Regulators from the OCC, FDIC, and OTS discussed credit quality, home equity products, and the Bank Secrecy Act during an RMA Regulatory Crossfire audioconference in June. The audioconference was a follow-up to the RMA Community Bank Council's meeting with regulators, held in Washington during May. The Council meets at least annually with regulators to discuss issues of concern to community banks, and the dialogue is continued throughout the year by other means, including audioconferences. This article is an edited summary of the regulators' remarks.

Credit Quality Is Strong, but Caution Is Indicated

Barbara Grunkemeyer, deputy comptroller for credit risk at the OCC, said the lagging indicators show credit quality to be good, but the leading indicators, such as underwriting standards, suggest that the industry needs to exercise caution.

"Credit quality is not likely to get much better than what we're currently seeing," said Grunkemeyer. "Measured by traditional performance indicators, credit quality is strong."

Retail Products

"Retail products have stable indicators within the satisfactory range," she said. "The products that have been commanding the most attention are those secured by residential, one-to-four family homes. Both mortgages and home equity lines of credit have stable delinquencies, well within acceptable ranges. Losses are barely registering, below one-tenth of a percent.

"For credit cards, where we normally see higher losses, the loss and delinquency rates have come down in the last couple of years and are generally in the 4% range, although we expect to see them go up on two fronts. First, as a result of the recent bankruptcy bill, it is expected that there will be a rush among some borrowers to declare bankruptcy before the implementation date. Also, the implementation of higher minimum credit card payment levels by many of the banks is likely to have some effect on credit card performance."

Commercial Portfolios

Grunkemeyer said commercial portfolios continue to improve quarter after quarter. "For all categories of commercial real estate, performance has been exceptional for the past 10 years, but we're all a bit anxious about the possible impact of continued interest rate hikes. In C&I portfolios, the loss and delinquency levels have reverted to the pre-1998 level. They're continuing to come down on a quarterly basis. Likewise for the agricultural portfolios, where credit quality improved over last year."

SNC Program Update

"Shared National Credits are loans larger than $20 million that are shared by three regulated institutions," she said. "Federal regulators review those loans annually at the agent banks and vote on what the ratings should be. Results are published around Labor Day and are a good indicator of what credit quality is for C&I portfolios. A lot of the smaller institutions don't hold Shared National Credits, but they still are a good indicator of credit quality in general.

"Although we don't yet have the results, I can tell from the number of early releases of examiners at the large banks that we're going to see continued improvement in Shared National Credit portfolios. This is borne out by the preliminary data that banks provided at the beginning of the year.

"So, we would expect to see some improvement in SNC portfolios. As you know, quality started to deteriorate in 1999 and stabilized in 2003. We saw a big drop--almost 50%--in the credit size of classified numbers last year. I certainly don't expect to see a drop anywhere of that magnitude, but we should see some continued improvement."

External Indicators

"Criticized and classified numbers and delinquency rates provide a limited measure of credit quality," said Grunkemeyer. "We also look at some external indicators. KMV, which reports expected default frequencies, has posted steady declines in the median and average default frequency. The OCC also collects some internal data, credit data, on C&I portfolios and that, too, has showed continued improvement in commercial quality.

"But the rate of improvement for both of these indices has slowed and perhaps could be bottoming out. We certainly wouldn't expect to see an uptick in criticized and classified numbers or delinquencies. But the fact that the expected default frequency, or the weighted average probability of default, which is measured by both KMV and the OCC's internal data, has certainly slowed may indicate we are nearing the end of this phase of the credit cycle."

Leading Indicators

"Up to this point, I've talked about lagging indicators of credit quality," said Grunkemeyer. "The more interesting question is, what do the leading indicators tell us? With respect to leading indicators, my focus is primarily on underwriting standards, and most of my comments are drawn from the Federal Reserve's April 2005 Senior Loan Officers' Survey.