Bank Credit Quality Is a Long Game

Short-term rate reductions, declining inflation or even the election results may seem like boons to borrowers’ repayment capacities and the broader lending environment. However, we need to acknowledge the inherent long-game nature of banking and credit. As we enter 2025, there are both challenges and opportunities related to credit quality.

First the obstacles.
One of the commercial banking sector’s biggest challenges has always been the fund short but lend long reality of our business model. While media attention often centers on the Federal Reserve’s decisions regarding the short-term fed funds rate, borrowers are more significantly affected by long-term rates. The mortgage industry’s ongoing struggle to recover from the post-pandemic rate shocks is a prime example of this.

According to numerous experts, commercial real estate (CRE) loans are still facing potential upward re-pricing impacts of $1 trillion to $2 trillion, inevitably degrading borrowers’ debt-service coverage ratios. Certain CRE types are facing increasing use obsolescence. Regional and community banks must confront their historical dependence on CRE lending, a trend that has persisted since the 1990s.

Inflation, irrespective of the Fed’s mischaracterization as transitory, has arguably been the biggest burden on the economy and credit since the massive government outlays to offset the pandemic. Its impact on consumer borrowing and business expenses has been epic — likely influencing recent national election outcomes. However, potential policy shifts towards increased tariffs and workforce deportations also could prove inflationary.

While many bankers anticipate regulatory relief, history tells us it could take months or years to see the results of those directives from the top. It’s likely that any relief will focus more on compliance rather than safety and soundness protocols. In 2024, there were a record 22 credit union acquisitions of commercial banks. Credit unions have traditionally focused on consumer lending, and their commercial lending risk practices are still evolving to match those of banks. Currently, we’re seeing pronounced scrutiny of bank’s credit processes and even a focus on the effectiveness of banks’ independent loan review methods. Focus on credit risk management should not be expected to lessen.

Now, the opportunities.
Despite post-pandemic rate and inflation challenges, emerging bipartisan consensus suggests that recent policy initiatives, such as infrastructure and domestic technology manufacturing acts, have set the stage for a more prosperous, and thus positive credit quality, environment going forward. Obviously, this outlook is further aided by the prospect of more normalized interest rates.

Private credit (non-insured credit providers) is a very significant growth phenomenon in our economy. The efficacy of this segment’s risk practices is arguably ill-defined and varied. However, as it grows in relevance to financing economic activity, banks should increasingly view these groups as alternatives for highly leveraged or specialized lending, potentially reducing banking’s exposure to heightened repayment and regulatory scrutiny risks.

The reason, irrespective of the recent economic landscape, that commercial bank credit quality metrics, on aggregate, remain somewhat benign is credit risk management investments since the Great Recession over 15 years ago. Beyond initial underwriting and approval, three key risk-monitoring tools have significantly benefitted the industry — effective loan review, portfolio analytics and stress testing. These post-booking disciplines should be embraced and continuously improved.

Regardless of the challenges and opportunities the future banking environment presents, remember that bank credit quality remains a long game.