The Federal Reserve, along with other federal bank regulators, recently communicated its concern about the rapid growth and increased competitive pressures in commercial real estate (CRE) lending. In addition, regulators noted concerns about weaker credit risk management practices, including loosening underwriting standards, approving excessive underwriting policy exceptions and inadequately monitoring market conditions. The federal regulators issued these concerns in a joint statement titled “Statement of Prudent Risk Management for Commercial Real Estate Lending.”1 The statement does not communicate new regulatory expectations; instead, it reminds the industry, especially those financial institutions operating with high CRE concentrations, of the existing regulatory expectations and guidance for prudent CRE risk management practices.
The statement describes several characteristics, consistent with regulatory expectations, of banks that prudently managed the risks associated with high CRE credit concentrations. This article discusses the statement’s description of successful financial institutions’ actions taken during difficult economic cycles. It also provides our observations—which do not set new expectations—based on Ninth District state member bank exams.
Establish Adequate and Appropriate Loan Policies
Successful banks in the Ninth District typically have a clearly and thoroughly documented loan policy communicated throughout the institution. Effective loan policies typically include internal guidance addressing regulatory expectations communicated in SR letters and the Commercial Bank Examination Manual. Additionally, bankers and boards with a successful CRE credit culture review and update their loan policy, especially CRE guidance, during times of rapid change in market and economic conditions.
Establish Lending Strategies
An effective lending strategy can supplement the loan policy by providing more detail about additional credit risk management practices needed to prudently manage credit risks. For instance, a bank may make CRE loans in several different markets, with each market posing unique risks that could adversely affect the volume and/or quality of loans in that market. Banks can benefit from a lending strategy specific to each market. Also, some banks may operate with a high concentration in a specific CRE type, such as multifamily loans, while other banks may be newly participating in this type of lending. In either case, a lending strategy specific to the concentration or the new lending activity can help the bank establish prudent risk management practices. An effective lending strategy may also address portfolio objectives, goals, specific risk controls and management information systems (MIS) needed to manage and monitor the risks.
Adopt Strategies to Ensure Adequacy of Capital and the Allowance for Loan and Lease Losses (ALLL)
Banks should ensure that the level of capital and allowance they hold is commensurate with their CRE exposure—particularly construction loans—which was not the case for many institutions going into the financial crisis. In partial response, regulation now requires banks to hold higher levels of capital against these types of loans, commonly known as Highly Volatile Commercial Real Estate (HVCRE) loans. Several factors suggest that banks should give a second look at the adequacy of their capital and allowance relative to their CRE exposure, including the new capital standards just mentioned and pending allowance accounting changes.
Provide Boards and Management with Appropriate MIS
Bankers face challenges in ensuring that management gets the information it needs on CRE lending while also ensuring that the board has the right information to make well-informed decisions. Management and the board typically need different types of information. While senior management often needs granular detail to successfully manage the CRE loan portfolio on a daily basis, a board member may need less-detailed information and a broader overview to help ensure that management has adopted prudent CRE risk controls. Some banks complete an internal self-assessment to consider the type, quality, volume and detail of MIS that staff members throughout the organization need in order to make better and timely decisions.
Conduct Global Cash Flow Analysis
Successful bankers understand the importance of proper global cash flow analyses of their borrowers. They understand the cash flow sources and ensure that borrowers base projections on reasonable expectations. Additionally, since many borrowers have loans from multiple creditors, successful bankers understand the repayment terms of all borrower debts when assessing the sufficiency of cash flows to service all debts. Banks’ lack of proper global cash flow analyses often explains risk rating differences between banks and examiners.
Assess the Ongoing Ability of the Borrower and the Project to Service All Debt
Banks should assess borrowers’ ongoing ability to service bank debt as a pillar of their CRE loan management. This assessment includes analyzing borrowers’ ability to meet both present and future debt service requirements. For instance, debt service terms could change due to variable rate pricing. Or a borrower may have debt with an interest-only structure subject to future amortization. Successful banks assess the adequacy of borrower cash flow to service all debt by including forward-thinking assessments of future debt service repayments, including under stressed conditions.
Perform Market and Scenario Analyses
Market and scenario analyses are frequently associated with stress testing. Bankers should understand and quantify the potential risks that changing economic conditions can have on specific loans and the overall loan portfolio. In particular, bankers should understand the impact of stresses in the CRE market on earnings, capital and the ALLL. Community banks absolutely do not need to conduct stress testing that banks over $10 billion must complete. But they should analyze the potential impact of adverse outcomes on their bank’s financial condition by assessing the impact that bad conditions would have on their portfolio, loan type, market and/or individual loans. SR 07-1 (Interagency Guidance on Concentrations in CRE) provides regulatory expectations on CRE stress testing.
Implement Procedures to Monitor the Potential Volatility in the CRE Supply
Successful CRE lenders generate good data and useful analytics on their CRE markets. Prior to funding projects, they understand the market supply and demand, pipeline projects and the ability of the market to absorb new units, such as a new loan for a multifamily project. While most community banks have a good understanding of their local real estate markets, successful bankers document market conditions, monitor changes and make any necessary adjustments to risk controls or policy. They also understand out-of-area markets in which they may have credit exposure, often acquired via purchased (participation) loans.
Implement Processes for Reviewing Appraisals
As noted in SR 15-17, low capitalization rates (cap rates) have heightened regulatory concerns about rapid CRE growth and increased competitive pressures. A snapback in cap rates will occur with rapidly rising real estate values. Bankers must review appraisals (especially for income-producing CRE) carefully in the current low cap rate environment to ensure the appropriateness of assigned market values. Minor changes in expenses and the cap, rental, occupancy and absorption rates can result in a significant change in a real estate valuation. Successful bankers understand the metrics impacting the valuation and will often stress these metrics to ensure that the borrower has an ongoing ability to cover debt service requirements.
As further discussed in SR 15-17, bankers should expect regulators to pay close attention to potential risks associated with CRE lending. During a review of CRE activities, examiners will focus on the bank’s implementation of prudent CRE risk management practices using existing regulatory guidance. Bankers should refer to SR 15-17 for more information about supervisory expectations and also for a list of relevant interagency CRE guidance.
Endnote
1 Within the Federal Reserve System, the Statement was issued as SR Letter 15-17.
