KEEPING AN EYE on Asset Quality

Susannah Marshall | Commissioner | Arkansas State Bank Department

Bankers and regulators alike have spent a significant amount of time recently commenting and discussing the fact that Asset Quality has generally been stellar for several years now and continues to perform at a high level. I am seeing and hearing a few signals that indicate an ever so slight change in some loan performance metrics across the state as well as regionally and nationally. As we all continue to monitor this area of bank operations, I think now is an important time for us to focus on another component of the Asset Quality conversation – the Allowance for Credit Losses (ACL).

I was recently in a discussion with a few federal regulators and the conversation turned to the topic of Asset Quality and the ACL. One question was posed as to where does our industry stand in the adoption of the Current Expected Credit Losses (CECL) methodology? Have banks appropriately adopted CECL and what is the examination process telling us about the banks’ analysis, documentation and implementation of CECL? I can answer that question quite easily as it pertains to Arkansas state banks. Overall, at this stage, we are not seeing any issues regarding the adoption of CECL by our state banks; however, we continue to acknowledge that it is a process and with each examination, additional information will be obtained, and further reviews will be conducted to more fully ascertain how banks have transitioned to the new methodology.

This accounting change comes at a very interesting time in the cycle of the banking industry. The consumer impact due to the unprecedented rise in interest rates between 2022 and 2023, remains to be seen; however, we are beginning to hear and see incremental changes in performance metrics within banks’ loan portfolios. Additionally, the regulators are increasingly concerned about recent changes in third-party evaluations and appraisals. State Bank Department examiners are beginning to report that in some cases, updated appraisals are reflecting notable declines in values on certain property types in certain markets; however, this remains limited and not a systemic issue at this time. Although we are not seeing this as often in local markets, it is telling that an early indicator of economic stress is beginning to emerge. Now, is the time to truly strengthen your risk management and risk mitigant processes (stress testing) around credit, especially if your institution holds loan concentrations and more specifically concentrations in commercial real estate. The enhanced focus on credit risk should also cover other types of credit portfolios, in particular, the C&I lending sector and the strength of credit card portfolios in relation to the larger pressures on the economy and households.

Further, an additional focus is on the recent comments we are receiving about banks reporting negative provisions or a decrease in provision expense. This topic presents challenges as it is difficult to reconcile all current factors: strong asset quality, new accounting guidelines, interest rate pressure and valuation decay. I will share that regulators often respond with skepticism when we learn of institutions planning or executing negative provisions. We truly understand that the analysis to support a proper reserve or ACL is challenging, even in the best of circumstances or more definitive economic conditions, but in the current environment, additional pressure exists when making the determination how to analyze, estimate and budget provision expense in relation to the qualitative factors. However, from a regulator’s opinion, now is the time to ensure the ACL is funded appropriately, the analysis is well documented and supported and above all, the bank is prepared for the uncertain, but likely, downturn in asset quality that may occur in the near future.