Bank, Credit Union, and Other Depository and Lending Institution Industry Developments 2007/2008 - Audit Risk Alert

This Audit Risk Alert is intended to provide auditors of financial statements of banks, credit unions, and other depository and lending institutions with an overview of recent economic, industry, technical, regulatory, and professional developments that may affect the audits and other engagements they perform. This alert can also be used by an entity’s internal management to address areas of audit concern. This alert is an important tool in helping you identify the significant risks that may result in the material misstatement of financial statements. Moreover, this alert delivers information about emerging practice issues and current accounting and auditing developments.

This alert includes a subprime mortgage update in addition to other industry specific developments. You will also find information on recently issued accounting and auditing standards such as:

• Fair Value Accounting Standards (FASB Nos. 157 and 159)
• SOP 07-1
• FIN 48
• Risk Assessment Standards
• SAS No. 112

You will also find information on emerging issues such as:

• The ASB’s Clarity Project including convergence with international standards
• The FASB Codification Project
• Business Combinations

This publication is an other auditing publication as defined in AU section 150. Other auditing publications have no authoritative status; however, they may help the auditor understand and apply the Statements on Auditing Standards. The auditing guidance in this document has been reviewed by the AICPA Audit and Attest Standards staff and published by the AICPA and is presumed to be appropriate. This document has not been approved, disapproved, or otherwise acted on by a senior technical committee of the AICPA.

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Content is from the 2006/2007 edition

Industry and Economic Developments

Slow Economic Expansion--Calm Before the Storm Economic expansion in 2005 started off slowly in the first quarter, with the U.S. annualized growth rate holding constant at 3.8 percent from the fourth quarter of 2004. Real gross domestic product (GDP) only increased 3.3 percent in the second quarter, according to the Bureau of Economic Analysis. (The pace of expansion slowed in the early spring, but activity picked up by the end of the second quarter.) Financial institutions contributed to GDP second quarter growth, as its major factors included residential fixed rate investment, along with personal consumption expenditures, exports, equipment, software, and government spending.

Before Hurricane Katrina, the yield curve had started to flatten and inflation came into view, with the rising price of oil, gas, and commodities being passed on to consumers. In an effort to slow inflation, the Federal Reserve Board increased rates 25 basis points seven times in 2005 to raise the federal fund discount rate to 3.75 percent. Interest rate increases tend to dampen loan demand and refinancing activity and increase a financial institution's funding costs. The auditor needs to consider the rising rate impact on a financial institution's profitability, liquidity, and investment portfolio value. Management needs to have adequate asset liability management procedures in place to understand and manage its interest-rate risk and liquidity risk in this rising interest rate environment.

The Federal Deposit Insurance Corporation (FDIC) stated that "loan demand strengthened, especially for residential mortgages and commercial and industrial loans. Large institutions' net interest margins were hurt by higher funding costs. Revenue growth continued to slow. Growth in insured deposits surpassed growth in the deposit insurance funds, and the insured deposit growth caused the Bank Insurance Fund Ratio to drop for the third consecutive quarter. Adversely, short-term interest rates rose during the second and third quarters, causing large institutions' costs of funding their assets to rise more rapidly than the yields they earned on their interest earning assets. In contrast to large institutions, funding costs for the rest of the industry did not rise as rapidly. As a result, net interest margins improved at almost two out of every three FDIC-insured institutions (63 percent)." Additionally, the FDIC article "A Changing Rate Environment Challenges Bank Interest Rate Risk Management" noted that "aggregate industry trends--specifically higher levels of exposure to long-term assets, concentrations in mortgage-related assets, and a greater reliance on non-core funding sources, including those exhibiting optionality--suggest heightened vulnerability to rising interest rates." Also, it appears that the refinance boom has ended.

Credit unions reported strong midyear growth; however, the National Credit Union Administration (NCUA) identified four economic fundamentals that are important to credit unions at this time: interest rates, inflation, consumer spending, and employment. Interest rates and inflation are of heightened concern, as rising interest rates could negatively affect margins, liquidity, member credit quality, and mortgage demand.

Credit quality remains strong; however, this may be a carryover effect from the low interest rate environment of the past few years. Some analysts fear a trend reversal in credit quality as payments will be harder for borrowers to make in a world of higher rates, and auditors should be aware of potential problems that could arise down the road. Certain aspects of the market environment, including an overabundance of variable rate receivables, the relaxation of lending standards, the much talked-about housing bubble, and the influx of new loan products introduced into the marketplace to gain competitive advantage, may contribute to future potential credit quality problems in the lending arena. For specifics, see the section "Home Equity Lending and Mortgage Market Risks" in the "Industry and Economic Developments" section of the Alert.

For credit card receivables, credit losses typically represent a greater risk than does interest rate risk due to the variable rate and short-term nature of cards. Recent news reports have cited the increase in delinquencies, particularly in credit card receivables. With higher funding costs, the marketplace has seen a significant reduction in zero-percent balance transfer offers and a corresponding decrease in account balance growth at many issuing institutions. Issuers may have increased their marketing to customers with little or no credit or subprime borrowers as competition for customers continues to increase.

Additionally, minimum payments have come under scrutiny. Current guidance indicates that minimum payments must amortize the current balance over a reasonable period of time consistent with a borrower's documented creditworthiness. Increasing minimum payments beyond industry averages may drive away prime borrowers and increase delinquencies. However, while there are no bright lines in setting minimum payments, the interagency guidance Account Management and Loss Allowance Guidance for Credit Card Lending notes that credit risk is "exacerbated when minimum payments consistently fall short of covering all finance charges and fees assessed during the billing cycle and the outstanding balance continues to build," perhaps leading to negative amortization. The regulatory position is that prolonged negative amortization should be avoided.

Finally, potential effects surrounding the new 2005 bankruptcy law could affect lenders' credit quality for fiscal year-end 2005, due to an expected spike in filings prior to the effective date of October 17, 2005. For specifics, see the section of this Alert titled "Credit Loss Allowance Update."