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. An Analysis of the Impact of the Commercial Real Estate Concentration Guidance (Washington, D.C.: April 2013). Monitoring speculative single-family housing development can be especially challenging. 1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. 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 … However, investing in assets that management does not understand can also carry significant risks. History has clearly demonstrated that CRE can experience cyclical changes in which supply and demand get out of balance, resulting in significant losses for financial institutions. Supervisory Examiner, Independent property inspections—There should be initial site visits and ongoing inspections during the construction phase. The granularity warranted may be product-by-product, location-by-location or some other degree (e.g., price point, speculative versus presold), depending upon the institution’s markets and product types. Much of this guidance is based on lessons learned in downturns of the past, especially the banking crisis of the late 1980s and the early 1990s. Many banks fail to collect the data necessary to produce the reports listed above. 3. In many instances during the 1980s and early 1990s, developers walked away from partially finished properties, and some lenders were forced to complete projects to salvage their investment. Adhering to these regulatory LTV limits should make institutions less vulnerable to downturns in CRE markets, as borrowers will have more tangible equity in the collateral real estate to cushion against declining values. 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. Columbia, MO, Tracy E. Fitzgerald PDF ATTACHED: FIG Partners Industry Analysis 9-7-16 – Impact of CRE Concentration Guidance. How are My Deposit Accounts Insured by the FDIC? Real estate lending represents one of the major components of credit risk at many banks. The Federal Reserve Board’s real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50–51 for state member banks. each current rating grade to the grades reflected in the stress year ratings matrix. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. A granular rating system that effectively rank orders risk should aid management in identifying the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon. Not surprisingly, CRE-related loans account for a significant portion … For example, a community bank might assume layoffs at a major employer and measure the anticipated results on new housing demand and other CRE property performance. 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. 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. Distribution: FDIC-Supervised Banks (Commercial … If CRE lending is the primary earnings driver, the institution should be prepared to diversify into other areas of lending or wait for CRE markets to return. 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. 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 Risk–Management Practices", Section 2040.1, "Loan Portfolio Management" (Mortgage Banking Subsection), Section 2043.1, "Nontraditional Mortgages–Associated 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". (2) Total commercial real estate loans as defined in this Guidance 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. Specific, objective rating criteria rather than broad, subjective criteria promote consistency in the rating process. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. With such concerns in mind, federal banking agencies in December issued guidance on risk management expectations for banks with significant concentrations in commercial real estate (CRE) loans. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. 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. Alternatively, the bank could develop a relationship between economic variables and ratings migrations. In general, the loss rates from the reference portfolio will be a good starting point. Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. While not providing specific information for managing CRE concentrations, it should inform management of the possible level of the bank’s exposure if a CRE downturn were to occur. Steven G. Johnson Bank management should also be willing to forego potential CRE income when the risk exceeds the reward. Learn if your bank is insured, view locations, track history, and more. Robust risk management systems can also track the number of exceptions by type and amount to help point out areas of policy that may need permanent amendment or that need to be reinforced by the institution’s board of directors. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. The Guidance reminds institutions … 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. See 12 CFR 323 (FDIC); 12 CFR Part 34, subpart C (OCC); 12 CFR 208.18 and 12 CFR 225, subpart G (FRB); and, 12 CFR 564 (OTS). 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