Hello! Kiah here. Welcome to Fintech Takes Banking, my weekly newsletter where I highlight things I think are interesting or important for bankers and the surrounding environs.

The end of the fourth quarter is looming, which means it’s a great time to write about one of the most important and strangest topics of the third quarter: credit quality.

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What You Should Think About Credit: Part I

Is credit quality at banks fine or worrisome?

Credit quality is rightly an important issue at financial institutions. Weakening credit quality erodes earnings, distracts management and drives failures. The 2007-09 financial crisis and Great Recession underlined how devastating credit quality issues can be for financial institutions and how long they can take to flow through the banking system and work out. We passed an entirely new approach to reserving for credit losses in response!

Leading up to, and through, the third quarter, I decided to keep a best-efforts running list of when credit quality would be mentioned in bank earnings or in broader economic news. Over the quarter, this list grew to be pretty long, and indicated two camps: Credit is worrisome, or it is fine. This and next week’s newsletter will explore both sides of this issue. Today, we’ll explore the argument that credit quality in the third quarter was worrisome.

Why You Should Worry

Since the end of the financial crisis, credit quality has been good — very good. It’s been so good, in fact, that it’s harder to improve on. But the macroeconomic variables have shifted in the last five years, and some current conditions work against borrowers. The Federal Funds rate was 3.88% at the start of December, which could pressure variable-rate loans, or those that are periodically refinanced and rolled over. These credits may have been opportunistically cheap in 2020-21 and could be harder for borrowers to afford the next time they reset.

“Credit quality has been clean for so long that some [banks] may have forgotten how to manage a problem loan,” said Ryan Swope, principal and national practice leader for loan review at Forvis Mazars.

Forvis Mazars provides loan review services to more than 400 financial institutions across the country annually, and the firm has seen an “uptick” in problem loans during engagements, Ryan said. While credit quality remains “stable,” elevated interest rates, higher labor costs, inflationary pressures and economic uncertainty are starting to impact some borrowers’ cash flow and repayment abilities.

Criticized loans, which combine classified plus special mention loans, were about 15% of bank capital in 2023 for Forvis Mazars’ clients; it was over 20% in 2025, he said. Classified loans were around 9% of capital in 2023 and increased to 11% in 2024; they were 11.4% through mid-November.

“That might not sound a lot, but given the size of the portfolios in the clients we work with, it takes quite a bit to move the needle,” Ryan said. “We are having more discussions at exit meetings about potential downgrades over the past 12 months.”

While no banks have failed this year, six credit unions have (or liquidated, in industry parlance), according to data gathered by S&P Global. These six occurred within four months, spanning the end of April to the end of August, and are the largest number of failures since 2018. No credit unions failed in 2024, according to the news organization. They were all very small; the largest failure had only $58.5 million in assets.

Generally, credit unions focus on consumer lending to their member base. Credit quality led to the failure of three institutions. At one failed institution that made mostly personal loans without collateral, delinquent loans to total loans ratio jumped to 28.98% in its last quarter before failure, after recording zero delinquencies for at least three years.

Are Businesses OK?

Perhaps it’s not surprising to see weakness in credit, given that corporate bankruptcy activity is on the rise. Bankruptcy filings at large corporates are on pace this year to reach their highest annual level since 2010, with 717 filings through the end of November, according to S&P Global. There were 687 bankruptcy filings in 2024. S&P Global defines large corporates as companies with public debt and assets or liabilities of at least $2 million or private companies with assets or liabilities of at least $10 million at the time of filing. Some of these bankruptcies are for liquidation, and some are for restructuring; a Chapter 11 reorganization allows companies to continue operating while restructuring their debt.

Bankruptcy activity led to incidental charge-off activity at Westerly, Rhode Island-based Washington Trust Bancorp, which announced an $11.3 million charge-off of two commercial loans during the third quarter. The first loan was a shared national credit participation loan in a telecom infrastructure construction contractor that had filed for Chapter 11 bankruptcy the quarter prior, the bank said in its earnings release. The second charge followed the sale of a nonaccrual commercial real estate loan secured by Class B office property during the quarter. Washington Trust Chairman and CEO Ned Handy III said, despite these charge-offs, the bank is “confident” in its current portfolio quality.

Small businesses may also be feeling financial pressures, which flows downstream to banks. Back in August, after charge-offs soared, St. Petersburg, Florida-based BayFirst Financial Corp. announced the termination of its Bolt loan program. The bank’s Bolt loan program is an SBA 7(a) loan designed to provide small balance loans of up $150,000 to small businesses, typically used for working capital. Losses in the portfolio shot up in the second quarter, and bled into the third: Nonperforming assets at the bank were 1.97% of total assets, up from 1.38% a year ago.

The bank opted to exit the program entirely and sell about $100 million of these balances to Banesco USA. Boosting provision expenses and selling the portfolio led the $1.3 billion bank to report a third-quarter net loss of $18.9 million, which followed a second-quarter net loss of $1.2 million.

CEO Thomas Zernick said in the release that the bank expects to agree to “additional actions with the [Office of the Comptroller of the Currency] … focused on credit administration, strategic planning, and capital preservation.” A public enforcement action has yet to be made public.

“Management has already taken significant steps to address credit quality issues, and we are dedicating substantial resources to strengthen our credit administration,” Zernick said in the release, later adding that these credit quality issues are the bank’s “top priority.”

SBA loans are “a good canary in the coal mine” because of the cyclical nature of business ownership, said Brett Rabatin, director of equity research at Hovde Group. He said that in 2021-24, credit demand was strong and the economy was emerging out of the worst impacts of the pandemic, and so lenders in this space expanded. Loans originated during that time may have looser credit terms; borrowers may be more sensitive to a decrease in sales or have less liquidity or financial backstops to repay their loans. Further, these loans have variable interest rates, which may have made them harder to afford as rates rose.

“I wouldn't be surprised to see some additional weakening in SBA,” he added.

These losses may be surprising, but the circumstances around them are certainly understandable — maybe even predictable. But there was another trend in bank credit quality during the third quarter that gave the public pause: giant corporate frauds.

What is Going on With These Frauds?

Banks are in the risk management business. Lending money carries with it a lot of risks, including loss due to being tricked in a fraud. So fraud is somewhat of an occupational hazard. If you read my newsletter, I assume you read Bloomberg News’ Matt Levine, and so you are familiar with his assertion that “the optimal amount of fraud is not zero.” But I don’t think the amount of fraud-driven loan losses in the third quarter was optimal either.

Reports of fraud also popped up in some unusual places. Brett has been covering Abilene, Texas-based First Financial Bankshares for more than 20 years. The bank is routinely recognized as one of the nation’s top-performing banks by financial metrics (by both of my former employers, weirdly). The bank reported a $21.6 million credit loss due to fraudulent activity associated with a commercial borrower during the third quarter. Brett said it was the worst credit the bank has ever had — including during the financial crisis.

“Where's all this fraud coming from? Why aren't the banks able to catch it? Why are people all of a sudden deciding that they're going to try and beat the system with fraud?” Brett said. “I think we're seeing a bit of this everywhere. It’s weird and I don't know how you would've caught it per se, but these things seem to be cropping up.”

So let’s take a look at some of the larger, fraud-related credit hits to banks in the quarter (Also, yes, I know there is concern about credit quality in the private credit space. This piece is focused on bank credit quality, or we might be here all day).

Tricolor

Shortly after subprime auto lender Tricolor Holdings filed for bankruptcy this fall, a review found that about 40% of its 70,000 active loans, which the company used as collateral to obtain bank warehouse lines and asset-backed securitizations, “contained attributes identical to those of at least one other loan, including vehicle identification numbers,” according to Bloomberg News.

JPMorgan Chase & Co., one of Tricolor’s warehouse lenders, recorded a $170 million charge-off connected to the company. Chairman and CEO Jamie Dimon said during the earnings and media calls that “It was not our finest moment” and “When you see one cockroach, there are probably more,” according to a Banking Dive article. He also indicated his vigilance had increased:

“When something like that happens, you could assume that we scour every issue, every universe, everything about how it could be taking place. … You can never completely avoid these things, but discipline is to look at it in cold light, and go through every single little thing, which you can imagine we’ve already done,” he said.

Fifth Third Bancorp, one of the company’s warehouse lenders, recorded a $178 million charge-off. Other banks with exposure to the company include Truist Financial Corp., U.S. Bancorp., Tupelo, Mississippi-based Renasant Corp. and Dallas-based Triumph Financial.

First Brands Group

Lenders connected to First Brands Group alleged a widespread fraud that involved double-pledging assets after the auto-parts supplier filed for bankruptcy in the fall, according to an October Bloomberg News article. Western Alliance Bancorp had $168 million of exposure to First Brands through a leveraged facility with a fund linked to Jefferies. First Citizens had $84.4 million in unsecured exposure to First Brands Group, according to a September research report.

Cantor Group

Two western regional banks recorded charge-offs and provisions in connection with investment funds called the Cantor Group. The alleged fraud in this case involves apparent misrepresentations and contractual defaults by the borrower and irregularities relate to the underlying collateral for the loans, according to S&P Global. Phoenix-based Western Alliance Bancorp sued the borrowers behind the Cantor Group for alleged fraud and set aside $30 million in reserves. In response to Western Alliance’s lawsuit, Salt Lake City-based Zions Bancorp undertook an internal review and also set aside a $50 million charge-off and a $60 million provision.

According to S&P, Raymond James analyst David Long called the incident a “one-off credit hiccup” for Zions in an October research report. Still, he wrote that the optics aren’t great: “The optics of a large balance C&I loan to a fraudulent borrower from a bank that specializes in small balance C&I loans is not great, and puts into question Zions' underwriting standards and risk management policies,” he wrote.

One-Off or First Shoe?

One sentiment emerged as the phrase du jour during the third quarter to explain credit weakening: “One-off.”

I saw it sprinkled in earnings call write-ups and research reports, as a way to address that yes, there was a concerning credit incident, but that it was isolated and idiosyncratic. But how many times should one read the phrase “one-off” before one thinks that some of these one-offs actually have something in common with other one-offs? How many cracks are needed to finally “break” or “sink” credit quality?

I asked Ryan about this, since he must’ve heard the same repetitive explanation over and over during the quarter. He had.

“Many times, I think there’s an isolated issue — poor management of the company or property or [some] local effects on a particular business. Or there’s a poor loan structure, some stretching by the bank to make the loan. I would say anything could be a one-off until it isn't,” he said. “The question is, when are these one-offs starting to accumulate? Although you look at each loan or credit by its own individual metrics, you [start to] see a bigger trend. A large swath of the portfolio is starting to show those same issues with higher [loan-to-value ratios] and cash flow issues.”

Ryan said one reason why it can take credit weaknesses a while to surface is because borrowers, especially commercial borrowers, can stave off delinquencies by tapping other resources, like postponing paying real estate taxes or accessing guarantor support. So, although there hasn’t been a significant increase in delinquencies, foreclosures or losses, Ryan is seeing some early indicators of rising risk in portfolios.

The other question is what will banks do with this information? Early on in a weakening credit, a bank may have some flexibility about how aggressive or relaxed it wants to be about the loan, or the borrower. Last year’s financial statements may show the borrower was strong — what if this year’s struggles are passing and the long-time borrower bounces back? The bank may rate the loan’s guarantor support as strong, or see it has a healthy loan-to-value ratio. Ryan said a bank may keep the loan’s passing grade when it should’ve tested the covenant and notified the borrower about any violations. The bank could also request a principal reduction or a debt service reserve, or negotiate additional collateral.

Maybe it does some of those or none of them, but another year passes. Now, Ryan or someone on his team is looking at a loan or borrower that doesn’t have sufficient cash flow. What now? What next?

But broadly, credit quality did not crack in the third quarter. And next week, we’ll explore the argument that, actually, credit quality is fine.

FROM THE VAULT

What I’ve been reading, watching and listening to this week:

🎁 More gifts: An air fryer (I’m partial to ones that can reheat a slice of pizza). An annual membership to a museum in the ROAM program, which grants reciprocal admission privileges to other institutions on the list. Wool wax crème, which I picked up in the Bozeman airport and has been great for my dry hands this winter; I’ve already bought another container. None of these are affiliate links. What gift ideas do you have that I should feature?

🍗 Impressed that: the Raising Cane’s Cane’s Sauce genuinely seems to be a secret recipe, according to this article in The Wall Street Journal. There’s only one handwritten recipe, which is “in a safe at an undisclosed location,” and store managers have to sign nondisclosure agreements. Ingredients are delivered in unmarked packages? Customers can order sauce in a drink cup for $8? Obsessed. (I do think the chicken tenders themselves are kind of mid and the fries should be cooked longer. Discuss.)

🔮 Feeling Prescient About: Asking Runway Group’s Andrew Grant to discuss the 1978 U.S. Supreme Court case Marquette National Bank of Minneapolis v. First of Omaha Service Corp. We talk about this important case in light of the November Tenth Circuit decision that Colorado could cap interest rates on loans given to borrowers in the state. Listen to my latest episode of Bank Nerd Corner to hear me lose my mind trying to conceptualize what it even means when we say a loan is “made” these days.

Thanks for reading! Be on the lookout for next week’s companion piece, and as always, let me know your thoughts. And if you’re enjoying this newsletter, please forward it to someone who might also like it!

– Kiah