Credit quality across community financial institutions remains generally healthy. Net charge-offs are still near pre-COVID levels, and problem loans remain manageable by historical standards.
There are, however, some trends worth watching. Nonperforming loans have been moving higher; commercial real estate conditions have changed in some markets, and borrowers may be approaching maturities on loans originated when interest rates were considerably lower.
For lenders, the next 12 to 18 months may be less about responding to widespread credit problems and more about identifying individual borrowers that could feel pressure when it comes time to refinance.
What Is Happening with Credit Quality at Community Banks?
The overall picture remains fairly steady. Net charge-offs have operated within a relatively tight range over the past six quarters and, for most institutions, remain comparable to the pre-COVID period.
Banks between $1 billion and $10 billion in assets have been averaging roughly 10 basis points above their pre-COVID charge-off levels. Even there, losses remain at manageable levels.
Problem loans tell a slightly different story. Nonaccrual loans and loans 90 or more days past due and still accruing have been trending upward across asset sizes. They remain comparable to historical levels, but the direction deserves attention.
This does not necessarily point to broad deterioration in credit quality. It does suggest lenders should pay attention to what is moving through the portfolio rather than waiting for charge-offs to confirm that a problem has developed.
Why Could Refinancing Be the Next Test for Borrowers?
One of the bigger issues to watch is the refinancing calendar.
Prime remained below 5% through July 2022. Loans originated in that environment may now be approaching renewal at meaningfully different rates, particularly those structured with five-year maturities or balloons.
A borrower does not have to be struggling today to experience pressure at renewal. The business or property may be performing reasonably well, but a higher interest rate can change the economics when the loan resets.
For credits approaching renewal, lenders should be considering:
- What will debt services look like at the expected renewal rate?
- How much debt-service coverage remains under that scenario?
- Has occupancy or rental income changed?
- Has the borrower’s cost structure changed?
- Are guarantors still in the same financial position?
- What happens if current conditions continue for another year or two?
Historical payment performance still matters, but it does not tell the whole story. For loans approaching renewal, prospective cash flow may tell lenders more about where risk is developing.
Are Current Collateral Values Still Reliable?
Commercial real estate deserves attention because conditions have not moved uniformly across markets or property types.
Lower-than-average appreciation, higher vacancy, and declining values in some multifamily markets can change the picture from when a loan originated. A property that supported a comfortable loan-to-value ratio several years ago may look different today.
For loans approaching renewal, lenders may want to revisit:
- The age of the existing appraisal
- Assumptions used in that appraisal
- Current market and vacancy conditions
- Current or index-adjusted collateral values
- Updated loan-to-value ratios
- Current and stressed debt-service coverage
This does not mean every loan needs a new appraisal. It means institutions should recognize when older information may no longer reflect current conditions. When evaluating risk today, current values and prospective performance can be more useful than relying solely on what was true at origination.
What Should Banks Be Watching in Their Loan Portfolios?
Risk-rating migration is one area that deserves attention. Changes within the portfolio can provide an earlier sign of developing issues than charge-offs or broad delinquency statistics alone.
Management should also consider whether allowance assumptions are keeping pace with what is happening in the portfolio. Stable historical charge-offs are useful information, but they are only one part of the picture.
Current allowance considerations may include:
- Changes in borrower performance
- Risk-rating migration
- Commercial real estate vacancy
- Current collateral values
- Multifamily and other property-specific trends
- Upcoming refinancing exposure
- Changes in lending standards and broader economic conditions
The objective is not to assume a downturn is coming. It is to make sure today’s assumptions reflect today’s portfolio.
Why Early Conversations Matter
Community banks often have an advantage when credit conditions become more complicated because they know their borrowers. That relationship provides context around what is happening in a business or property and can create an opportunity to address an issue while there are still several options available.
The key is to use that advantage early. Monitoring risk-rating migration, updating collateral information, and talking with borrowers well ahead of maturity can give both the institution and the borrower more room to work through potential pressure.
Credit quality remains healthy by many measures, and there is no reason to assume every upcoming refinancing will create a problem. The next 12 to 18 months do, however, give lenders a reason to look forward rather than relying too heavily on what the portfolio has done in the past.
If you have questions about what these trends could mean for your institution, talk with your YHB advisor. We can help you think through allowance considerations, credit assumptions, and the areas of your portfolio that may deserve a closer look.
