commercial real estate concentration guidance
A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html. The regulatory agencies have gone on record stating that 'concentrations are bank killers' - and that most of the banks that failed during the great recession were 'CRE Concentrated'. 9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp. Tulsa, OK, Charles M. Foster Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. Such an analysis would measure the depth and breadth of the portfolio’s vulnerability to changes in real estate markets and interest rates. 3. This includes meaningful information on CRE portfolio characteristics relevant to the institution’s lending strategy, underwriting standards, and risk tolerances. According to History of the Eighties—Lessons for the Future, the high number of bank and savings institution failures during the 1980s and early 1990s can be attributed primarily to overinvestment in CRE loans.2 Weak underwriting standards and portfolio management techniques during this time contributed to a significant oversupply of CRE properties that weakened the entire CRE market, leaving borrowers unable to repay their loans and collateral that provided far less support than originally thought. On December 6, 2006, the Federal Reserve and the other federal banking regulatory agencies issued interagency guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. To assist and encourage banks to recognize and control CRE lending risks, bank regulators have developed a significant body of regulatory guidance for CRE transactions. Subprime lending involves extending credit to borrowers who exhibit characteristics that indicate a significantly higher risk of default than traditional bank lending customers. The usefulness of this type of test relies heavily on the reference portfolio selected to conduct the test. If agreement with a high percentage of assigned credit ratings cannot be achieved, the rating guidelines may Level of pre-sold units or other types of take-out commitments on construction loans. Many lenders found during the CRE downturn of the 1980s and early 1990s that the “first loss is the best loss,” meaning that it would have been cheaper in the long run to have disposed of distressed CRE assets earlier rather than later. Minimum prompt corrective action capital levels, as a result, are not typically appropriate for banks with concentrations.3Likewise, banks with a significant exposure to a particular loan type, market, or industry should incorporate the likelihood of strong correlations among the loans when determining the appropriate allowance for loan â¦ The CRE guidance provides a good framework to assist banks in addressing the concentration risk and also helps establish the federal banking agencies’ expectations during subsequent risk management examinations. Examination Specialist, Markets may be monitored by staff or management, but ultimately both must understand what is being monitored and why. The guidance does not state that the supervisory cri teria should be viewed as a hard cap on CRE concen tration levels. Loan agreements should clearly communicate draw schedules, release provisions, and repayment requirements. In institutions with limited or only recent experience in CRE lending, the historical perspective required to conduct this sort of stress analysis would be based on external data that may or may not be applicable. For example, the ADC loss history on the reference portfolio is for a geographically diverse group of loans, but the current portfolio is largely concentrated in one location. Another technique used by some banks with larger portfolios and more sophisticated internal data is to stress ratings migrations. In areas where management deems risks to be higher, lenders may be instructed to curtail or discontinue lending activities altogether. While loan-level sensitivity analysis is a valuable tool for all banks originating CRE loans, this type of analysis could be performed on a portfolio-wide basis. The following is the next installment in RMAâs Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.. Various tools may be available to monitor CRE markets, depending on the size of the market. If a bank’s portfolio goes outside of these general guidelines, as many do, the bank will not automatically be criticized, but heightened risk management practices may be needed. Review of Monetary Policy Strategy, Tools, and Communications, Banking Applications & Legal Developments, Financial Market Utilities & Infrastructures. In markets where demand is very strong, management may instruct lending staff to pursue additional opportunities and adjust pricing and other terms to attract additional business. As banks grow, this process is typically brought in-house. However, investing in assets that management does not understand can also carry significant risks. Examination Specialist, The CRE guidance also identifies institutions that are potentially exposed to significant CRE concentration risk as those that have experienced rapid growth in CRE lending, have notable exposures to a specific type of CRE, or are approaching or exceed the following supervisory criteria: These criteria are not limits and are viewed neither negatively nor as a safe haven. The level of CRE monitoring required can differ among institutions depending on exposure level or perceived risk in a product type or geographic area. The risks posed by concentrations of credit risk in general, and Commercial Real Estate concentrations in particular, have long been an area of focus for bank regulators. Many institutions will want to expand the level of information captured to specifically include underwriting characteristics, such as LTVs, debt service coverage levels, speculative versus presold units, etc., to allow for more enhanced reporting and analysis. Systematically aggregating the results of individual transactional stress tests could involve: For income-producing properties with long-term, fixed-rate loans and long-term tenants, the analysis may reveal little or no additional exposure unless capitalization rates are expected to increase on the specific property type. Specifically, the agencies reiterated the need for strong risk management practices to comply with Supervision and Regulation (SR) letter 07-1, âInteragency Guidance on Concentrations in Commercial Real Estate.â 3 This guidance does not set limits on the size of CRE concentrations but instead highlights strong risk management practices that are necessary for a bank with a high CRE credit â¦ Additionally, banks that have experienced recent, significant growth in CRE lending will receive closer regulatory review than those that have demonstrated a successful track record of managing the risks of CRE concentrations. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. The failure to control exposure levels when warning signs are evident can result in excessive loan losses. FIL-104-2005, Joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (, 12 CFR 365, Real Estate Lending Standards and Interagency Guidelines for Real Estate Lending Policies (, Interagency Appraisal and Evaluation Guidelines (, FIL-90-2005, Residential Tract Development Lending (, FIL-94-1999, Interagency Guidance on High Loan-to-Value Residential Real Estate Lending (. Demand for CRE lending—a traditional core business for many community banks—has been very strong in recent years, and a growing number of banks have CRE concentrations that are high by historical standards and rising. Calculate the losses that would be expected in a market downturn by applying the adjusted historical loss rates to the current portfolio. The guidance reminds institutions that strong risk management practices and appropriate levels of capital are essential elements of a sound commercial real estate (CRE) lending program, particularly when an institution has a concentration in CRE loans. is the third leg to any successful rating system. The Interagency CRE Statement reminds financial institutions to re-examine existing regulations and guidance related to Commercial Real Estate (CRE) lending. The key is to have someone other than the original credit analyst attempt to come to the same conclusion using the tools provided by policy. In these institutions, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome. In addition to providing supervisory guidance regarding residential real estate lending, this subsection also contains guidance on subprime lending. Communication must occur between lending and risk management functions. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. Credit Underwriting Standards and Administration. The lending staff must pass along market information to the risk management function. An Overview of the Interagency Guidance The interagency guidance, " Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (SR7-1)," was issued in 2006. Steven G. Johnson The $51.2 billion-asset New York Community disclosed in a regulatory filing that its regulators lifted a cap that had limited its portfolio of multifamily, non-owner-occupied CRE, and acquisition, development and construction loans to 850% of total risk-based â¦ Many de novo banks in areas with significant job and population growth (predominately in East and West Coast states) have used ADC loans as the primary asset class to drive growth and meet pre-opening projections. Atlanta, GA, Mark D. Sheely 3 The federal bank and thrift regulatory agencies have adopted substantially similar appraisal regulations. See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. Branches and Agencies of Foreign Banks, Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks, Senior Loan Officer Opinion Survey on Bank Lending Practices, Structure and Share Data for the U.S. Offices of Foreign Banks, New Security Issues, State and Local Governments, Senior Credit Officer Opinion Survey on Dealer Financing Terms, Statistics Reported by Banks and Other Financial Firms in the United States, Structure and Share Data for U.S. Offices of Foreign Banks, Financial Accounts of the United States - Z.1, Household Debt Service and Financial Obligations Ratios, Survey of Household Economics and Decisionmaking, Industrial Production and Capacity Utilization - G.17, Factors Affecting Reserve Balances - H.4.1, Federal Reserve Community Development Resources, Concentrations in CRE Lending, Sound Risk-Management Practices (PDF), An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (PDF), Interagency Statement on Meeting the Needs of Creditworthy Borrowers, Section 2231.0, "Real Estate Appraisals and Evaluations", Section 3270.0, "Section 4(c)(8) of the BHC Act (Real Estate and Personal Property Appraising)", Section 3070.0, "Section 4(c)(8) of the BHC Act (Mortgage Banking)", Section 2128.08, "Subprime Lending (Risk Management and Internal Controls)", Section 2080.1, "Commercial and Industrial Loans", Section 2100, "Real Estate Construction Loans", Section 2103.1, "Concentrations in Commercial Real Estate Lending, Sound RiskâManagement Practices", Section 2040.1, "Loan Portfolio Management" (Mortgage Banking Subsection), Section 2043.1, "Nontraditional MortgagesâAssociated Risks", Section A.2040.3, "Loan Portfolio Management: Comprehensive Mortgage Banking Examination Procedures", Section 2135.1, "Subprime Mortgage Lending", Section 2200.1, "Other Real Estate Owned", Section 4140.1, "Real Estate Appraisals and Evaluations". Another major expense often overlooked is the opportunity cost of holding a large volume of nonearning assets. 4 An Analysis of the Impact of the Commercial Real Estate Concentration Guidance higher than loss rates for owner-occupied loans, were significantly lower than those for construction loans. For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. Information can be captured on mainframe systems or other systems—including the use of simple spreadsheets—but should be retained in a form that can be readily accessed for analysis purposes. Portfolio diversification across property types. Loss rates may lag the downturn by a number of months or years. Larger banks often use rating systems that assign separate ratings for default risk and loss severity. After all, how beneficial can market monitoring and analysis be if concentration limits and exposures are not adjusted when that market information indicates a change in market conditions? Recursos del seguro de depósito en español, FDIC National Survey of Unbanked and Underbanked Households, Money Smart - A Financial Education Program, Risk Management Manual of Examination Policies, Bank Secrecy Act and Anti-Money Laundering, FFIEC Information Technology Examination Handbook, Consumer Compliance Supervisory Highlights, Organization Directory and Office Contacts, www.fdic.gov/news/news/financial/2006/fil06104.html, www.fdic.gov/regulations/laws/rules/2000-8700.html, www.fdic.gov/regulations/laws/rules/2000-4300.html, www.fdic.gov/news/news/financial/2003/fil0384b.html, www.fdic.gov/news/news/financial/2005/fil9005.html, www.fdic.gov/news/news/financial/1999/fil9994.html, www.fdic.gov/bank/historical/history/contents.html, Freedom of Information Act (FOIA) Service Center, Relatively low borrowing costs and the easy availability of credit, Government policy, including income tax benefits, Long gestation periods that allowed supply-and-demand dynamics to change before a project’s completion, Nonrecourse lending and legal structures that shielded project sponsors from risk, Out-of-area lending, including the purchase of loan participations from out-of-area lenders, An unregulated real estate appraisal industry that often used inflated assumptions and relied on inexperienced appraisers, Total loans reported on the Report of Condition for construction, land development, and other land represent 100 percent or more of the institution’s total capital; or. While the direct costs of these actions are apparent, there are often other costs that bear mention. Individuals outside the lending process should evaluate and validate the entire process. Credit review personnel should provide the board and senior management with periodic feedback regarding the effectiveness of the rating system and any recommended changes for improving transparency and granularity. Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. Before making a commitment for financing, an institution will analyze sponsor and lender assumptions to determine the degree to which a project can withstand market fluctuations and still repay the loan. The stressed loss rates would be developed through an analysis akin to the following: If the bank has not previously experienced significant CRE downturns, using external data may be more appropriate than using internal data. 71, No. Consequently, the real benefit of implementing systems to identify and control CRE concentrations lies in limiting the level of risk brought on by those concentrations when markets begin to falter. Bank management should also be willing to forego potential CRE income when the risk exceeds the reward. 5 See Interagency Guidelines for Real Estate Lending Policies: 12 CFR 365 and appendix A (FDIC); 12 CFR 34, subpart D and appendix A (OCC); 12 CFR 208, subpart E and appendix C (FRB); and 12 CFR 545 and 563 (OTS). Monitoring speculative single-family housing development can be especially challenging. Although most banks do not perform bankwide scenario stress testing, the process of developing such Yet, while the CRE credit market has been influenced by excess liquidity for a number of years, recent events in the credit markets for housing and leveraged finance demonstrate that liquidity can evaporate quickly if lenders’ and investors’ perceptions of the level of risk inherent in those loan products change. For BHCs, the appraisal standards can be found in Regulation Y, subpart G, 12 CFR 225.61-67. To reduce potential losses in the future, banks must have strong board and management oversight as well as robust risk management processes for their CRE loan portfolios to recognize and control risk through all phases of the economic cycle. Necessarily been related to commercial real estate risk '' ( April 2007 ) explains the guidance does state! Their systems market monitoring and analysis, credit risk at many banks cri teria should be based on in. 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