Summary of Current Credit Conditions

• Credit quality is normalizing but still historically good,
• Reserves are adequate for most banks,
• What under-reserving there is, generally, is manageable with respect to earnings and capital,
• As always, there are outliers,
• Importantly, we are in the early stages of increased formation of underperforming loans in certain categories.

Table 1 shows the level and trend of the stock of underperforming Total Loans over the past year for a consistent universe of 512 publicly traded banks.

Chart 1

Credit remains benign, and over the past year, banks have been diligently charging off underperforming loans in order to maintain the stock of underperforming loans at low levels. While there are some outliers, even relatively poorly performing banks have Underperforming Loan Ratios of 1% or less. For context, the members of this group that existed at year-end 2009 (and survived to today), had a median Underperforming Loan Ratio 6 times the current levels.

The Rate of Formation of Underperforming Loans

Chart 2

As shown in Chart 2, the Formation Rate of Underperforming Loans is rising moderately from the low levels of the past year—indicating that credit quality may be beginning to normalize. [2]

For all but the smallest banks (those in $1 billion) C&I lending was the primary contributor to under-performing loans. For banks under $1 billion, the primary source of the increase in formation was an increase in Residential 1-4 Family Mortgages (See Chart 3).

Surprisingly, for most bank cohorts Owner-Occupied ComRe is deteriorating faster than Non-Owner-Occupied ComRe.

Chart 3

Chart 4 shows the change in the distribution of formation rates over the past year for C&I loans. While formation rates are still low, it’s clear that the curve is shifting rightward. 57 banks have shifted from the less-than-zero categories to positive categories. That number corresponds to an increase of 11 percentage points to 65% of our universe now experiencing positive formation of underperforming loans–up from 54% last year.

Chart 4

As shown in Chart 4, the YoY deterioration in the distribution of formation rates for Owner-Occupied ComRe is seen clearly in the rightward shift of the curve.

Chart 5

Adequacy of Reserves

We are able to estimate reserve adequacy for about 600 banks. More than 80% of these banks are adequately reserved or better based on our reserve adequacy methodology (See Chart 6). We regard our methodology as cautious. Most of the remainder of the banks have sufficient capital to true up reserves if necessary. Therefore, we don’t view asset quality as a capital issue for most banks as of yet.

Chart 6

[1] ALLL is Allowance for Loan & Lease Losses

[2] 1Q23 &The Change in Accounting for TDRs: The decline in the stock of underperforming loans in 1Q23 is entirely the result a one-time redefinition of loans considered to be troubled debt restructurings (TDRs). We’ve estimated the effect on the formation rate for 1Q23; but data are insufficient for an exact calculation. The increase in formation between 1Q23 and 2Q23 is not affected by this change.

Explanation: The accounting for troubled debt restructuring (TDR) changed in the first quarter of 2023 as a result of a new accounting standard, ASU 2022-02, “Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures.” The standard eliminated the recognition and measurement guidance for TDRs for creditors that have adopted the Current Expected Credit Losses (CECL) methodology. Instead, the new standard introduced enhanced financial statement disclosure requirements for loan modifications to borrowers experiencing financial difficulty.

The FDIC adopted a final rule to incorporate the updated accounting standard in the risk-based deposit insurance assessment system applicable to all large and highly complex insured depository institutions. The final rule amended the assessment regulations to include a new term, “modifications to borrowers experiencing financial difficulty,” in two financial measures—the underperforming assets ratio and the higher-risk assets ratio—used to determine deposit insurance assessments for large and highly complex insured depository institutions. The final rule was effective on January 1, 2023.

For the details on calculations and Cybiont’s approach to credit quality see Cybiont’s Approach to Credit Quality