Regulators probing banks' NDFI portfolios after Q3 blips

Banks must brace for more regulatory scrutiny of their nonbank lending portfolios following a few flaws uncovered in the third quarter.

Nondepository financial institution (NDFI) lending was thrust into the spotlight in the third quarter after several of the largest banks reported exposures to the bankruptcies of Tricolor Holdings LLC and First Brands Group LLC, and fraud by Cantor Group. As regulators shift their supervisory focus to material financial risks, banks should prepare for increased scrutiny of their nonbank lending books, bank advisers told S&P Global Market Intelligence.

"When losses begin to cluster in a particular asset class, regulators naturally recalibrate their expectations," Jera Bradshaw, shareholder at Greenberg Traurig LLP and former bank regulatory counsel at the Federal Deposit Insurance Corp., said in a statement to S&P Global Market Intelligence. "Whether these losses prove to be a momentary blip or a more durable trend, institutions should prepare for the potential that scrutiny is going to increase."

As regulators dive deeper into banks' lending activities, they will look closely at credit administration, underwriting discipline and risk-rating accuracy, she added, with a focus on segments that are showing early signs of stress.

The agencies will likely conduct horizontal reviews, which are reviews of multiple institutions that focus on a specific business or function, focused on the NDFI segment, said Barry Wides, former deputy comptroller in bank supervision policy at the Office of the Comptroller of the Currency and now a managing director at Artisan Advisors.

"I do not think that the regulators are going to do a lighter touch on regulation where there's material financial risks or where it can threaten the financial system, pose significant risks to the insurance fund," Wides said.

Proper preparation

As regulators up scrutiny, they will focus on "the credit portfolios of banks with risk profiles, business models, and credit portfolios that are similar to those institutions that have recently experienced credit issues," Dimitri Nionakis, financial services partner at Holland & Knight LLP, told Market Intelligence in an email.

While the credit slips seen during the third quarter are largely expected to be one-offs rather than the start of a broader trend, it is prudent for banks to prepare for the increased regulatory focus, advisers said.

"Banks may not want to wait for examiners to raise questions," Bradshaw wrote. "The institutions that prepare now, with data-driven transparency and well-documented governance, will likely be better positioned for any shift in supervisory posture."

Regulators will be on the lookout for "strong controls, clear risk-appetite statements, and credible stress-testing around vulnerable portfolios," she said.

Banks should review their own portfolios for potential credit issues in anticipation of more attention from their supervisors and keep their compliance and risk management functions strong, advisers said. Banks should also consider that issues could arise in the future and prompt succeeding regulators to use their authority to perform look-back analyses.

"Regulatory scrutiny and enforcement activity ebbs and flows, so these programs should remain sufficiently robust so a bank will continue to operate in a safe and sound manner," Nionakis told Market Intelligence in an email. "As we've seen, it just takes one large event to cause increased scrutiny industrywide. And some regulators have a long look-back period — the OCC's is seven years."

Regulatory expectations

The third-quarter losses related to NDFI loans have inspired calls for improved diligence and disclosures, specifically on the performance and quality of those portfolios. In 2024, the FDIC began requiring banks with over $10 billion in assets to report their NDFI exposure among five categories, but there is still a lack of proper insight into the performance of those loans, experts have told Market Intelligence.

While regulators may enhance their scrutiny of banks' NDFI portfolios following the third-quarter events, it's unlikely that they will issue guidance about lending to NDFIs or require more disclosures, experts said.

"It seems likely to have an increase in controls in the near future," Alec Hollis, principal at ALM First, told Market Intelligence in an email. "However, given the strong backdrop of earnings, capital, and current credit performance of even the NDFI lending sector, there may not be a material shift apart from enhanced scrutiny. Many market participants view the current exposure (NDFI and otherwise) as being manageable."

It is "undeniable" that the Board of Governors of the Federal Reserve System is looking at the topic of NDFIs, even if there is no indication of new guidance on the way, and likely working with banks on managing their exposure, said Young Kim, counsel advising on bank regulation at Clifford Chance LLP.