Regulators to Banks: CRE Lending May Lead to More Required Capital

Be prepared to raise additional regulatory capital if your bank can’t prove to examiners that your CRE concentrations are well-managed – and can also withstand an economic downturn.

Regulators announced in December that they “will pay special attention to potential risks associated with CRE lending” in 2016. 

Banks that don’t have adequate risk management practices and capital strategies to quantify and manage CRE concentrations will likely be required “to raise additional capital to mitigate the risk associated with their CRE strategies or exposures,” regulators advised.

Banks whose strategic plans call for an increase in CRE lending should stress test their portfolios to see if they have sufficient capital under severe economic scenarios.

The CRE warning is broad: Banks that will come under regulatory scrutiny do not need to have exceeded concentration limits. Banks must merely be contemplating an increase in CRE loans, have already increased CRE lending or “operate in markets or loan segments with increasing growth or risk fundamentals,” regulators said.

Under joint regulatory guidance issued in 2006, examiners will subject a bank to increased supervision if their total reported loans for construction, land development and other land represent 100 percent or more of the bank’s total risk-based capital, or total commercial real estate loans represent more than 300 percent of capital, and the outstanding balance of the CRE loan portfolio has increased by at least 50 percent during the prior 36 months.

Acquisitive banks should take special notice of the concentration warning.  Many potential acquisitions will also result in a crossing of the 300 percent threshold, especially if they are cash-heavy transactions and are dilutive to tangible book value.  There are already rumblings that the CRE focus will result in more intense regulatory scrutiny during the M&A approval process.  Look for regulators to make an example of a bank or two to send a message to the market.  It is highly recommended that acquiring banks be prepared to demonstrate in their regulatory application that they have the infrastructure from a capital management and risk management perspective to manage concentration risk.

Regulators emphasized in December that banks need the right strategies “to ensure capital adequacy and allowance for loan losses” that support a bank’s lending strategy and are consistent with the level of CRE risk in their portfolios.  The regulators advised banks to perform “market and scenario analyses” to quantify the potential impact of changing economic conditions on asset quality, earnings and capital – in other words, forward-looking capital stress tests.

Regulators noted that competitive pressures are contributing to “historically low capitalization rates and rising property values.”  In a downturn, those higher initial collateral values would fall. Regulators noted that the quality of CRE portfolios remained strong, based on non-performing loans and charge-off rates.  Because of those “reassuring trends” in asset-quality metrics, regulators said that many banks are increasing their concentration levels. But they are also decreasing their underwriting standards, with less-restrictive loan covenants, extended maturities, longer interest-only payment periods and limited guarantor requirements.

The CRE levels are of utmost concern because post-mortem reviews of community banks that failed during the 2008 financial crisis showed similar concentrations – yet regulators did not act in time to save the banks.  Congress and watchdogs will be monitoring how regulators react to an impending CRE crisis this time around.

An overlooked Government Accountability Report, which was issued in June, discussed the failure of regulators to oversee rising CRE concentrations at banks prior to the financial crisis of 2008. The 71-page report, “Lessons Learned and a Framework for Monitoring Emerging Risks and Regulatory Response,” discussed how bank supervisors embraced forward-looking supervision as a solution. It revealed that the GAO would monitor how bank supervisors monitor warning signs in the future.

The GAO report offers some clues about how forward-looking bank supervision will affect banks. Regulatory staff, for instance, told the GAO that they had previously been reluctant to downgrade the management component if earnings and capital were strong, a mistake it now realized.  Examiners are now directed to use the management score in the CAMELS composite to reflect a bank’s underlying risks.  Federal Reserve staff told the GAO that “the stress test is the best way to communicate to bank management that risks have built up and need attention, because it is data driven.”