posted on 05 March 2017
85 Percent Of The 414 Financial Institutions That Failed Between January 2008 And December 2011 Had Less Than $1 Billion In Assets
from the Atlanta Fed
-- this post authored by Vanessa Cameron
The key to successful commercial real estate (CRE) lending is the development of a robust risk management framework that includes strong underwriting standards and credit administration practices. A January 2013 Government Accountability Office (GAO) study, Financial Institutions Causes and Consequences of Recent Bank Failures, noted that 85 percent of the 414 financial institutions that failed between January 2008 and December 2011, had less than $1 billion in assets.
The study also found that the failed financial institutions pursued aggressive growth strategies, combined with weak underwriting standards and weak credit administration practices. These actions led to high CRE concentrations that increased the banks' exposure to the sustained real estate and economic downturn that began in 2007. As the figure below shows, 10 states experienced 10 or more bank failures between 2008 through 2011. Together, failures in these 10 states made up 298 of the 414 bank failures (72 percent) across all states during this time period.
This article addresses the importance of the adequacy of sound risk management when high levels of CRE concentrations raise credit risk. For purposes of this article, a CRE loan refers to a loan where the use of funds is to acquire, develop, construct, improve, or refinance real property and where the primary source of repayment is the sale of the real property or the revenues from third-party rent or lease payments. CRE loans do not include ordinary business loans and lines of credit in which real estate is taken as collateral. (Such loans are often described as loans secured by nonfarm nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property. This information is detailed in SR Letter 15-17, Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, and SR Letter 07-01, Interagency Guidance on Concentrations in Commercial Real Estate.)
Supervision and Regulation Letter 07-1, Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices was issued in December 2006 to address institutions increased concentrations of commercial real estate (CRE) loans. The guidance emphasizes the importance of strong risk management practices and appropriate levels of capital when concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. SR Letter 15-17, Statement on Prudent Risk Management for Commercial Real Estate Lending was issued in December 2015, to reinforce existing guidance because the regulatory agencies observed substantial growth in many CRE assets and lending markets, increased competitive pressures, rising CRE concentrations in banks, and an easing of CRE underwriting standards, including less restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements.
Currently, there is some concern that the credit cycle may be about to change. Community banks that identify, monitor, manage, and control risks arising from CRE lending activity should maintain underwriting discipline and prudent risk management practices. Financial institutions should meet regulatory expectations found in SR 15-17. The regulatory expectations indicate that financial institutions should:
Consider the following scenario:
ABC Bank is located on the Gulf Coast in a high income, high net worth market where the economy is heavily reliant on the oil and gas industry. The firm has traditionally maintained a wealth management lending strategy. The strategic initiative focuses on lending to individuals with substantial liquidity, net worth, and disposable income. Loans are typically well secured by cash collateral. The bank has experienced nominal losses as a result of its lending strategy and as a result, the allowance for loan and lease losses (ALLL) is relatively low when compared to peers of comparable asset size. Further, capital levels are sufficient for the bank's risk profile and the inherent risk in the loan portfolio. Bank management has noted an increase in CRE development in the market, resulting in an increase in construction and land development (CLD) lending by its competitors. In an effort to increase earnings bank management adds CRE lending, focusing on CLD loans, to its strategy as a growth initiative. The lending staff has wealth management and consumer lending experience. What should management do prior to moving forward with a CRE growth strategy?
Management must ensure that a sound risk management framework is in place to support the CRE growth initiative. Management should also consider the level and nature of expected growth when developing and implementing CRE policies and procedures if CRE concentrations are expected to approach or exceed the supervisory criteria found in SR 07-01:
Risk and concentration limits should be set that are aligned with the firm's risk appetite and tolerances. Sound underwriting policies commensurate with this risk, as well as lending and risk management staff with the appropriate skills should be hired to grow and manage the inherent risk in CRE loans. Management Information Systems (MIS) should be robust, appropriately capture risk in the portfolio, and accurately report the performance of the CRE portfolio. Management should ensure that the ALLL and capital levels are adequate and sufficiently support the bank's risk profile.
Key CRE risk management elements noted in SR 07-01 are essential to establishing an effective risk management framework, and the figure below depicts them.
The question is why? Trends that identify increasing or excessive risk indicate the need to further assess and mitigate risk in portfolios, individual loans, projects, or lending personnel.
Keeping risk management CRE in mind down the road
The need for sound risk management cannot be understated. Firms should stay apprised of regulatory guidance and ensure that expectations are met. (The commercial bank examination manual and the bank holding company supervision manual, both from the Fed's Board of Governors, are resources.) Activities and associated documentation should clearly reflect this. CRE risks should be appropriately identified, monitored, measured and controlled as examiners will consider the nature of inherent risk as a result of CRE growth. Examiners will also assess the implications of the growth on asset quality, earnings, and capital, as well as assessing the level of the ALLL in relation to the CRE growth and concentrations levels, for consistency with the heightened risk that results from the CRE growth and concentration. Examiners may ask institutions that have inadequate risk management practices and capital strategies to develop a plan to better manage CRE concentrations. Actions may include reducing risk tolerances in the firm's underwriting standards, or raising additional capital to mitigate the risk associated with the firm's CRE strategies or exposures, particularly if the concentration levels exceed CRE guidance supervisory criteria for construction and land development and nonowner-occupied CRE.
About the Author
Vanessa Cameron is a Senior Examiner in the Atlanta Fed's supervision and regulation division
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