Introduction

The Office of the Comptroller of the Currency (OCC) conducted its ninth annual survey of credit underwriting practices during the first quarter of 2003. The survey identified trends in lending standards and credit risk within the national banking system for the most common types of commercial and retail credit offered by national banks.

The 2003 survey included the 66 largest national banks and covered the 12-month period ending March 31, 2003. Although mergers and acquisitions have altered the survey population somewhat, the surveys for the last eight years have covered substantially the same bank group. All companies in the 2003 survey have assets of $2 billion or greater. The aggregate loan portfolio of banks included in the 2003 survey was approximately $2.2 trillion as of December 31, 2002. This represents 91 percent of all outstanding loans in national banks.

The OCC examiners-in-charge of the surveyed banks were asked a series of questions concerning overall credit trends for 18 types of commercial and retail credit. Commercial credit for purposes of this survey included 10 categories of loans: syndicated/national loans, structured finance, asset-based loans, middle market loans, small business loans, international credits, agricultural loans, residential construction, commercial construction, and other commercial real estate. For this year’s survey, commercial real estate was split into three product types-residential construction, commercial construction, and other, which includes non-construction owner-occupied and investor property. Retail credit consisted of eight categories of loans: residential real estate mortgages, affordable housing, credit cards, other direct consumer loans, indirect consumer paper (loans originated by others, such as car dealers), consumer leasing, conventional home equity, and high loan-to-value (HLTV) home equity loans.

The term “underwriting standards,” as used in this report, refers to various requirements, such as collateral, loan maturities, pricing, and covenants, that banks establish when originating and structuring loans. Conclusions about “easing” or “tightening” of underwriting standards are drawn from OCC examiners’ observations since the 2002 survey. A conclusion that the underwriting standards for a particular loan category have eased or tightened does not indicate that all the standards for that particular category have been adjusted. It indicates that the adjustments that did occur had the net effect of easing or tightening such underwriting criteria.

Part 1 of this report discusses the overall results of the survey. Part II depicts the survey results in graphs and tables.

Part I - Overall Results

Primary Findings

• The 2003 survey results for commercial underwriting indicate a slowing in the pattern of tightening standards that has prevailed since 2001. The economy and its effect on product performance continue to exert significant influence over commercial underwriting.

• Retail underwriting standards continue to evidence greater stability. Most banks reported retail underwriting standards were unchanged, but when standards were changed, tightening outweighed easing.

• For the first time since 2000, examiners report that credit risk in the commercial loan portfolios, while still increasing, is starting to moderate. Portfolio trends for retail credit, similar to prior years, are relatively constant.

Although the majority of banks reportedly tightened commercial underwriting standards during the 12 months covered by the 2003 survey, the percentage of banks tightening standards declined. Tightening of commercial underwriting standards peaked at 67 percent in 2002 and decreased to 60 percent for the current period. Similar to 2002, most of the remaining surveyed banks reportedly made no changes to commercial standards. Examiners also reported that six percent of the surveyed banks eased commercial underwriting standards, compared to no banks easing commercial standards in 2002. Both the decreased rate of tightening and the reappearance of easing, albeit at a very low level, suggest that the current credit cycle may be ebbing.

The change in commercial underwriting at the product level is one of degree, with most products evidencing slightly less tightening. Two products that continue to experience credit quality problems, structured finance and syndicated/national loans, received the greatest tightening, albeit, at slightly lower levels than in 2002. Examiners also reported that the level of tightening increased for three products - agriculture, asset-based, and international loans - reflecting sectoral problems in agriculture and international and a wave of restructured loans for troubled borrowers in the asset-based loan category. Consistent with the 2002 survey, examiners reported the three primary reasons for tightening commercial underwriting standards were, in order of importance, economic outlook, risk appetite, and product performance. The most common methods to tighten standards were adjusting covenants, collateral, and the amount of the credit line. All three of these methods provide more structural support to better control the risk in a credit facility. Pricing, which has been one of the most frequently cited methods used both to tighten and to ease credit standards in prior surveys, dropped to fourth place.

Examiners reported a subtle shift in commercial credit risk trends. At the portfolio level, for the first time since 2001, more examiners reported no change in credit risk for the past twelve months than those reporting increased risk. Additionally, for all of the commercial products, examiners reported smaller increases in credit risk, year-over-year.

Little change is observed from 2002 to 2003 in the survey results for retail credit. Most of the surveyed banks, 46 percent, reportedly made no changes to retail underwriting standards in 2003, and tightening outweighed easing for those banks changing the standards. The primary reason for tightening was a change in risk appetite, followed by the economic outlook. The economy had a significant bearing on tightening for both retail and commercial standards, but its impact was much greater on commercial underwriting; in this instance, over 75 percent of the banks identified the economy as a reason for tightening compared to just over 50 percent for retail. Modifying scorecard cut-offs remained the preferred method of tightening retail underwriting, followed by adjusting collateral and pricing.

At the retail product level, examiners reported the majority of surveyed banks did not adjust underwriting standards. While tightening remained more prevalent than easing, there was an increased level of easing for several retail products; and two products, credit cards and conventional home equity loans, exhibited a material degree of easing. The primary reason for retail easing was competition.

Risk trends for retail credit indicate that the majority of banks experienced no change in the overall level of risk for the past twelve months, while a somewhat lower percentage of respondents expect retail credit risk will remain unchanged for the next 12 months. At the product level, six of eight retail products were reported to have increased credit risk, but in most instances, for each of those products, almost as many banks reported decreased levels of risk. Home equity products exhibited the greatest increase in risk, followed by credit cards and indirect consumer loans. Although credit cards and home equity products are significant portfolios for several banks, retail portfolios are dominated by residential mortgages, which historically have exhibited stable, low-risk profiles.

Commentary

In this ninth year of the OCC underwriting survey, we begin to have a sense of a full credit cycle. In 1995, the first year of the survey, we reported banks were relaxing their underwriting standards in response to competitive pressures. Commercial underwriting standards experienced a significant wave of easing over the next few years and then, beginning in 1999, a period of tightening that only recently has started to ebb. Throughout this period, retail credit exhibited greater stability with selective easing and tightening of certain products. Also, during this period, credit risk was building in commercial and retail portfolios as a result, first, of liberalized underwriting, and, second, a weakening economy. Banks experienced deteriorated performance in segments of both portfolios, but better risk management and diversified sources of income helped to contain problems at manageable levels. Now, there are indications that credit risk is beginning to abate as the economy show signs of recovery.

As we look back on this cycle and the trends in underwriting and credit risk, certain themes emerge:

· Decisions about risk selection and underwriting practices need to be made in tandem. Targeting a higher-risk customer or market segment without a corresponding adjustment to underwriting standards often introduces higher-than-intended levels of risk.

· Competition pressures banks to move away from prudential underwriting standards. Banks need to redouble diligence during periods of intense competition.

· Basic credit principles - sound underwriting, unbiased risk identification, active portfolio management, robust management information systems, and good controls - need to be sustained throughout the credit cycle.

With these themes in mind, two portfolios are noteworthy. Home equity lending has experienced tremendous growth for the last three years, and many banks plan to continue to increase this product over the next 12 months. In addition, the underwriting for home equity products has been subjected to a fair degree of easing during the last several years. The degree of easing is particularly significant when the proliferation of high-loan-to-value home equity loan products is considered. While the performance of home equity loans remains strong, banks need to be alert to the risks that are introduced when high growth is coupled with liberalized underwriting.

The second portfolio of note is commercial real estate. This is a significant product line for many banks and another portfolio with liberalized underwriting standards and high growth rates, particularly in regional and community banks. Certain metropolitan markets and property types such as offices, hotels, and multifamily housing are experiencing high vacancy rates. In the 2003 survey, examiners reported that commercial real estate is the product posing the greatest potential risk to their companies. To date, performance has been satisfactory, but market conditions, underwriting trends, and unseasoned portfolios raise concern about the embedded risk in these portfolios. Also, when interest rates start to move up, commercial real estate portfolios may be exposed to added stress.

The OCC will continue to focus supervisory attention and resources to ensure that credit risk in national banks is accurately classified and that credit risk management practices are commensurate with risk levels.