Saturday, July 13, 2024

February 2007 Legal Briefs

Joint Guidance on Commercial Real Estate Concentrations

Joint Guidance on Commercial Real Estate Concentrations

The OCC, FDIC and Federal Reserve have issued final guidance on concentrations in commercial real estate (CRE) lending.  These provisions are effective immediately, but banks will have a reasonable time to develop required risk management practices and written policies.

The provisions do not impose any absolute limits on a bank’s total commercial real estate lending.  Instead, the joint guidance establishes two threshold tests to define a concentration in commercial real estate lending.  Above these thresholds, examiners will analyze whether risk management practices and capital levels are adequate for the bank’s level of risk.

A.  What Loans are Covered

The guidance focuses on real estate loans where the cash flow from the property is the primary source of repayment.  This includes mortgages on rental property (residential, office, retail, warehouse, etc.).  It also includes loans for which a sale of the property is the intended source of repayment–for example, loans for construction, to purchase land for development, or to develop raw land into lots.  Farm loans are excluded from this guidance.

A mortgage loan to a builder is always considered a commercial real estate (CRE) loan.  A loan for purchase or construction of a property for the borrower’s own use (not for rental) is never a commercial real estate loan. 

B. CRE Concentrations

The final version of the guidance defines a CRE “concentration” more narrowly than the proposed version did.  There now are two separate threshold tests, either being sufficient to identify when a bank is “potentially exposed to significant CRE concentration risk”:

The first test is as follows: “Total reported loans for construction, land development, and other land represent 100 percent or more of the institution’s total capital.”  (Loans in this category anticipate a sale of the property, or other cash flow from the property, as the primary source of repayment.)

 State-chartered banks in Oklahoma have a lending limit equal to 30% of capital, so just three CRE loans to developers or contractors, each near a bank’s lending limit, could push a bank very close to having a CRE concentration.  In a community with significant demand for new housing and other construction, a bank might need to turn down even some very good loan applications to stay within this “100% of capital” test—if it wanted to do so.  (A bank that exceeds this threshold–another possible strategy—needs more sophisticated loan underwriting guidelines and risk-monitoring procedures, explained later.)

The second test of CRE concentration is this:  “Total commercial real estate loans [those relying on cash flow from renting or selling the property as the primary source of repayment] represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 months.” 

The regulators originally proposed just a strict “300% of capital” test as an indicator of CRE concentration.  Instead, based on comments received from banks, the “300%” test was combined with the new “50% growth” test.  The resulting definition singles out only those banks (1) that are experiencing a significant increase in CRE lending, and (2) that have total CRE loans exceeding 300% of capital.  (If either half of this second test is not satisfied, there is no CRE concentration based on the second test.)

There are various reasons why a bank’s CRE lending could increase by more than 50% in the last 36 months–but most reasons are something the regulators would like to look at more closely, even if everything is well-handled.

A bank’s CRE loans might grow because of a conscious decision to emphasize CRE lending—and regulators would want to know whether the bank is adequately geared to handle this new emphasis, including enough experienced staff to handle the increased quantity of CRE loans, appropriate policies, and good risk-management procedures.  Alternatively, a bank’s CRE lending might skyrocket because its underwriting standards, rates and other terms are overly liberal, compared to competitors—raising safety and soundness issues.

A bank with a history of CRE lending will not necessarily attract more scrutiny under the guidance than it already has.  If a bank already had 300% of capital invested in CRE loans 36 months ago, and it hasn’t had a further 50% increase in CRE loans since that time, it has already had a regulatory examination of its CRE lending program.  Without the 50% increase, it won’t be treated as having a CRE concentration based on the second test.  (Growth in CRE lending is not rapid enough to raise special concern.)  However, the “100% of capital” test explained above is a separate test (a more narrowly focused concentration made up of construction and development loans), and if that test is met, the bank still will become subject to special scrutiny of its CRE lending.

C.  Varying Risk in CRE Loans

“Total CRE loans” is a very broad category—all loans primarily dependent on real-estate-related cash flow.  Loans in this grouping can have widely different risk characteristics.  Depending on what’s there, some banks with total CRE loans of greater than 300% of capital may not have much risk.  Other banks with total CRE loans at 300% of capital may have significant exposure to changes in the economy and the real estate market.

The 300% test is not intended as a cap on lending, but only a “numerical screen” or threshold for examiners to use as a starting point in identifying banks that are potentially exposed to significant CRE concentration risk.

To illustrate some practical scenarios, a loan to a contractor building pre-sold homes for qualified buyers who are have obtained permanent mortgage commitments will involve substantially less risk than a loan to a contractor who builds on speculation.  Similarly, a CRE loan to someone building a pre-leased commercial building may be quite different from building new retail space on speculation.  Have you ever seen an investor who purchases a lot for commercial development, puts up a large billboard to attract tenants for the proposed space, but has to wait years to attract serious interest?

Likewise, loans secured by existing multifamily residential property with stable rental income are much more a “known quantity” (with proven debt service capacity), compared to a development of new multifamily property for which rent and occupancy rates can only be projected.  Although even a portfolio of seasoned mortgage loans on multifamily property, now paid down to very reasonable loan-to-value ratios, can technically trigger the “concentration” threshold, these loans will typically be viewed as having very little risk, if other factors are favorable.

Some banks establish a more conservative loan-to-value limit on new CRE loans, requiring a substantial equity “cushion” in the property to minimize possible loan losses.  Other banks are comfortable with higher LTV ratios.  More accommodative loan standards will attract more CRE loans but also more risk. 

As indicated below in more detail, if CRE loans trigger either of the two “concentration” thresholds outlined above, regulators will expect a bank to have written policies for CRE lending, including such things as loan underwriting guidelines, target limits on certain categories of loans, oversight of CRE lending, and strategies for responding to changes in portfolio risk as relevant factors change in the economy.  Where a CRE loan concentration exists, examiners will ensure that the bank knows what it is doing and why it is doing it, and has procedures appropriate to the level of risk.

D.  Why This New Guidance?

More than other categories, CRE lending is always subject to up-and-down cycles.  Certainly we have seen that in Oklahoma.  CRE loan concentrations can inflict large losses on banks in an economic downturn.  According to the banking agencies, CRE loans today are at a level that could create safety and soundness concerns if the economy weakens significantly.

The most significant increase in CRE lending is occurring at small and mid-size banks, which may not have strong enough risk-monitoring procedures.  Many banks around the country have relaxed their underwriting standards in response to competition.  If CRE markets were to become depressed (and we see some signs of it in other parts of the country), large losses could result. 

  However, local CRE lending is one of the few remaining areas where banks feel they can compete effectively for loan business.  Lots of consumer loans and even agricultural loans are being siphoned off by other lenders.

Many banks have expressed the view that CRE loan concentrations should be addressed in examinations, on a case-by-case basis, without imposing more guidelines and written policy requirements.

Regulators, however, do not think it is enough to comment on an over-concentration of loans at the time of an examination.  They want to influence CRE lending at an earlier stage, by requiring a written “blueprint”–something laying out underwriting standards and the intended subcategories and total amount of loans within the CRE loan portfolio.  They want a bank to establish systems and procedures for adequately monitoring the level of risk inherent in CRE loans, including analysis of trends in the local real estate market.  Instead of just reviewing individual loans, a bank should consider the “big picture” by estimating its financial exposure if all loans having similar risk characteristics were affected by adverse changes in local economic and real estate conditions.

Although some banks’ CRE lending policies and risk-monitoring systems are already adequate, regulators probably will expect those procedures to be reduced to writing in more detail than what may now exist.  Other banks perhaps have never formalized a CRE lending policy or a process for monitoring CRE-related risk, and they will have to do more work to satisfy the guidance, if they have a CRE loan concentration.

When either of the two thresholds defining a CRE concentration is exceeded, examiners will carry on a more lengthy discussion with the bank.  However, if a bank already has an appropriate written CRE lending policy and other required procedures appropriate to the level of risk represented by that CRE concentration, the bank will not necessarily receive any adverse criticism. Regulators will clearly expect a bank to be able to defend the soundness of its CRE loan program, if a CRE concentration exists.  Although banks falling below the CRE concentration thresholds will not get an automatic “free pass” on CRE lending activities, they certainly should get a lower level of scrutiny.  (This is another example of risk-based examination.)

E.  Cash-Flow-Dependent Loans

By definition, CRE construction loans look to property-related cash flow as the projected means of loan repayment.  Either the property will be sold shortly after construction is completed (for example, a “spec” home), or a developer planning to retain the property and convert to a permanent loan will be trying to lease the property to tenants.  In some cases a property is pre-sold under a binding contract, or, in the case of income property, is completely pre-leased.  For some types of property, such as multifamily residential, it’s not really possible to do much pre-leasing.  Other properties (such as office, retail or warehouse space) may be at least 50% pre-leased when construction is completed. 

When a property is built on speculation and sale of the completed property at market value is the anticipated method of loan repayment, the borrower bears a risk that the real estate market may decline while construction is going on.  A bank should generally require more borrower equity for speculative construction, to prevent the bank from sharing the risk of uncertain future market conditions.  The bank should do its own analysis of market trends, not relying on an overly optimistic builder’s “gut instinct.”

Income property loans of all types are also included in the new guidance, but the risk could be either high or low, varying considerably with the structure of the loan.  Although income property is still vulnerable to the local economy and real estate conditions, at least a permanent loan on such property is not structured to require near-term sale. A borrower has some flexibility to continue to hold the property and ride out a temporarily depressed real estate market–if cash flow is adequate to service the debt.  In a more serious downturn, such as a recession or the loss of a major local employer, an income property’s rental and occupancy rates may drop sharply enough to force the sale of the property–at the very point when market value (based on rental and occupancy) is at its worst.

Oklahoma certainly went through a dramatic real estate “bubble” (in the early 1980’s), followed by a “bust.” In the last several years, other parts of the U.S. have experienced runaway real estate prices, but Oklahoma real estate prices, by contrast, have been rising at a rate roughly in line with wages.  This pattern is sustainable and fairly stable.  Some parts of the U.S., after experiencing an over-heated real estate market, are starting to see a “correction” in prices.  It’s easy to see why regulators are concerned that banks in other parts of the country may be setting themselves up for a serious risk of losses, in the event of a real estate downturn.  Oklahoma banks will have to follow the new guidance, but may not have as much CRE lending risk as banks elsewhere do.

F. Some Oklahoma Examples

Oklahoma’s past is an excellent reminder of what can go wrong if banks have too much CRE loan risk and the economy declines significantly.

The “oil bust” in Oklahoma in the 1980’s, the resulting disaster in the real estate market generally, and the failure of over 100 banks, represent an ugly chapter that we hope never to experience again.  Problems from that era illustrate very vividly what can go wrong when loans are concentrated too much into a few categories or industries, lenders focus on rosy economic assumptions (without considering down-side risk), credit standards are loosened to compete with other lenders, and the “perfect storm” happens.  

I remember reading that 60% of the office space in Oklahoma City was occupied by oil-related companies in 1983, when Penn Square Bank failed.  Soon thereafter, most of those companies were gone, the office space they had occupied became vacant, and the market value of office buildings in Oklahoma City came crashing down along with rental rates. 

The collapse of the oil industry damaged the Oklahoma City office market so badly that, almost 25 years later, vacant office space is still a problem.  It is still uneconomical to build new office buildings, except in special areas where office space is in shorter supply, or where a building is designed for a specific tenant’s needs and is pre-leased. 

Lenders making CRE loans on office buildings in Oklahoma City in the early 1980’s were not worrying that too much local office space was occupied by oil industry tenants.  They weren’t considering what might happen if the oil business went “bust.”

The new guidance asks lenders to consider issues such as this.  Even if a bank has many separate CRE borrowers, and each loan is performing, does the bank have a risky concentration because too much of the space in the various borrowers’ office buildings is occupied by tenants in a single industry? 

The residential rental property market in the early 1980’s in Oklahoma City is another example of CRE lending gone wrong.  In 1982, Oklahoma City’s overall residential rental property occupancy rate was more than 95%.  Rents were strong, and many people were moving into the metro area to take advantage of available jobs.  It was easy to assume that everything would keep going the way it was already going—meaning that the demand for apartments would continue rising.

The multifamily residential market looked great, and floods of investors were getting in on the action.  However, when the oil-related jobs went away, the people who moved here for those jobs decided to go back home, and the occupancy rate for residential rental units declined dramatically.  Unfortunately, when Penn Square Bank failed there were also many large apartment complexes under construction, and these were completed in the midst of a deep recession, adding to the serious housing glut that by that time already existed. 

I have sometimes wondered what those lenders were assuming when they decided to fund construction of so many new apartment complexes.  Maybe each project taken separately could be justified on paper by assuming that the existing market rental rates and occupancy rates would also apply to the new building.  I strongly doubt that each lender that was financing construction of an apartment complex was looking at anything more than the impact of “one more property” added to the existing market.  Most lenders apparently were not considering, or even aware of, the total number of rental units under construction at the same time, and what the impact of adding all of those units at once would be.  In other words, in the midst of enjoying the “party” of good economic times, they were not doing an adequate study of what else was going on in the market.  They made flawed conclusions about the viability of constructing even more apartments; and Oklahoma City was about to go through half a dozen years of really painful rental property foreclosures and bankruptcies.

G.  Ongoing Risk Assessments

The new guidance anticipates that banks actively engaged in CRE lending will perform ongoing risk assessments with respect to CRE concentrations.  Those assessments then should be used by management and the board as a basis for appropriate action.  A bank must regularly analyze its CRE loans, dividing them into segments based on similar risk characteristics or sensitivities to economic, financial or business developments. 

Risk assessment will be an ever-changing process, at least to the extent that local factors change over time.  Doing exactly the same type of risk assessment that another bank does may not cover everything that’s required, because each bank has a different portfolio of CRE loans, as well as certain unique aspects in its local economy and real estate market.

A bank should carefully approach the process of grouping together CRE loans with similar risk characteristics.  The desired result is a realistic picture of concentration risks that exist in the bank’s own CRE portfolio, so that management, the board and examiners can get an accurate understanding of the bank’s risk position.  With good information as a basis for decision-making, the board can decide on any policy adjustments that may be appropriate.

The process of categorizing CRE loans by similar risks may point out imbalances or “watch issues.”  A concentration justifies scrutiny of the overall group of loans (more than looking for weakened status of individual loans).  When economic circumstances affecting a particular CRE loan sector begin to shift in an unfavorable direction, a bank that is already focusing on the concentration may be able to take faster corrective action, such as reducing lending in that area, selling participations, or tightening underwriting standards—even before losses occur.  

A bank should not divide CRE loans into multiple categories just for the sake of doing so.  Too many categories can provide false confidence–giving the appearance of greater diversification than actually exists.  The guidance emphasizes that separate types of loans with similar risk should be combined into a single category for risk-assessment purposes.  (If CRE loans on income property rented to restaurants and retail businesses involve the same sensitivity to local economic conditions, they should not be analyzed as two separate risk categories.)

When there is an announcement that a large local employer may close, all CRE loans exposed to the same economic event would logically be included in the same risk category.  For this purpose, the bank might add up in a special group not only its loans directly related to the local employer, but also loans on income property occupied by other companies heavily dependent on that employer, including providers of parts, equipment and supplies to that employer, or closely-related service providers and independent contractors.  CRE loans on multifamily residential properties might also be included if particular rental properties have a high concentration of tenants working for the local employer.  If a bank analyzed its CRE loans only based on separate CRE segments, the greatest risk for a group of separate loans that are related to a particular event (in this example, the fallout from a large employer’s closing) might not be sufficiently considered.  

The economy of a small community is sometimes highly concentrated in a single income sector, although many separate pockets make up that sector. Agriculture is an example—lots of separate individuals, but one basic economic activity. In a small town, it may be true that “every loan is an agricultural loan,” in the sense that almost every business in town is dependent on how much money the farmers and ranchers are making.  

By contrast, the gas station and motel located at the exit from the interstate may provide some diversification of CRE risk, because the main income source is different:  These businesses depend more on highway traffic than on local farming and ranching. (Travel-related businesses have their own risk factors, including seasonal fluctuations, possibility that declining economic conditions may reduce travel, high gasoline prices, and terrorist threats.)

It’s generally true that CRE loans related to any kind of local service business or manufacturing business that has substantial customers outside of the local community will provide some amount of risk diversification, in situations where too many local businesses are dependent on the same industry or economic sector.  Also, there are economic sectors at least partly supported by fairly stable public and private funding sources from outside the community, such as county, state and federal offices and facilities, and educational or health facilities.  (For example, doctors, dentists, hospitals and nursing homes are largely paid by insurance companies, Medicare and Medicare, instead of directly “out of pocket” by individuals in the community.)

Geographic location is another way to analyze a bank’s CRE lending risk.  Subdividing a bank’s CRE loan categories by location (town) may give a more thorough picture of the bank’s portfolio risk. A bank with six large multifamily residential loans spread over three different communities where it has branches is probably more diversified than a bank that has six such loans all in one community.  A severe blow to the economy of one community (a natural disaster or plant closing), would not affect the CRE loans in the same category at other bank locations.

It’s also appropriate to analyze CRE loans based on specific features related to risk—no matter what CRE loan category they may fall in.  A bank should add up all CRE loans with an LTV ratio higher than a certain percentage, to show which loans have least equity coverage and most sensitivity to a decline in local economic or real estate conditions.  At the opposite extreme, a bank might add up all CRE loans that are paid down to less than a 50% LTV ratio (or some other benchmark) with good debt-service coverage. These CRE loans are so low-risk that they soften the bank’s total CRE concentration numbers.

H. Risk-related Modifications

Information provided by an internal risk assessment can be used in many ways by management and the board to improve the bank’s CRE risk profile. As one example, if a risk assessment shows that two categories of loans should be combined for risk purposes (having similar risk), the process of combining the categories may call attention to the fact that the two types of loans are priced quite differently.  Management might increase the rates and fees on the category of CRE loans that is priced too cheaply in relation to the other loans that have similar risk; or, if rates and fees on the cheaper category cannot be increased because of competition, management may decide no longer to emphasize the loan category that does not generate rates and fees appropriate to the risk.

  If a bank determines from its risk assessment that it has too many CRE loans of one type, or too many loans of that type in one geographic area, the bank might place a temporary moratorium on approving loans of that type, until the CRE loan portfolio can be brought into better balance.  Alternatively, the  bank might raise the underwriting standards (and/or pricing) on that category in order to slow the rate of growth of those loans–also assuring that any new loans that are made will have excellent characteristics.  In deciding to put overall limits on certain categories of CRE loans, the board might decide at the same time that it needs to increase other segments of the loan portfolio to achieve more diversification—for example, in looking at how to move away from a too-high concentration in CRE loans, the board might decide that it needs to more actively market certain types of consumer loans. 

If a bank has more loan demand than it can satisfy, it might use the risk assessment to determine what loan participations to sell–with a deliberate goal of reducing a geographical concentration, or an over-concentration in certain categories of CRE loans.

I.  Risk Management Processes

According to the guidance, a bank’s risk management processes should include the following key elements: (1) board and management oversight; (2) portfolio management; (3) management information systems; (4) market analysis; (5) credit underwriting standards; (6) portfolio stress testing and sensitivity analysis; and (7) credit risk review function.

The sophistication of a bank’s risk management processes will vary with the size of the bank’s CRE loan portfolio, as well as the level and nature of concentrations and the risk to the institution. A bank with a fairly simple situation is still expected to have risk management processes, but not more elaborate than the bank’s circumstances require. 

J.  Board/Management Oversight

The guidance places ultimate responsibility on the bank’s board for the level of risk a bank takes on.  To make appropriate decisions regarding risk, the board must first be presented with adequate information on which it can act.  Whenever a bank has significant CRE concentration risk, the bank’s strategic plan should address the reasoning behind its CRE concentration levels, relating that to the bank’s overall growth objectives, financial targets, and capital plans.

Banks are already required to adopt and maintain a written policy establishing appropriate limits and standards for all extensions of credit secured by real estate, including CRE loans. To build on that foundation, the guidance directs each bank’s board to do the following:

(1) Establish policy guidelines and approve an overall CRE lending strategy stating what level and nature of CRE lending exposures are acceptable to the bank.

(2) Ensure that management is implementing procedures and controls, so that lending policies and strategies are adhered to and monitored for compliance.

(3) Review information that identifies and quantifies the nature and level of risk presented by CRE concentrations, including reports describing changes in CRE market conditions.

(4) Periodically review and approve CRE risk exposure limits and appropriate sub-limits (by type of concentration) to implement any changes in the bank’s strategies and to respond to changes in market conditions.

K.  Portfolio Management

Banks with CRE concentrations should manage the risk of the overall CRE portfolio, not just individual CRE loans.  A concentration of loans that are similarly affected by cycles in the CRE market can potentially expose a bank to an unacceptable level of risk.

Management should develop strategies to manage CRE concentration levels, including internal lending guidelines and concentration limits and a contingency plan to reduce or mitigate concentrations in the event of adverse CRE market conditions.  Saying, “We’ll sell participations if the market gets bad” may be unrealistic as a plan for reducing concentrations.  A more workable approach may be to identify CRE over-concentrations up front, selling participations while the market remains good.  If a bank waits too long to sell loans or participations in order to reduce risk in its CRE loan portfolio, and economic conditions worsen, the only remaining solution may be to increase the bank’s capital to compensate for risk that cannot be reduced.

L.  Mgmt. Information Systems

According to the guidance, a strong management information system (MIS) is a key to effective CRE loan portfolio management.  Whether the MIS should be sophisticated or not will depend on the size and complexity of the CRE loan portfolio and the level and nature of concentration risk. At any bank, MIS should be adequate to provide information that is relevant to the bank’s CRE lending strategy, underwriting standards, and risk tolerance.

The guidance encourages analyzing the bank’s CRE loan portfolio numbers in a variety of ways related to risk.  A bank could group its CRE loan information based on fixed or adjustable rate; construction, short-term or permanent financing; loan-to-value ratios; debt service coverage; exceptions from loan policy; and affiliated loans (for example, grouping together the bank’s loan to a tenant and the bank’s CRE loan to the owner of the building, because  both depend on the tenant’s operations).

M.  Market Analysis

Market analysis should be provided to management and the board, for review in determining whether the bank’s CRE lending strategy and policies remain appropriate as CRE market conditions change. Market analysis should be performed periodically for the various property types in the CRE loan portfolio, and for the separate geographic markets where the bank is making loans.

 Especially when a bank is deciding to enter new markets, or to start new types of lending, or to expand its activities in existing markets, market analysis is important.

Market information can be gathered from a variety of sources, including published research data, real estate appraisers and agents, the county assessor’s office, local contractors, builders, investors and community development groups.  A bank located in a non-metropolitan area will have fewer sources of detailed market data, but needs to be able to demonstrate its understanding of economic and business factors influencing its lending markets.

Most banks have already been using this type of information, but perhaps have not been collecting it in a file or making written reports.  The guidance expects a bank to collect and retain supporting economic and market data (so that an examiner can review it), rather than just having conversations and reading articles and retaining the information in one’s head.  The guidance anticipates that management and the board will receive written reports concerning local economic and CRE market changes (something an examiner can review later), instead of verbal reports made in loan committee or board meetings.



N. Credit Underwriting Standards

According to the guidance, lending policies should reflect a level of risk acceptable to the board of directors, and should provide clear and measurable standards that enable the institution’s lending staff to evaluate all relevant credit factors.  Although economic or market events may cause unexpected CRE concentrations, ideally a concentration is something that is planned, not something that just happens.  A board may need to plan to avoid a CRE concentration—such as by imposing limits—or plan how to reduce a concentration, such as by selling participations.

The regulators expect the board to take a hands-on role in choosing the bank’s CRE lending policy.  In order for this process to work, the bank must provide sufficient market information and loan portfolio information to the board so that it can understand the guidelines it is asked to adopt, such as acceptable portfolio risk, appropriate lines of business, acceptable levels of concentration, loan pricing that matches risk, and capital maintenance appropriate to the level of risk. A bank should consider its market position, historical lending experience, present and future trade area, probable future loan and funding trends, staff capabilities, and technology resources.

CRE lending policies should include the following underwriting standards:  (1) maximum loan amount by type of property; (2) loan terms; (3) pricing structures; (4) collateral valuation; (5) loan-to-value limits by property types; (6) feasibility study requirements for certain CRE loans, and sensitivity analysis or stress testing; (6) minimum standards for initial investment and maintenance of hard equity by the borrower; (7) and minimum standards for borrower net worth, property cash flow, and debt service coverage.

Exceptions to the bank’s written underwriting standards should occur only on a basis where they are documented carefully and approved by management.  The board should receive reports on the number, nature, justifications and trends for exceptions.  All exception loans and their condition should continue to be monitored and reported regularly.  Trends in exceptions should be analyzed to avoid violating the bank’s established risk tolerance limits.

Credit analysis should reflect the borrower’s overall creditworthiness and also considerations specific to the project, as appropriate.  For development and construction loans, the bank’s loan disbursement procedures should make sure that the borrower maintains minimum equity throughout the development and construction periods.  Prudent controls should include an inspection process, written documentation on construction progress, tracking of pre-sold units and pre-leasing activity, and exception monitoring and reporting.

O.  Portfolio Stress Testing

A bank with CRE loan concentrations should perform portfolio-level stress tests or sensitivity analysis to measure the possible effect of changing economic conditions on asset quality, earnings, and capital.  CRE loan segments with similar risk in relation to market conditions should be considered together. 

Less robust stress testing is required for low-risk loans such as well-margined and seasoned performing loans on multifamily housing.  More sophisticated stress testing may be required for most types of CRE acquisition, development and construction loans.

A bank’s stress testing should emphasize the more vulnerable segments of a bank’s CRE portfolio, taking into consideration the prevailing market environment and the institution’s business strategy.  (Choosing to develop a CRE lending concentration in a particular loan segment almost automatically implies that more sophisticated stress testing will occur in that area.)

P.  Supervisory Oversight

If either of two tests of “concentration” in a CRE portfolio is met, as defined earlier, examiners will examine more carefully the effectiveness of the bank’s risk management policies and practices.  (If there’s a dramatic shift in CRE lending, examiners will check for appropriate procedures and controls.)

Examiners will consider the bank’s own written analysis of its CRE portfolio.  The following factors may help to mitigate the risk posed by a CRE concentration:  (1) portfolio diversification across property types; (2) geographic dispersion of CRE loans; (3) underwriting standards; (4) level of pre-sold units or other types of take-out commitments on construction loans; and (5) ability to sell loans or participations to reduce a concentration).

Q.  Capital Adequacy

The guidance requires a bank to maintain capital levels appropriate to the level and nature of risk in the CRE loan portfolio.  If the level of capital is inadequate to serve as a buffer against unexpected losses from the bank’s CRE concentration, the bank will be expected either (1) to reduce its CRE concentrations to make existing capital adequate, or (2) to increase capital to match the level and nature of CRE concentration risk.

To determine whether capital is adequate for the level of risk, examiners will consider details of the CRE concentration, management expertise, historical performance, underwriting standards, risk management practices, market conditions, and any loan loss reserves allocated for CRE concentration risk.

The new guidance is sort of an “early intervention” process, allowing regulators to step in based on concentration risk– before classifications and losses actually turn into a problem.