Bank boards should make sure they are reviewing their policies and practices related to commercial real estate (CRE) lending. Regulators have made clear that CRE concentration risk management will be a focus at exam time.
While many banks are approaching the CRE limits that trigger regulatory scrutiny, they are often not following best practices for managing concentration risk, particularly in stress testing, Comptroller of the Currency Thomas J. Curry warned recently in a speech.
As a result, the Office of the Comptroller of the Currency elevated CRE concentration risk management to “an area of emphasis” in its latest Semi-Annual Risk Perspective. The Federal Deposit Insurance Corp. also reports that CRE-related informal enforcement actions known as Matters Requiring Board Attention are increasing.
The OCC says that CRE portfolios have seen rapid growth, “particularly among small banks.” The decision to emphasize CRE concentration risk management follows a statement from all three prudential regulators late last year that they would “pay special attention to potential risks associated with CRE lending” in 2016. Regulators said they could ask banks to raise additional capital or curtail lending to mitigate the risks associated with CRE strategies or exposures.
“At the same time we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices,” Curry said in announcing the new emphasis.
Proper stress testing is crucial to managing CRE concentrations—but stress testing is the right tool for the job, it’s not the job itself. Too many banks think they can solve the CRE problem with stress testing alone. Here’s how they are doing it wrong:
- Only the CRE loan portfolio is being stress tested, which does a disservice to parts of the bank that are strong.
- Data gathering for stress testing each loan is a nightmare. Most banks don’t have it centralized. This will be an issue for banks when the Financial Accounting Standard Board’s new Current Expected Credit Loss standard (CECL) is implemented as well.
- Banks are treating the stress tests as a check-the-box exercise, without including top management to guide the process or use the results to position the bank for success.
- Management doesn’t understand the results, so they are not in a position to have effective conversations with examiners about why the tests are important.
- Most banks are not applying the stress test results toward strategic and capital planning.
Banks should use a combination of top-down and bottom-up stress testing to demonstrate to examiners that they can be trusted with elevated levels of CRE concentration. Key to that analysis is using loan-level data to analyze performance of the portfolio by vintage—e.g. the risk factors affecting loans change depending on the economic and market conditions on the date of origination—another lesson that will be important for banks when they implement CECL.
CRE concentration risk management best practices also include global cash flow analyses, an understanding of lifetime repayment capacities, proper appraisal reviews and ongoing monitoring of supply and demand. Banks must ensure that they have the right policies, underwriting standards and risk management policies to allow the board to monitor the concentration risk and understand the CRE limits. Appropriate lending, capital and allowance for loan and lease losses (ALLL) strategies are crucial.
Many banks are making the same mistakes when it comes to CRE concentration risk management, the FDIC reported in a recent teleconference. Besides insufficient stress testing, common weaknesses include:
- Outdated market analyses that conflict with the bank’s strategic plans, either because the market data is wrong or not unique to the bank
- Excessive limits
- Poor concentration reporting and board documentation
- Lax underwriting and insufficient loan policy exception programs
- Appraisal review programs without sufficient expertise or independence
- No CRE contingency plans
- ALLL analyses that fail to consider CRE risks
- No CRE internal loan review
- Limited construction loan oversight
M&A can be an attractive solution to CRE issues for some community banks. Acquisitive banks, however, need to take special notice of the CRE concentration regulatory warning. Many potential acquisitions will result in concentrations that trigger special regulatory scrutiny, especially if they are cash-heavy transactions and are dilutive to tangible book value. Acquiring banks must be prepared to demonstrate that they have the capital management infrastructure to manage concentration risk.