In today’s lending environment, maintaining strong credit quality is more than just monitoring delinquency reports and reviewing annual financial statements. Economic uncertainty, elevated interest rates, inflationary pressures, commercial real estate (CRE) challenges, and changing consumer spending patterns are creating conditions that can accelerate borrower stress and elevate credit risk. Recent loan review engagements across financial institutions have identified an increase in Watch List activity, more risk rating changes, and growing concern surrounding borrower performance.
No matter the credit climate, effective credit risk management recognizes emerging warning signs before they become serious credit events. Timely identification can be the difference between a manageable workout and a significant charge-off. Below are helpful insights for financial institutions to consider when navigating credit risk.
Early Indications of Stress in Credit Quality
1. Do Not Wait For Delinquency To Downgrade
Many troubled borrowers find ways to keep payments current, including but not limited to increased outside borrowings, depleting liquidity/working capital, capital injections/shareholder loans, selling assets to generate liquidity, delaying tax obligations or vendor payments, and deferring property maintenance.
These actions may mask underlying weaknesses while debt payments remain current. Financial Institutions should focus on understanding how borrowers are making payments, not simply whether payments are being made.
2. Financial Reporting Delays
Financial institutions continue to see increased levels of borrowers filing tax return extensions. This often results in a six-month delay in collecting financial statements and creates a bottleneck in annual reviews that need to be completed at the end of each year. A common and often overlooked indicator of emerging credit issues is delayed, incomplete, or diminished quality in financial reporting.
Common red flags observed in loan review engagements relating to financial information include delayed financial statements, incomplete reporting packages, borrower avoidance of lender communication, and requests for repeated reporting extensions.
These issues may indicate operational challenges, cash flow stress, accounting problems, or management distraction. Financial institutions may benefit from a defined approach to escalation/remediation when reporting requirements are consistently missed rather than discounting delays as administrative concerns.
3. Trend Analysis Goes Beyond the Current Period
Strong credit risk management requires looking further than one period in time.
Trend analysis can help lenders:
- Evaluate trajectory of operations and cash flow
- Identify emerging risks
- Detect weakening liquidity
- Monitor changes in profitability and cash flow
- Support forward-looking credit decisions
Furthermore, balance sheet analysis may indicate weakening borrower performance, including:
| Liquidity Concerns | Operational Weakness | Capital Erosion |
|---|---|---|
|
|
|
“Trends are important to track because they give a trajectory rather than a singular moment.”
– Andrew Harper
4. Commercial Real Estate Risks Continue to Deserve Scrutiny
Commercial real estate remains a significant area of focus within many loan portfolios.
The challenge is not necessarily widespread defaults. Rather, refinancing risk and property-specific stress are creating pressure for certain borrowers. Many CRE loans originated during historically low-rate environments are approaching maturity and may need to be refinanced at significantly higher interest rates.
Several indicators may signal emerging CRE risk, such as:
- Actual net operating income below appraisal assumptions
- Lease expirations
- Past due property taxes
- Depressed occupancy levels
- Deferred maintenance
- Underfunded reserves
- Elevated operating expenses
Property operating costs have increased substantially in recent years, driven by insurance premiums, taxes, labor costs, maintenance expenses, and utilities. In certain sectors, weakened demand limits a property’s ability to absorb those higher costs through increased rents, creating additional pressure on borrower cash flow.
Risk can vary significantly by property type, geographic market, location quality, leverage levels, sponsorship strength, and asset class.
5. Effective Risk Grading & Timely Intervention
Credit quality management is most effective when institutions act early.
Regulatory attention continues to focus on:
- Prudent grading practices
- Clear identification of repayment sources
- Ongoing risk measurement, monitoring, and reporting
- Timely risk rating adjustments
- Appropriate interpretation of criticized and classified regulatory definitions
Another consideration comes down to special mention and substandard credits. A special mention credit reflects potential weaknesses requiring management attention, while a substandard credit includes well-defined weaknesses that jeopardize repayment prospects.
When signs of deterioration emerge, institutions should consider a structured response framework that includes:
- Recognizing issues
- Identifying root causes
- Downgrading risk ratings in a timely manner
- Developing targeted action plans
- Verifying collateral values and positions
- Strengthening collateral or guarantor support where appropriate
- Evaluating restructuring alternatives
- Recognizing losses when necessary and realistically
Early intervention often provides more options and improved outcomes as opposed to delaying difficult credit decisions.
Strategic Implications for Financial Institutions
As financial institutions navigate evolving economic conditions, portfolio oversight must become increasingly proactive and data-driven.
Institutions that strengthen credit risk management practices may be better positioned to identify deterioration sooner, improve risk-rating accuracy, prepare for examination, focus resources on the highest risk relationships , and strengthen portfolio resilience during periods of uncertainty.
Credit quality challenges rarely emerge overnight. More often, they develop through a combination of subtle warning signs, operational pressures, and changing market conditions. Recognizing these indicators early allows management teams to take informed action before challenges become significant losses.
A disciplined approach to monitoring credit quality, evaluating borrower trends, and responding to emerging risks remains a foundational element of effective loan portfolio oversight.
“Watch lists are getting bigger, trouble loan restructures are more frequent, lots more grade changes are up and down, but more down than up. And often those downgrades are driven by updated financial information.”
– Jack D’Ambrosia
How Forvis Mazars Can Help
The Loan Review & Credit Risk Services team at Forvis Mazars works with financial institutions nationwide to provide observations on selected loans, credit administration practices, risk-rating effectiveness, and emerging trends. The team’s experience spans a broad range of asset classes and financial institutions, assisting them with developing a deeper understanding of credit risk management frameworks and enhanced portfolio oversight.
If your institution would like to discuss portfolio risk trends, loan review strategies, risk grading practices, or emerging credit quality concerns, contact our team today.