Bank Regulators' Data Show Stabilization in Credit Quality

WASHINGTON — The quality of large syndicated bank loans stabilized this year, according to the Shared National Credit (SNC)¹ review released today by federal bank regulators. However, regulators noted that adversely rated loans remain at an elevated level, and will require continued vigilance.

The results — reported by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision — are based on analyses that were prepared in the second quarter and reflect business and economic conditions at that time.

Total loan commitments² classified as either substandard, doubtful or loss fell by $4.9 billion or 3 percent over the previous year, compared with a net increase of $39.8 billion or 34 percent the year before. Commitments rated special mention decreased by $23.8 billion or 30 percent, in contrast to 2002 when they grew by $3.5 billion or 4.6 percent. None of these figures include the effects of hedging or other techniques that individual organizations might have employed to mitigate risk.

The ratio of classified loans to total commitments rose to 9.3 percent, close to the previous peak in 1991, driven by a 12 percent decline in total commitments. At the same time, total adversely rated credits (classified and special mention combined) stabilized at 12.6 percent of total commitments (see Chart 1 below).

Adversely rated credits (also known as criticized credits) are the total of loans classified substandard, doubtful, and loss-and loans rated special mention. Under the agencies' Uniform Loan Classification Standards³, classified loans have well defined weaknesses, including default in some cases, while special mention loans exhibit potential weaknesses, which may result in further deterioration if left uncorrected.

Overview

In aggregate, the SNC Program covered 8,232 credits totaling $1.6 trillion in loan commitments to 5,111 borrowers in 2003. Total commitments were down by 20 percent from the 2001 peak of $2.0 trillion, driven by lower customer demand, tighter underwriting standards, attractive capital market financing alternatives, and repositioning by banks to exit non-strategic business lines and less profitable customer relationships.

For the 2003 review, total loan commitments classified as substandard remained roughly even with the prior year, while doubtful credits edged up $3.2 billion or 12.3 percent (see Table 1 below). At the same time, commitments classified as loss remained elevated at $10.7 billion, but were down 43.8 percent from the extraordinary level of the prior year. That decline in turn led to a fall in total classifieds of 3.2 percent. While total classified commitments fell moderately, the portion of outstanding classified loans not accruing interest⁴ was unchanged from the prior year at $51.0 billion.

Table 1 SNC Classifications ($ billions)

Industry Trends

The quality of the SNC portfolio was mixed as modest-to-strong improvements in the majority of industry sectors were nearly offset by deterioration in the energy sector (oil, gas, pipelines, and utilities — see Appendix B). In total, improving industry segments more than offset deteriorating ones by $4.9 billion. The strongest improvement occurred in manufacturing, with an $18.2 billion decline in classified commitments largely driven by loan repayments from a handful of substandard borrowers. Classifications in the telecommunication and cable segment fell $2.4 billion, but remained at significantly elevated levels. Other segments such as financial services and insurance showed modest declines, with classification rates that were below those for the entire SNC program. In contrast, the energy sector showed rapid deterioration with a $21.1 billion rise in classifieds largely attributable to leveraged firms involved in energy trading. In addition, the well-known problems facing U.S. passenger airlines drove a $1.1 billion net increase in classifieds for the lodging and transportation sector. Credits identified for special mention fell by $23.8 billion with strong declines experienced in nearly every industry. These declines were driven by a migration of a portion of prior year special mention credits to classified categories, as well as a decline in newly identified potential weaknesses.

Despite a decline of 44 percent in loans identified in the loss classification, this year's level of losses, $10.7 billion, was the second highest on record. Of total losses, $5.0 billion, or 47 percent, were directly attributable to the weakened telecommunication and energy sectors, the Argentina default, and asbestos-related litigation (see Table 2 below). The remaining losses were spread widely across a variety of industries. In contrast, during 2002 more than 60 percent of losses were attributable to the telecommunications and energy sectors. Table 2 also highlights that nearly half of 2003 SNC classified commitments were related to the telecommunications and energy sectors, compared to roughly one-third in 2002.

Table 2 Selected Industry and Country Losses for 2003 (in $ billions)

Trends by Entity Type

During 2003, the share of SNC commitments held by nonbanks⁵ continued to grow, edging up 1 percentage point to 11 percent, while the share held by foreign banking organizations (FBOs) fell to 44 percent and that held by U.S. banks⁶ held steady at 45 percent (see Table 3 next page). U.S. banks experienced a 20 percent decline in classified assets during 2003, compared to a rise of 5.5 percent at FBOs and a 6.0 percent rise at nonbanks. These disparate trends further differentiated the quality of holdings among entity types, with classifieds amounting to just 5.8 percent of total commitments for U.S. banks, compared to 9.0 percent at FBOs and 24.4 percent at nonbanks. Similarly, total nonaccrual outstandings fell for U.S. banks and rose for FBOs. However, despite a rise in classified commitments, nonaccrual outstandings for nonbanks fell.

Table 3 - Exposures by Entity Type

To a great extent the deteriorating trend in SNC credit quality at FBOs is explained by their higher share of riskier energy commitment holdings relative to U.S. banks. Of the $21.1 billion increase in energy commitments, $16.1 billion was attributable to FBOs, resulting in a 23.5 percent classification rate in energy commitments. In contrast, U.S. banks experienced a $2.9 billion increase, and a classification rate of 10.2 percent in energy commitments. At the same time, nonbank classifieds were up by $2.1 billion, amounting to 31.4 percent of energy commitments. Notably, both FBOs and nonbanks increased their dollar holdings of energy commitments in 2002 and only began reducing them in 2003, while U.S. banks reduced their exposure in both 2002 and 2003. The increasing share held by nonbanks likely stems from the purchase of troubled loans in the secondary market at steep discounts.

Table 4 - Energy Classifications (2003)

The significantly higher classification rate for nonbank holdings is consistent with market observations that nonbanks continue to be active participants in the sub-investment grade portion of the syndicated loan market and are active purchasers of distressed loans in the secondary markets at discounts to par value; all dollar amounts in this release are par amounts.

Response by Banks

Banking organizations have continued to remain vigilant in identifying problem credits and have generally reflected the appropriate risk rating in their internal credit ratings. Although credit problems have stabilized, banking organizations must continue to carefully monitor the condition of their borrowers in the current environment to ensure that they promptly identify and address any emerging weaknesses and adjust loan loss allowance levels appropriately⁷.

Related Links

• Appendices A & B (PDF)

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