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2025 Credit portfolio risk and balance-sheet management outlook

December 20, 2024

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This article covers these key topics:

Top priorities for managing portfolio risk, assets, and liabilities at banks & credit unions

Abrigo's Advisory Services team and financial institution clients shared their expectations of key focus areas related to credit portfolio risk, ALM, and other topics.

Likely trends are shaped by a dynamic rate environment

The top issues facing executives managing credit portfolio risk and the balance sheet at financial institutions are shaped largely by the dynamic rate environment, according to Abrigo’s outlook for major trends in the year ahead.

Based on comments from the Abrigo Advisory Services team and our bank and credit union clients, executives will have their work cut out to manage profitability, balance sheet growth, and credit risk. Both groups were recently asked to identify top priorities and trends ahead, and many pointed to efforts to manage the various impacts of still-high interest rates—even before Fed officials indicated they could reduce the number of potential rate cuts in 2025 from previous expectations.

Interest rate uncertainty will mean banks and credit unions focus on understanding and managing interest rate risk, pricing, and customer behavior related to prepayments and deposits, Abrigo’s advisors say. Advisors and customers alike say growing deposits will be a primary focus, especially for institutions looking to grow and manage funding costs. Several customers also say that lowering non-interest expenses and optimizing institutional processes are top priorities heading into 2025.

Here's a quick look at some trends and issues likely to affect banks and credit unions in the new year.

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Priority: Managing the risks of interest rate uncertainty

Abrigo experts have noticed a growing shift in clients’ concern toward interest rate risk, so one focus will be managing that.

Dave Koch, Managing Director of Abrigo Advisory Services and a lead faculty member of the Graduate School of Banking at the University of Wisconsin–Madison, said that with additional rate cuts, financial institutions could face a squeeze on net interest margin spread. “The deposit side may see continued pricing pressures, with CD and savings rates potentially remaining higher than pre-crisis levels,” he said. “On the lending side, loan rates are expected to follow prime rates down, but the spread over prime may remain higher due to lingering credit risk concerns.”

As a result, banks and credit unions will face challenges in managing repricing risk (both for loans and deposits that need to be repriced at lower rates). “Stability of funding will be a critical focus, so institutions need tools to price risks accurately on both loans and deposits,” Koch said.

Neekis Hammond, Abrigo’s Vice President of Sales and Professional Services, agreed that rate-related topics will continue to shape the commercial banking landscape. “Managing the profitability of loans and deposits in a volatile interest rate environment will be a key focus” for banks and credit unions, he said.

Focusing on the economy, credit risk, and allowances

Another rate-related issue that managers of credit portfolio risk management will face is economic uncertainty. Still-elevated interest rates are running into declining consumer purchasing power, which stands to add pressure to credit risk.

As a result, Abrigo advisors and customers say managing loan portfolio stress will be a top 2025 issue. Financial institutions with high concentrations in specific segments, such as consumer lending and especially commercial real estate (CRE), will need to proactively manage risks through stress testing, early intervention, and adjustments to loan loss provisioning. Some Abrigo customers named managing watch-list loans and complying with new stress test reporting as among their institutions’ top priorities heading into next year.

Expect continued examiner emphasis on concentrations and monitoring. Many examiners’ expectations include more sophisticated stress testing and more information on how lenders are complying with policy limits. Monitoring risk effectively and proactively remains an essential function in 2025.

“It is important that banks continue to use sound credit risk management practices such as stress testing at both the portfolio and facility levels, timely and accurate risk ratings, and effective concentration risk management,” the OCC said in its Semiannual Risk Perspective released Dec. 16. “The commercial real estate office sector remains stressed. Risks in multifamily CRE lending remain elevated, particularly in the luxury segment.”

Indeed, even with additional interest-rate cuts, challenges in CRE portfolios aren’t going away in the near term, based on customer and advisor comments. CRE loans originated five to seven years ago during the low-rate environment that reprice or mature in the coming year pose risks on two fronts.

First, pricing sensitivity among attractive borrowers and heightened loan-pricing competition will increase the risk of losing refinancing deals. Second, lenders have seen an increase in CRE delinquencies, but related charge offs haven’t yet followed in many cases. Some CRE loan renewals will force a reckoning of the impacts of higher rates and rising vacancies in hard-hit sectors and areas. Banks and credit unions, some of which are experiencing increased past-due loans, will be managing the troubled financial status of some customers, including, in some cases, foreclosures and higher credit losses. Others will reassess their strategies around CRE exposures.

Speaking of credit losses, expect increased scrutiny in the months ahead of allowances under CECL, particularly related to model validation and sensitivity to changes in economic forecasts (including prepayment and curtailment rates). Additionally, auditors are under more pressure from the Public Company Accounting Oversight Board (PCAOB) to audit qualitative factors, according to Abrigo’s experts. Financial institutions likely have only seen the beginning of this pain point in 2024 with many smaller banks having year-end audit work in early 2025.

Growing deposits

Many of Abrigo’s bank and credit union customers who shared top priorities for 2025 reported plans to grow deposits. Financial institutions will need deposit strategies that can be effective in a dynamic rate environment.

Abrigo advisors said institutions especially need to understand the differences in the financial assets and banking habits of their aging deposit base and younger people. Without that understanding, they risk losing out on the generational transfer of wealth between Baby Boomers and later generations.

Competitors are increasing, so knowing which core deposits are sensitive to pricing and having the right products and services will help retain and attract additional depositors. A core deposit study examines the institution’s pricing behavior (the beta and the lag in pricing) and the member or customer’s behavior (the decay) to inform pricing strategies.

Mergers and acquisition activity, which has slowed in recent years amid the high interest rates, credit quality concerns, and lower bank stock prices, could also be in focus for some financial institutions looking to grow deposits through deals. The recent Fed Funds rate decreases could potentially boost merger activity, according to Abrigo advisors. Abrigo’s purchase accounting and valuation services advisors have completed over 30 buy-side fair value projects since 2023, and they produce a quarterly review of loan portfolio fair value analytics.

Efficiently managing portfolio and balance sheet risk

Given the potential for squeezed net interest margins, it’s unsurprising that lowering non-interest expenses and optimizing institutional processes are also among financial institutions’ top priorities heading into 2025. Nearly half of customers said their bank or credit union’s goals include efficiency-related efforts or leveraging technology to manage risks and improve efficiency.

To be sure, technology plays a vital role in efficiently managing a dynamic interest rate environment. For example, a banking intelligence platform can leverage upcoming loan repricing and maturity information to help understand portfolio trends, risks, and market dynamics. Executives can quickly identify the driving forces impacting portfolio credit quality. They can maximize net interest margins using industry-wide data about interest rates for originated loans by type and geography to ensure competitive pricing. Automating the CECL calculation can mean work that takes weeks using spreadsheets can be completed compliantly in half an hour, providing more time for analytical or revenue-producing activities.

Streamlining investment accounting and management with automated workflows will help institutions manage fixed-income and liability instruments in the portfolio.

A quality asset/liability management model will go beyond regulatory requirements and add strategic value by helping optimize net interest margin, assess risk exposure, and develop contingency funding plans while aligning assumptions and reporting with allowance and stress testing.

Banking executives will face challenges ahead, especially with interest rate trends expected to come down. Consider accessing banking advisory services for decision support, strategic planning, process outsourcing, or guidance on incorporating technology for improved processes.