Remarks by
Julie L. Williams
First Senior Deputy Comptroller and Chief Counsel
Office of the Comptroller of the Currency
Before the
Robert Morris Associates
Lending and Credit Risk Management Conference
New Orleans, Louisiana
October 5, 1999



	It is a real honor and genuine pleasure to again 
have the opportunity to address an RMA conference, and to 
talk again about credit risk developments in the banking industry.  

	As you probably are aware, the OCC has just released 
its latest annual credit underwriting survey.  The 1999 survey 
results show some positive trends from previous years' survey 
findings, as underwriting standards for commercial loans appear 
to have strengthened in several significant categories.   I am 
happy to be able to report these improvements, but they are not 
cause for complacency. 

The aggregate data from our underwriting survey does not 
tell the whole story.   Beneath the statistics of the survey, 
there are some troubling trends that require bankers' 
attention.  Easing continues in some important loan markets.  
And today's improvements cannot mitigate the overhang of 
credit risk created by weaker standards used in previous years.  
To illustrate this concern, I'll be talking about the findings 
of our credit-focused exam work, including our "Ugly Loan" 
review.  This work provides important perspectives and depth 
to understanding the credit underwriting picture we see today.

	Finally, I want to talk about what you, as bankers, 
can and should do to manage and mitigate your institutions' 
credit risk.

	First, the results of the OCC's 1999 credit underwriting 
survey reflect some positive developments.  For the first time 
in five years, the survey indicates that underwriting standards 
for commercial loans have strengthened, with examiners reporting 
that 25 percent of the surveyed banks tightened standards, 
compared to just 4 percent in 1998.  Examiners also reported that 
only 13 percent of surveyed banks eased standards, compared to 44 
percent in 1998.  Overall, firming up was evident in syndicated/national 
and international lending, areas that appear to be most affected by 
the credit events in the fall of 1998, and in agricultural lending, 
which reflects low commodity prices and weakened export demand.  

While we're encouraged to see strengthened underwriting standards 
in these areas, easing of standards persisted for some commercial 
products -- commercial real estate and middle market lending.  This 
is of concern because these two categories represent a large portion 
of bank loan portfolios.  Further, a large percentage of banks 
reported either a mixture of easing and tightening, or no change 
from last year.  While this indicates standards did not deteriorate, 
we must keep in mind that "no change" also means no improvement.  

Increased pricing was the most prevalent method used to tighten 
standards (56 percent), followed by adjusting maximum credit availability 
(33 percent), increasing collateral requirements (31 percent), and 
strengthening loan covenants (28 percent).  For those banks strengthening -
standards, examiners reported economic outlook and a change in risk 
appetite as the primary reasons.

The story has parallels on the retail side.  Strengthening continued 
for the third successive year with slightly more banks tightening 
standards at 27 percent, than easing (22 percent). Products where 
tightening was most pronounced included consumer leasing, indirect 
consumer loans, credit cards, and other direct consumer loans.  
This seems appropriate as these products have been particularly 
vulnerable to rising consumer delinquency and charge-off rates in 
recent years.

But, among the retail products, the trend toward easing standards 
for home equity loans continued for the third successive year.  By 
definition, a high LTV home equity product represents an easing of 
underwriting standards, and poses greater risk of default and risk 
of loss in the event of default. 

Those banks that strengthened underwriting standards for retail 
products most commonly used scorecards or pricing and, for real 
estate-related  products, enhanced collateral requirements. Most 
banks tightening standards did so because of a change in risk 
appetite or market strategy.

Perhaps the most worrisome finding in the 1999 survey is the 
continued increase in credit risk reported for all commercial 
and retail products.  For the fourth successive year, examiners 
report increased inherent portfolio risk, and they expect risk 
to continue to increase over the next twelve months.
	 
	Overall, the modest changes in risk tolerance and the 
additional emphasis on risk-based returns for commercial credit 
highlighted by this year's survey are certainly trends that we 
would all like to see continue.  But, we all recognize that competitive 
pressures of the marketplace will continue to exert pressure, and that 
continued strengthening of  underwriting standards in this economic 
environment is very challenging.  

Moreover, positive news this year about underwriting standards 
does not erase the increased risks embedded in bank portfolios caused 
by four successive years of easing commercial loan underwriting 
standards.  Nor, in the face of this year's results, can we ignore 
that banks shoulder increased portfolio credit risk not only as a 
legacy of weaker underwriting standards employed in recent years, 
but also as a result of the more limited credit risk selection 
options available to them.  As the better quality loans continue 
to migrate to the capital markets, bankers are left to compete 
with other lenders for less desirable, riskier paper, which increases 
the risk of default.

In response to all these developments, the OCC has been 
implementing a series of modulated supervisory responses.  
These actions commenced with early warnings and advisories.  
Last year, when I spoke at the RMA conference in Chicago, 
I announced a series of calibrated actions designed to further 
focus examiner and banker attention on signs of deteriorating 
credit standards, and to highlight the need for bankers to 
implement risk evaluation and management systems commensurate 
with the increasing credit risks they held.

We instructed our examiners to identify loans with specific 
types of structural weaknesses in reports of examination and 
factor those weaknesses into their judgments about the quality 
of individual credits, portfolios, and the quality of portfolio 
risk management.  Our subsequent findings give rise to concerns.  
Particularly at our largest banks, we found significant numbers 
of loans containing various structural weaknesses.  The most 
frequently cited weaknesses include:

* Non-existent, weak or waived covenants;
* Indefinite or overly liberal payment terms;
* Inadequate financial analysis;
* Insufficient collateral support;
* Elevated leverage ratios; and
* Repayment dependent on highly optimistic or undemonstrated 
cash flows.

    	Loans with such structural weaknesses were listed in 
the reports of examination or other supervisory communications 
with management and/or boards of directors, to ensure that they 
understood the nature and extent of the weaknesses disclosed and 
their impact on our judgments on portfolio quality and management.

	Simultaneously, we formed a team of our best credit experts 
and instructed them to review loans across the population of our 
larger banks in order to better identify examples of the types of 
structural weaknesses that we were seeing.  Unfortunately, the team 
had no trouble finding example after example.  Based on this review -- 
which came to be nicknamed the "Ugly Loan Project" -- we developed 
and delivered a focused training program designed to advance the 
credit risk evaluation and classification skills of our examiners 
and clarify our expectations about how structural weaknesses should 
be incorporated in their judgments of credit risk in individual 
loans and portfolios.  We also communicated these efforts to the 
CEOs of our largest banks.

	These efforts coincided with the interagency Shared National 
Credit Review, which recently concluded.  As you all probably know, 
the Shared National Credit Review is jointly conducted by the OCC, 
FRB and FDIC each Spring.  That review covers all commercial loans 
that are shared among three or more banks and exceed $20 million.  
This year's program covered approximately 30 percent of all commercial 
loans in the U.S. banking system.  

The results of this year's SNC review have shown a marked increase 
in classified and special mention credits compared to 1998 -- an 
increase of roughly 70 percent in the dollar value of adversely 
rated loans.   Fifty-nine percent of the adversely rated loans had 
been rated "pass" last year.  Of particular concern, 14 percent of 
the adversely rated loans were to new borrowers.  In other words, 
banks are booking new loans that are weak at their inception.   
These results reflect the increasing portfolio risk building up 
in the system as a result of weakened underwriting and risk 
selection standards.

	Thus, while our most recent credit underwriting survey 
indicates that banks are firming up their underwriting standards, 
our exam work also tells us that banks have heightened embedded 
credit risk as a result of previous years' underwriting practices.

What should bankers be doing about this?
 
Let me offer some suggestions and cautions. 

We all know that risk-taking is inherent in the business of 
banking and that exceptions are an expected component of the 
underwriting process.  We expect that you will underwrite a 
certain number, hopefully not too large, of loans with exceptions, 
but we also expect that you will have good controls over and 
intelligence on changes in the underwriting standards applied 
in your banks.  This requires a system that routinely identifies 
the aggregate level of loans that do not meet your own underwriting 
criteria, segmented by portfolio and type of exception. Over 
he years, many bankers have resisted the need to identify and 
track exceptions to their risk selection and underwriting policies; 
however, recent studies indicate that those that do routinely 
track exceptions and analyze their implications for portfolio 
risk are among the better performing banks. 
 
The need for such information is precisely why OCC initiated 
examination procedures to identify loans with structural weaknesses 
last year.  Indeed, a number of the banks we supervise were appreciative 
of the detailed work performed by our examiners to identify "ugly" loans.  
Because examiners identified, reported and discussed the specific 
underwriting weaknesses they found as well as their risk implications, 
bank management and boards were better informed and could more readily 
determine whether weaknesses represented isolated events or common 
occurrences.  Bankers found examiner's feedback regarding specific 
underwriting weaknesses to be much more valuable than general expressions 
of concern about deteriorating underwriting standards.  As a result, we 
will continue to perform these procedures in every safety and soundness 
examination, and we will continue to urge bankers to adopt the exception 
reporting processes. 

Another critical component of sound portfolio risk management hinges 
on the  integrity of banks' own internal risk ratings.  Many banks are 
making substantial progress, setting higher internal standards for accuracy 
and using credit models to back-test and cross-check the integrity of their 
internal ratings.  We applaud these advances, but our recent examination 
activity, including the 1999 SNC review, has made clear that most banks have 
room to improve the accuracy and timeliness of their problem loan identification.  
Even the most sophisticated banks can improve the level of precision and 
reliability of distinctions among various risk levels of "pass" rated 
credits.   This becomes  particularly imperative for the additional 
reason that today consideration is being given to using those internal 
risk ratings to set components of banks' capital requirements.

Unfortunately, in too many banks today, risk management advancements and 
MIS to provide timely risk analysis information to senior management and 
the board of directors are not being pursued with the same vigor as new 
business and revenue generation opportunities are being pursued.   In 
practical terms, this is akin to ignoring termites in the foundation of 
your house while you're busy adding a sunroom to the second floor.   

We also are concerned with the continuing relative decline in the 
ALLL.  The average ratio of the ALLL to loans for all national banks 
is at its lowest level since 1986.  That ratio, which was maintained 
above 2 percent for all years between 1987 and 1995, dropped to 1.82 
percent at the end of the second quarter.    That is why the OCC and 
the other bank regulatory agencies were extremely concerned earlier 
this year that certain actions and pronouncements by the Securities 
and Exchange Commission last year and earlier this year would have 
the unintended effect of prompting unwarranted reductions in banks' 
reserve levels.  We applaud SEC Chairman Levitt's statements clarifying 
the SEC's positions in this area, and we continue to strongly believe 
that given the higher risk inherent in bank portfolios today, it 
would be more appropriate for banks to be increasing their reserve 
coverage, rather than decreasing it.  

	One particular credit issue that caught our attention during 
our efforts of the past year has been the evolution of leveraged 
finance.  Earlier this year, the OCC issued guidance to bankers 
advising them of the risks in leveraged lending activities and the 
need for more intensive risk management of these types of credits.  
This guidance was in keeping with our measured responses to loans 
with structural weaknesses, but also reflected our growing concerns 
with the developing trend toward higher leverage in the lending 
markets overall.

	In that guidance, we expressed a number of concerns about 
the risk characteristics involved with today's leveraged lending 
activity.  As a result of our more recent exam work, however, our 
concerns have particularly escalated about the increasing reliance 
on so-called "enterprise values" to justify collateral shortfalls 
common to many leveraged financing packages.  The premise behind 
banks' reliance on "enterprise values" as a secondary source for 
repayment of a loan is that the borrower's business can be sold or 
refinanced at an amount that can be estimated based on a projected 
earnings capacity.  But, the interagency Shared National Credit 
Review revealed that too often documentation and analytical support 
for enterprise values are inadequate.   

Let me give you some examples of enterprise value lending situations 
that concern us:

The first example is a loan made to finance an acquisition.  The 
loan was "collateralized" by all assets of the company; however, 
the bank group did not value the assets, but instead relied on 
the estimated enterprise value.  Optimistic earnings and cash 
flow projections never materialized.  Market prices for the 
company's product declined and now the company is closing plants 
and attempting, thus far unsuccessfully, to sell assets.  The 
acquisition price now appears inflated as does the "enterprise value" 
used to underwrite the loan.  The potential for substantial loss 
to the bank group is considered very high.

	Lending against valuations based on multiples of stabilized 
cash flow valuations can be dangerous.  In another example, the 
borrower is a highly specialized manufacturer who sought funds for 
working capital and growth.  Accounts receivable, inventory and 
fixed assets only covered 60 percent of total bank debt.  The 
balance of the loan was supported by a stabilized cash flow 
enterprise valuation that provided a modest 10 percent cushion.  
The borrower's product has met reduced demand and increased 
competition.  Cash flow has been severely reduced -- it was 
inadequate to service debt in 1998 and is negative YTD 1999. 

A final example is a consumer goods manufacturer that required 
re-capitalization.  Although the bank group took a lien on fixed 
assets, their value was considered minimal.  To justify the loan, 
he bank group relied on an enterprise value based on anticipated 
refinance or sale of the borrower.  Unfortunately, product demand 
has weakened, the  borrower has lost a number of key customers, 
and operating margins have shrunk,.  Cash flow is no longer adequate 
to service debt.  The likelihood of a refinancing or sale of the 
company that will rescue the banks from the loan is bleak.   Thus, 
the risk of loss is very high.

	Stepping back from these particulars, this type of 
transaction raises several fundamental concerns:

	Our first concern arises from the interdependence 
between the primary and secondary sources of repayment 
when "enterprise value" is the secondary repayment source.  
Enterprise value is often a calculated multiple of the borrower's 
historical or projected cash flow.  As long as cash flow is 
sufficient to meet the repayment terms of the loan, there's 
no problem; but if cash flow does not materialize as 
projected, both the primary and secondary sources of 
repayment of the loan are at risk.  The same events 
that endanger the first source of repayment -- cash 
flow -- also will endanger the second source of repayment -- 
the enterprise or going concern value of the business.

	Our second concern lies with loan officers' and 
loan review officers' apparent level of comfort with 
"enterprise value" as a substitute for real collateral.  
"Enterprise value" is a volatile, disappearing intangible, 
inherently prone to vanish when it is most needed.  It is 
not the equivalent of hard assets and equity, properly 
assigned and hypothecated, valued under normal and stressed 
conditions, with reasonable margins at or above the loan 
amount.  There is a reason why market professionals refer 
to the enterprise value component of the support for a 
loan as the "airball."

	Our third concern in this area is with the increasingly 
equity-like appearance of many leveraged loan structures and 
whether banks are appropriately recognizing and mitigating the 
risks inherent in these loans.  In addition to relying on 
enterprise values, many such loans also evidence weakened 
structures that diminish a bank's controls, rights and collateral 
protection, extended maturities that defer meaningful repayment, 
and reliance on refinancing or re-capitalization of the borrower 
as a primary source of repayment.

	As we said in the leveraged lending advisory we issued 
earlier this year, bankers need to be able to identify the amount 
of leveraged loans in their portfolios, and should also be able to 
identify those loans where the financing gap  -- the "airball" -- 
between the value of assigned collateral and the amount financed 
relies on enterprise value.  Bankers should carefully analyze the 
assumptions used to support underlying enterprise values and be 
realistic in challenging those assumptions under normal and stressed 
conditions.  Where identified financing gaps are large relative to 
the overall portfolio, the bank's allowance, or its capital, bankers 
should be developing plans to reduce these gaps in an orderly manner 
and to augment the allowance or capital as necessary.   

	Bankers must not assume that economic conditions and the 
capital markets will always be conducive to a refinancing or 
re-capitalization needed to close the financing gap when a loan 
comes due.  I particularly hope that some bankers are not 
complacent because they implicitly assume that their "section 20" 
securities affiliate will be available to arrange a market 
transaction that will extract the bank from the loan.  Where a 
bank has such an affiliate, it must not only guard against that 
assumption infiltrating its credit decisions, but also ensure 
that its conflict of interest policies are up to date and vigorously 
enforced.  With the prospect of "financial modernization" 
legislation that will enhance the ability of banks and securities 
firms to be affiliated, it becomes essential that bankers assure 
that their credit decisions are not being shaded by the prospect 
that they will be rescued from questionable loans by their 
securities affiliate. 

	Bankers that will be successful -- in good times and 
bad  -- will be the bankers who recognize risk earliest and 
move decisively to control it and reduce it where warranted.  
This can only be done with good intelligence  -- meaningful 
and accurate MIS, reliable and timely risk ratings, effective 
and objective internal loan review and, most importantly, 
credit risk management that is adept at assessing the data, 
the trends, and relevant market intelligence.  Bankers should 
be asking themselves: "Am I comfortable that my bank's culture 
and credit controls, including my credit risk rating system, 
would prevent the problems bankers suffered in the late 1980's 
and early 1990's?"  And bank CEOs, in particular, should be 
asking: "Are my independent risk identification and control 
functions telling me what I want to hear, or what I need to hear?  

Downsizing to improve efficiency ratios and efforts to achieve 
merger-related synergies must not reduce the effectiveness of your 
credit risk control processes.  Given the higher risk inherent in 
bank portfolios today, bankers need to be more skilled at 
quantifying and mitigating the credit risk they undertake 
to be pursued with the same enthusiasm as new business and 
revenue generation activities.  And, risk management functions 
need the independence and empowerment to candid about risk in 
the portfolio.  

You in this room, our industry's credit risk managers, 
face all these challenges.  I urge you to take them up with vigor.  
Your efforts will be key to the industry's stability and success 
as we enter the next century.