Introduction: OCC (Office of Comptroller of Currency) which supervises national banks and agencies of foreign banks in US released it’s semi-annual risk report last week. The report presents risks facing banks that “pose threats to the the safety and soundness of banks and their compliance with applicable laws and regulations”. The report presents an optimistic message – while the risk of downside growth is increasing due to tightening financial conditions and geopolitical uncertainty the banks continue to be financially strong having navigated the pandemic well and are adequately capitalized to face the economic headwinds.
Topical Risks in next 6 months: The risks that are most pertinent for banks in the coming 6 months as per OCC report are risks from rising interest rates, Operational Risk and Compliance Risk. Valuations of investment portfolios for banks where duration was increased to offset low interest rates over last few years are most vulnerable now. Operational Risk is elevated due to increasing complexity of external environment from ongoing war in Ukraine and the elevated risks and advances in the nature of cyber attacks. Compliance risks is next on the top of mind of OCC due to geopolitical risks and related risks of maintaining sanctions and adapting to changing regulatory regimes. A third risk noted for the first time and very topical is the challenges facing banks (and other firms as this is not unique to banks) in retaining and hiring people and risk of increased turnover.
Outlook for the Economy: While US economy grew at a brisk pace of 5.7% in 2021 the growth is expected to slow and report cites that growth forecast has dipped by 50 basis points due to the Ukraine war from 3.7% to 3.2% (though IMF still maintains forecast of 3.7%). The war will add more inflationary pressure on grains and oil which is expected to ease over two years and fall back to 3% but could become higher if there is wage spiral due to tight job market. Other noteworthy forecasts in the report;
- The average home price is 33% higher before Covid with most counties seeing price increases of 15 to 49% since Dec 2019. While home buying is expected to cool down with rising rates there will be pressure on prices due to a decade of low homebuilding.
- Outlook for CRE is uncertain due to lesser vacancy as remote working continues to become a permanent part of the working week post pandemic and so properties most at risk are offices, hotels and retail stores catering to working commuters and business travelers. Office vacancies are expected to stay at 12% for next two years from a pre-Covid level of 9%.
Outlook for Banks: Return on Equity (ROE) for banks increased in 2021 from their pre-Covid level and now averages 12% despite the low interest rates which affected the Net Interest Margin (NIM) and bank profitability. NIM measures the average interest rate received by banks from loans and other interest bearing assets made over and above the interest rate paid on deposits and NIM for banks reached a low of 2.4% in 2021. However the release of $30 billion in credit reserves in 2021 which had been set aside for pandemic more than offset the decline in NIM from low rates. Going forward both loan sales and release of credit reserves are expected to slow down and challenges for banks will be maintaining expenses with rising labor costs. However the banks remain well capitalized and financially strong to withstand these economic winds; this has also been shown by the most recent stress test results which showed that the banks Common Equity Tier (CET1) ratio will remain well above the required minimum throughout the stress test period and that they have capital to withstand more than $600 billion in losses.