Background

On 7 December, the National Risk Committee of the Office of the Comptroller of the Currency (OCC) issued its Semiannual Risk Perspective for Fall 2023 (referred to as “report” or “fall report” throughout). The report covers data up to June 30, 2023, and aims to present risks facing national banks, federal savings associations, and federal branches and agencies. The report presents perspectives in four main areas:

• Operating Environment
• Bank Performance
• Special Topics in Emerging Risks
• Trends in Key Risks

While the report states that the federal banking system is strong, it underscores a number of areas, including the importance of managing credit, market, operational, and compliance risks.

Key Elements

Operating Environment

The report states that the U.S. economy remained solid in the first half of 2023 despite higher interest rates, with real GDP growing at an annual rate of 2.1% in Q2, slightly down from 2.2% in Q1. The report also highlights that consumer spending continued to be robust, supported by a strong labor market and pandemic-related excess savings. Moreover, it maintains that the conversion of securities to liquid deposits during 2020-2021 increased household cash holdings. While there has been a drawdown in excess savings, the report emphasizes that the drawdown is expected to support household spending into Q3 2023.

The report contends that while the inflation rate is slightly down, it remains above the Federal Reserve’s target. The Core PCE index increased 4.6% year-over-year in Q2 2023. Core inflation is projected to slow to 2.4% by end-2024. Residential real estate prices strengthened in the first half of 2023 due to low inventory, offsetting the impacts of elevated mortgage rates.

The report also mentions a decline in corporate profits in Q2 2023, especially in the financial sector, while consumer discretionary and information technology sectors showed strong earnings growth. High interest rates and rising costs are likely to affect profit margins going forward.

Bank Performance

The report maintains that bank performance remained resilient in the first half of 2023 despite the challenges of higher interest rates and an uncertain economic climate. It notes an improvement in profitability for the federal banking system, with return on equity strengthening from 11.6% in 2022 to 13.3%. This growth was primarily driven by the largest institutions and was attributed to a significant increase in net interest income (NII) due to a pronounced increase in asset yields.

For community banks, the report indicates more mixed performance. Higher interest rates benefited loan yields, but these benefits were more muted than in large banks. Community banks faced continuing pressures on higher funding costs, securities valuations, and liquidity. The report reveals that NII for the federal banking system rose by 24.2% year-over-year as of June 2023. This degree of increase is a historically elevated figure. Community banks experienced about half this rate of growth in NII due to a substantial rise in the system’s cost of deposits in the second quarter of 2023.

The report further highlights that banks continued to build reserves and experienced an increase in noninterest expenses; however, increased revenues were sufficient to offset those expenses. As a result, overall net income for the banking system increased by 21% year-over-year as of June 2023, and by 5% for community banks.

Special Topics in Emerging Risks

Each Semiannual Risk Perspective issue includes a Special Topic in Emerging Risks. In this issue, the OCC focused on banks leveraging artificial intelligence (AI) for various risk management and operational purposes. The Special Topic focuses on how banks are using artificial intelligence (AI), including for customer chatbots, fraud detection, and credit scoring, as well as increasing usage of generative AI following commercial availability of large language model tools.

While recognizing the benefits that AI may provide, the report affirms that the OCC is technology neutral and supports efforts to explore “safe and sound uses” of technology such as AI. The report also reminds the public that the OCC is mindful of associated challenges and risks, especially in rapidly evolving areas, including generative AI use. Common risks and concerns that can arise from all types of AI include lack of explainability, reliance on large volumes of data, potential bias, privacy concerns, third-party risk, cybersecurity risks, consumer protection concerns, and risks that inaccurate responses may appear credible.

Trends in Key Risks

The report asserts a detailed analysis of the risk landscape in the U.S. financial sector, highlighting moderate but increasing commercial credit risks due to slowing economic growth and persistent inflation. The report particularly notes the impact of wage inflation and staffing shortages on sectors with high leverage and limited financial flexibility, such as senior living and healthcare. It also emphasizes the growing risk in the commercial real estate (CRE) sector, driven by elevated debt costs and operating expenses, and notes increasing vacancy rates in retail and small business real estate in urban areas.

The report highlights the return to normalcy in retail credit post-pandemic, with a moderate increase in credit card and auto delinquencies. It points out the tightening of underwriting standards by banks amidst economic uncertainties, while acknowledging the buffer provided by a strong labor market and rising wages against the impacts of inflation and interest rate rises. The report also focuses on the significant changes in depositor behavior due to rising rates, underscoring the need for sound liquidity risk management in the face of ongoing investment portfolio losses.

On cybersecurity, the report underscores the sector’s challenges with sophisticated and evolving threats, stressing the importance of robust security measures. The adoption of new technologies and services, such as AI, is noted as bringing both opportunities and challenges, particularly in risk management. The report also sheds light on the necessity of effective third-party risk management due to increased digital transformation, outsourcing, and fintech partnerships.

Additionally, the report discusses the importance of managing operational and compliance risks, particularly in relation to the Bank Secrecy and Anti-Money Laundering Acts, as banks navigate evolving fintech relationships and payment methods. It emphasizes the ongoing challenges in consumer compliance and fair lending, highlighting the need for banks to ensure equitable access to credit.

Lastly, the report addresses climate-related financial risks, noting that while large financial institutions are focusing on managing these exposures, the integration of such risks into overall risk management frameworks is still at an early stage.

Patomak Insights

The report indicates several key takeaways that banks should pay close attention to, as examinations and scrutiny should be expected. Some of these include:

1. Increasing concerns around credit risk management,
2. Heightened scrutiny of real estate loan portfolios, and
3. Emphasis on the emerging risks and benefits associated with artificial intelligence.

Credit Risk Management

The OCC signaled increasing concerns around credit risk, which is now called out as the top risk area, moving from the number two risk area by supplanting liquidity risk. One notable change in the report relative to credit risk is the mention that the heightened risk environment could strain risk management functions, such as credit risk review and loan workout. Banks need to recognize and assess potential gaps in expertise and staffing levels around problem loan identification and mitigation experience. In response, credit risk review functions should consider adjusting sampling methodologies to ensure they proactively identify risk and respond appropriately.

For instance, when selecting a sample for credit reviews, firms should consider qualitative adjustments to capture higher risk industries, subsectors, and geographic locations. Another strategy could include identifying borrowers who may have exhibited marginal repayment capacity during stronger economic conditions, as these borrowers may reflect an increased risk profile as economic growth slows and recessionary conditions become more profound. Applying these types of strategies is likely to help firms proactively respond to heightened risk and ensure accurate and timely risk ratings, as these are key factors in successful credit risk management. Additionally, bankers can expect examiners to apply greater scrutiny to risk rating accuracy, often leading to increased rates of downgrades and increased levels of criticized and classified loans.

The OCC cites both commercial credit risk management and retail credit risk themes in the report. While impacts on retail credit have largely been muted with strong employment levels and wage gains, the report also calls out increasing levels of credit card and auto delinquencies, as well as retail charge offs. Banks should proactively review credit portfolios and consider portfolio attributes that may necessitate revised assumptions and/or additional provisions to the allowance for credit losses (ACL). This applies across all credit types, as the stress of a softening economy while rates remain high has had a variety of adverse impacts on all types of credit. Examiners will be looking closely at ACL accounting and analytical approaches, particularly as collateral valuations are weakening and the levels of criticized and classified assets are increasing.

Risk Management Surrounding Real Estate

The fall report slightly changed its outlook of the multifamily real estate market. Previously, the OCC assessed the multifamily market as sound with moderation beginning. The current report now concludes that risk in this market is increasing, driven by higher vacancy levels due to a combination of new inventory and slowing demand.

Although delinquency rates in this sector remain low, they are beginning to increase. Phoenix and Salt Lake City were specifically mentioned for their overbuild in luxury properties, which as a result has further devalued older properties in the metro area. Both markets were among the top beneficiaries of the pandemic remote work environment, and Phoenix in particular has historically outperformed in both the boom-and-bust parts of the cycle. Going forward, metro areas like Phoenix will be important to monitor, as these locations may provide early indicators of what is to come in other urban geographic locations.

The report slightly adjusts its assessment of the industrial CRE market, though the  Semiannual Risk Perspective Spring 2023 (referred to as “spring report” throughout)  did not include much discussion of the sector. The Fall 2023 report highlights that although the industrial sector has been the best performing CRE segment, it is also now showing signs of slowing.

Moreover, the spring report and fall report also differ in their assessments of risk in commercial real estate markets. The spring report  asserted that the office market was grappling with elevated vacancy rates in urban business districts, a direct consequence of the shift towards remote work. This transition led to a surplus of rentable space, surpassing levels seen during the Great Recession. The fall report  maintains that risk in the office market has expanded beyond the urban core to include suburban submarkets, reflecting the deepening impact of structural shifts due to remote work. The fall report indicates that businesses were increasingly opting for smaller office spaces, leading to resilience in newer, high-quality buildings, albeit often accompanied by lease concessions. This structural shift was not just confined to urban areas but was also evident in rising vacancy rates in suburban office spaces.

Artificial Intelligence

In the spring report  , AI is mentioned only once, in the context of banks’ adoption of new products and services. The Spring report suggests that while AI can benefit consumers by creating new products and fostering fintech partnerships, it also warns that such adoption can contribute to “a complex operating environment” and increase “compliance, reputational, strategic, and other risks.” In contrast, as discussed above, the fall report  dedicates its Special Topic to banks’ use of AI.

The fall report emphasizes that technological advances do not negate the need for existing safety and soundness standards and compliance requirements. The OCC asserts it takes a “technology neutral” stance toward AI, indicating that the agency has not yet solidified its regulatory stance toward the emerging technology. But, at the same time, the OCC also asserts that it “supports” national banks and federal savings associations in exploring “safe and sound uses of new and emerging financial technology.”

As banks increasingly use AI systems, bankers should expect increasing examiner scrutiny of their use, impacts on operational risks, data management, and compliance and privacy risks. It is likely that additional regulatory guidance will be forthcoming as examiners become more aware of the nature of AI use and associated risk management expectations. As bank regulators grapple with these areas, it is important that AI use is incorporated within risk management programs, and leverage guidance found in the OCC’s New, Modified or Expanded Bank Products and Services and Third-Party Relationships: Risk Management.

This fallreport also highlights how AI might pose challenges related to bias and discrimination, with concerns that AI systems could potentially “perpetuate” or “exacerbate” the effects of “historical discrimination.” The discussion of diversity, equity, and inclusion (DEI) as it relates to artificial intelligence appears influenced by the White House’s October 30th Executive Order on AI development and use. While the Executive Order does not specifically address the OCC, it mandates that AI aligns with the Biden Administration’s commitment to “advancing equity and civil rights.”

The Executive Order specifically directs the Director of the Federal Housing Finance Agency and the Director of the Consumer Financial Protection Bureau to require regulated entities to use appropriate methodologies, including AI tools, to ensure compliance with Federal law. This includes (i) evaluating underwriting models for bias or disparities affecting protected groups, and (ii) assessing automated collateral-valuation and appraisal processes to minimize bias. These methodologies may give banks insight into how the OCC may approach the DEI and AI in future risk assessments and rulemakings.

Put Patomak’s Expertise to Work

Patomak has deep experience in advising clients across the risk spectrum as delineated in the Fall 2023 Semiannual Risk Perspective, notably credit, market, operational, and compliance risk management and governance, as well as strategic decision making.

If you would like to learn more about how Patomak can partner with you, please reach out to John Vivian, Managing Director, at jvivian@patomak.com or Joshua Kuntz, Manager, at (jkuntz@patomak.com).