On December 18, 2015, the Office of the Comptroller of the Currency (OCC), along with the Board of Governors of the Federal Reserve System (FRB) and the Federal Deposit Insurance Corporation (FDIC, together with the FRB and the OCC, the “Banking Agencies”) issued the Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending (“Interagency CRE Statement”) To review the Interagency CRE Statement, click here. The Interagency CRE Statement reminds financial institutions to re-examine existing regulations and guidance related to Commercial Real Estate (CRE) lending. Through the Interagency CRE Statement, the Banking Agencies are warning financial institutions that there will be a renewed focus by regulators in 2016 on the management of concentration risk in commercial real estate lending.
Back in the fall of 2005, the banking regulators became concerned that community banks were becoming overexposed to the real estate market. In December, 2006, the Banking Agencies issued interagency guidance entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,” which focused on the risks of high levels of concentration in CRE lending at banking institutions. In particular, the agencies set forth two supervisory criteria that they intended to focus on:
- Construction and Land Development Loans (“CLD Loans”): Total loans reported for construction, land development and other land representing 100 percent or more of the institution’s total capital; or
- Total CRE Concentration: Total CRE Loans (as defined in the 2006 Guidance) representing 300 percent or more of the institution’s total capital, and whether the outstanding balance of the institution’s CRE loan portfolio has increase by 50% or more during the prior 36 months.
The 2006 guidance stated that banking institutions that exceed the concentration levels detailed within, should have in place enhanced credit risks controls, which includes stress testing of CRE portfolios. This guidance was not intended to provide a hard cap on banking institutions CRE concentration levels. Instead, banks that had acceptable risk management practices could retain CRE concentration levels that were higher than the suggested parameters.
According to a study conducted by the Banking Agencies in 2013, 31% of all commercial banks in 2006 exceeded at least one of the concentration levels specified in the 2006 guidance. During the “Great Recession” that followed, which officially lasted from December 2007 to June 2009, the Banking Agencies concluded that banks with high CRE concentration levels proved to be far more susceptible to failure. In particular, 13% of banks that exceeded the CLD Loans criterion failed or had significant declines in market value. Banks that exceeded the CLD Loans criterion also accounted for an estimated 80% of the losses of the FDIC insurance fund from 2007 to 2011.
US bank lending on commercial real estate has now rebounded to levels not seen since before the “Great Recession.” According to June 30 data compiled by the FDIC this year, the total volume of CRE loans made by banks is now 2% higher than it was going into the summer of 2007. Total CRE loans on the books of the nations’ 6,680 remaining FDIC insured banks stand at $1.63 trillion vs. $1.60 trillion as of March 31, 2007, according to the FDIC. In the FDIC’s third quarter Banking Profile, FDIC Chairman Martin J. Gruenberg discussed concerns about growing interest rate and credit risks as banks extend further out on the yield curve to try to manage low net interest margins. There is an increasing mismatch between asset and liability maturities and the FDIC has noted that there appears to be an increase in high risk loan categories such as construction and development. CLD Loans continue to make up more than half of the foreclosed inventory that weigh on the books of banks today. Based on the data compiled by the Banking Agencies, banks that attempted to reduce their CRE concentration levels post 2006 did so by reducing their exposure to CLD Loans. This data has validated the Banking Agencies concentration criterion and is one of the reasons why they are reinforcing their 2006 Guidance today.
We can expect examiners from Banking Agencies to pay special attention to CRE lending in 2016. Examiners will scrutinize:
- Underwriting standards for CRE loans to determine if standards have loosened. They will also look at the type and volume of exceptions from underwriting standards granted by an institution.
- CRE loan agreements to determine if banks are granting less restrictive loan covenants, extending maturities, providing longer interest-only periods, and agreeing to limited guarantor requirements.
- Whether banks have conducted a robust analysis of the borrower’s “ability to repay,” which should include determining whether borrowers can repay on an ongoing basis as rates rise or as loan terms reset.
- Whether management kept the Board informed as to the various concentration levels and whether there was appropriate oversight provided by the Board.
Finally, the Banking Agencies made a point of listing all of the appropriate guidance to follow as an attachment to their Interagency CRE Guidance. Financial institutions should review applicable regulatory guidance and consult their legal counsel to the extent that they are unsure what is relevant to them.