While credit quality has remained stable over the last few years, factors such as higher interest rates, inflation, and high labor costs continue to negatively impact borrowers’ repayment ability. Our professionals have begun to see this result in a slight increase in criticized assets. To help your organization be proactive in handling credit risk, consider the following tips to maintain credit quality.
Identify the Amount of Loans Repricing or Maturing Within the Next 6–12 Months
Many loans that will reprice or mature in the next 6 to 12 months will do so in a higher interest rate environment than the current interest rate. Identifying the dollar exposure set to mature and scrutinizing the impact of these higher rates and collateral values can allow the financial institution to see potential risk rating changes, not only on the individual borrower, but the overall portfolio.
Cultivate Robust Stress Testing & Scenario Analysis
Cultivating robust stress testing and scenario analysis is essential in understanding credit risks, especially during the approval and annual review processes. Key areas to focus on when conducting the stress tests include cash flow, interest rates, occupancy, and cap rates, where applicable. This stress testing can enable a financial institution to see any potential cash flow concerns that could result in risk rating changes.
In addition, a financial institution should consider comparing the actual net operating income (NOI) against borrower projections and appraisal NOI. Comparing these NOIs can empower the financial institution to decide if the project is in line with the borrower’s projections and if the property’s current value has declined since the appraisal.
Similar to repricing or maturing loans are construction loans. Construction loans with an upcoming permanent financing conversion most likely have a higher permanent financing interest rate than what was used in the original underwriting. A financial institution should study the projected cash flows with the current interest rate to decide if new projections should be considered (if the existing ones do not result in an ability to repay the loan with the new interest rate).
Early identification of problem loans may help your institution create a timelier course of action for credit loss prevention. Our Loan Review team can help your institution identify and deepen your understanding of credit risks. For more information, please contact a professional at Forvis Mazars today.