Credit Risk Assessment of Bank Investment Portfolios


by Suzanne Storm & Louis J. Dunham

The FDIC recently discussed their supervisory expectations for investment securities due diligence in the summer issue of Supervisory Insights. The new rules pertaining to permissible investments are effective as of January 1, 2013, and include the requirement for credit risk analysis of a bank’s investment portfolio and related risk management practices.

According to the FDIC, one of the contributors to the financial crisis and subsequent bank failures is attributed to a number of banks not adequately understanding or independently assessing the risk characteristics of a bond’s obligor, the underlying collateral, or the payment structure of individual securities. Dependence on the rating agencies’ conclusions and inadequate independent bank analysis led to the purchase of what were believed to be “investment-grade” bonds, but in reality, the economic downturn triggered the need for banks to recognize credit impairments in their investment portfolios, resulting in significant principal write-downs that affected both earnings and capital.

Dodd-Frank addressed this situation by directing all federal agencies to remove language in banking regulations that called for reliance on external credit ratings to form judgments about a fixed-income obligor’s repayment capacity. This replaced external credit ratings with “uniform standards of creditworthiness.”

The new rule defines “investment grade” as a security with a low risk of default and where the full and timely payment of principal and interest is expected.

Regulators are stressing that the new investment-grade standard is not a paradigm shift from previous supervisory guidance. Before the financial crisis, the guidance stipulated that banks were expected to have a robust credit risk management framework for securities in place, which entailed appropriate pre-purchase and ongoing monitoring by qualified staff that graded a security’s credit risk based upon an analysis of the repayment capacity of the issuer and the structure and features of the security.

Although the OCC rule is directed to national chartered banks, state chartered banks are not exempt from the new rule and guidance since state banks are generally prohibited from engaging in an investment activity not permissible for a national bank. If the state regulations still include a requirement that is based on credit ratings (for example, that all bank investments must be at least BBB+), banks will need to demonstrate that the external credit ratings meet the state criteria and still conduct the independent bank required analysis to meet the new OCC regulation’s investment-grade or safety and soundness standards.

Financial institutions should have a process that does not rely exclusively on credit agency ratings for determining their investment securities meet creditworthiness standards. The bank should have written policies in place that provide guidance on investment issues prior to the purchase of a security. The depth and detail of the policies that guide credit risk management in the investment portfolio will vary at banks depending on the complexity of the investment portfolio. For instance, banks with high concentrations of particular types of securities relative to capital would be expected to perform a more comprehensive analysis and a system to assure ongoing monitoring for credit worthiness.

Banks may purchase obligations of the U.S. government or its agencies and general obligations of states and political subdivisions without making an investment-grade determination. This exemption also applies to revenue bonds that are held by well-capitalized banks. However, the regulators will expect banks to have sufficient understanding of the credit risk of municipals to ensure standards for safety and soundness are observed and maintained.

As long as bank management demonstrates it has made good-faith progress to comply with the new rule, it appears that examiners will work with banks as they transition away from a ratings-centric bond selection and monitoring process and implement their own independent analysis of the investments.