings, and they begin to cut rates, resulting in more deposit inflows, lower earning-asset yields, and pressure on already reduced leverage and net worth ratios?
What to do next
No one can predict the future. The best alternative is to prepare by analyzing the potential capital impact of various economic outcomes from both an earnings and credit perspective. What could happen to credit if unemployment elevates to 5%? What if inflation remains above 8%? What if a combination of the two? Ultimately, what does this mean for overall capital?
Your institution may be highly capitalized today and credit may be strong, but earnings, growth, and credit ripples in the future may change that position. And while those pressures may not challenge the solvency of your institution, they will have an impact on your ability to achieve your strategic goals.
For those that find they are capital deficient, the options to increase capital may not be available when conditions deteriorate. It is critical to perform credit stress testing and capital forecasting today, not when conditions worsen and it is potentially too late. Having a hierarchy of remediation strategies – similar to a liquidity contingency plan – may grant a substantial head start.
How DCG can help
As more and more informal and formal comments surface in regulatory exams in the areas of concentration risk, credit stress testing, and capital planning/forecasting, now is the time to bolster your process. Hundreds of institutions have enhanced their risk management process through DCG’s easy-to-understand, supportable, and cost-efficient approach to credit stress testing and capital planning.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group working directly with senior management teams in capital planning and credit risk management initiatives. DCG’s web-based Credit Risk and Capital Simulator provides credit risk assessments through a multitude of macroeconomic scenarios and allows customizable and instantaneous capital ratio forecasting on growth plans.
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