Summary:While asset quality is strong, rising charge-offs in CRE and credit cards suggest it’s time for CFIs to revisit risk management strategies. We discuss the trend and responses to consider.
The proverb "forewarned is forearmed" is believed to be derived from the Latin phrase “praemonitus, praemunitus.” Though it was originally used to refer to military activity centuries ago, it has become commonplace as a metaphorical warning of much more mundane events that simply have unpleasant consequences rather than dangerous ones. This meaning of the phrase holds true in the current financial market, especially for community financial institutions (CFIs) navigating the complexities of lending. Despite overall asset quality looking solid in Q2, the rise in charge-offs — particularly within the commercial real estate (CRE) and credit card segments — means it might be time for CFIs to rethink their risk management practices.Charge-Off Trends and ImplicationsThe Federal Deposit Insurance Corporation (FDIC) Quarterly Banking Profile for Q2 2024 revealed an uptick in charge-offs among CFIs, a trend they simply cannot afford to ignore:
Net charge-offs reached 0.14% — only slightly below the pre-pandemic average.
The charge-off increase was most notable in commercial and industrial loans, where the community bank net charge-off rate jumped by 16bp from 2023 to 0.37%.
Given that commercial loans make up a moderate portion (12.8%) of CFI portfolios, this increase indicates stress CFIs should proactively manage.Meanwhile, asset quality metrics are still favorable despite some deterioration. The share of loans and leases 90 days or more past due or in nonaccrual status inched up to 0.61%, slightly up from Q1 but still well below the pre-pandemic average of 0.96%. This mixed picture indicates that, while overall asset quality is under control, CFIs should be monitoring their portfolios for signs of vulnerability.CRE Risks for CFIsThe office sector is dealing with ongoing issues. Higher vacancies have resulted in declining rental income, while refinancing has become much tougher due to persistently high interest rates. This has put more financial strain on CRE borrowers, which is starting to spur charge-offs.The OCC has stressed the need for concentration management, which is key for CFIs to handle these risks effectively. CFIs can better manage risks by adhering closely to OCC guidelines, ensuring that their commercial portfolios stay diversified, while regularly stress testing for distress.CFIs should also insist on securing strong loan guarantees. Requiring full personal guarantees from principals and individuals with at least 25% ownership can provide an extra layer of protection against potential losses if property values decline.Strengthening Risk Management Strategies in 2024/2025CFIs managed to boost their net interest margin (NIM) by 7bp from Q1 to 3.30%, thanks in part to a favorable balance between asset yields and funding costs. CFIs shouldn't count on these gains continuing without making some strategic adjustments.102424-FDIC NIM chart 2.png96.13 KB Source: Quarterly Banking Profile for Q2 2024
A stronger focus on stricter underwriting standards for both commercial and consumer credit is critical.
Tightening the terms for high-risk loan segments, such as for office properties and credit card portfolios, could help mitigate potential losses.
Given the 18.2% jump in provision expenses from Q1 (now at $913.5MM), more reserves should be set aside to prepare for potential future loan losses.
CFIs might want to invest in advanced data analytics tools to better spot early warning signs of borrower distress.
Outlook for CFIsOverall, CFIs are showing positive momentum, with net income growing by $72.6MM from Q1 to reach $6.4B in Q2. The growth in NIM and loan balances across most categories is also encouraging. But the uptick in charge-offs — especially in CRE and credit card portfolios — can’t be ignored. Concentration management, full guarantees for CRE loans, and stricter underwriting standards are all key to managing current and future uncertainty. By seeing the forest for the trees, CFIs can stay resilient and keep supporting their communities effectively while navigating a shifting economic landscape.
PCBB’s President’s Top Predictions for CFIs in 2025 We interviewed PCBB President Mike Dohren about the key trends he anticipates affecting CFIs in 2025, including regulatory changes, mergers and acquisitions, lending trends, and technology.
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