Several community banks issued warnings about potentially suspect loans in the third quarter, using a variety of terms to characterize areas of concern.
Industry observers expect more banks to follow suit in coming quarters, largely to demonstrate they are proactively addressing cracks in credit quality.
Banner Corp. in Walla Walla, Wash., Eagle Bancorp in Bethesda, Md., and Franklin Financial Network in Franklin, Tenn., are among the banks that noted increases in either watch-list loans or classified assets in recent months.
While overall credit quality remained sound at those banks, the disclosures are a good reminder that stellar credit metrics can’t last forever.
Banks often try to provide such disclosures “before regulators require them to do it,” said Charles Wendel, president of Financial Institutions Consulting. Wendel said he is advising banks that are examining their portfolios and weighing whether to put more loans on special watch lists.
“Bankers don’t want to be perceived as reactive to credit issues,” Wendel said. “They want to demonstrate that they have strong early warning systems in place, and that when they see warning signs, they can move quickly to resolve any problems efficiently.”
Bankers use a number of terms to characterize loans that could eventually cause problems.
Substandard loans are classified credits that are inadequately protected by the net worth and paying capacity of the borrower or the underlying collateral. Doubtful loans are another form of classified credits where collection or liquidation is highly questionable and improbable.
Special mention loans have a potential weakness that merits close attention by management.
Loans on a bank’s watch list are being paid as agreed and have generally acceptable asset quality, but the borrower’s performance is not meeting management’s expectations due to pressure on the balance sheet or income statement.
The $3.8 billion-asset Franklin said during its third-quarter earnings call that classified assets rose to 1.77% of loans held for investment on Sept. 30 from 1.45% a quarter earlier.
The increase, a result of internal reviews, “causes us to take a cautious stance, as we continue to evaluate substandard loans in our portfolio,” Christopher Black, Franklin’s chief financial officer, said during the call.
Franklin, which did not return calls seeking comment, has been looking to reduce exposure in its health care portfolio. The company had to charge off its exposure to a $10 million shared national health care credit in the second and third quarters.
Health care loans still account for roughly a tenth of Franklin’s total loan portfolio, said Laurie Havener Hunsicker, an analyst at Compass Point. She estimated that about 11% of Franklin’s health care loans are classified as substandard.
Community banks have reported loan losses across several sectors this year, including retail, energy, agriculture and health care. Bankers have described these issues as generally isolated and not indicative of broader troubles.
Still, industry observers are watching closely for wider cracks in credit quality because, in addition to an impact on banks, broader issues could signal the onset of a recession.
“This is a very long economic expansion we’re in and loan losses, if they start to mount to the point that we have a trend, will [create] serious concerns,” said Scott Brown, chief economist at Raymond James. “Right now, it’s not that things are horrible — not at all — but we’re seeing signs of softening, and [bankers] are smart to be proactive.”
Eagle is being “very cautious” about restaurant and hospital lending and is beginning to be “far more selective” about construction loans, President and CEO Susan Riel said during the $9 billion-asset company’s earnings call.
Special mention and watch loans at Eagle nearly doubled in the third quarter from a quarter earlier, to $216 million, or 2.8% of loans.
Michael Flynn, Eagle’s head of investor relations, said the increase reflected a spike in watch loans — identified internally — and primarily a single loan tied to an income-producing property. Construction on the property is complete and the business is operating, but it has yet to generate the income levels the bank expected, Flynn said.
“This is a conservative approach,” Flynn said.
At Banner, substandard loan balances increased by 40% from a quarter earlier to $113.2 million on Sept. 30. It was the first time since early 2018 that such loans topped $100 million at the $12 billion-asset company, said Tim Coffey, an analyst at Janney Montgomery Scott.
Though Banner did not return a call seeking additional comment, its quarterly financial results showed that the increase was driven due by an increase in substandard business loans, which rose by 67%, to $45.1 million.
Banner’s net loan charge-offs more than doubled from June 30, to $2.5 million. But the company said its asset quality on the whole remains solid — nonperforming assets represented just 0.15% of total assets in the third quarter.
“We continue to be well positioned to deal with the emergence of a credit cycle and the portfolio impacts of macroeconomic factors,” Chief Credit Officer Richard Barton said during Banner’s earnings call.
