Headlines about the financial crisis tend to focus on the subprime mortgage collapse, but the impact of the crisis on the banking industry hasspread well beyond residential lending. The biggest area of concern is commercial real estate (CRE) lending.
Many community banks have high concentrations of CRE loans in their portfolios, so it’s critical to assess your risk exposure in connection with theseloans and take steps to manage that risk.
The next crisis?
The next crisis in the banking industry is likely to involve CRE lending. Although construction and development loans for residential housing projectspresent the biggest risks, the current economic recession and credit crunch are affecting all types of commercial real estate.
Ironically, the very trend that shielded most community banks from the subprime meltdown also increased their exposure to CRE risk. When largefinancial institutions began to corner the market on residential loans, community banks turned their attention to CRE lending. As a result, accordingto the Office of the Comptroller of the Currency (OCC), by 2008, the average concentration of CRE loans at community banks reached approximately285% of capital, nearly twice as high as it was only six years earlier.
Even before the subprime mortgage meltdown, banking regulators had expressed concern about the risks associated with high CREconcentrations. In 2006, for example, the FDIC, OCC and Federal Reserve published interagency guidance on Concentrations in Commercial RealEstate Lending, Sound Risk Management Practices. Regulators were concerned not only with banks’ heightened risk exposure in the event of aneconomic downturn, but also because many banks had relaxed their underwriting standards to compete for CRE loans. The guidance focused onbanks in which:
Regulatory scrutiny isn’t limited to banks that exceed these thresholds, though. Any institution that has experienced rapid growth in CRE lending,or exhibits “notable exposure” to certain types of CRE, may be targeted.
For more information about the COSO framework, see www.coso.org/ERM.htm.
Build a profitable enterprise
ERM is a powerful tool that can help your bank develop a more accurate picture of enterprise risks. This information can be used to evaluatestrategic alternatives, develop appropriate responses to various risks, minimize unexpected losses, improve
the deployment of capital and make themost of your opportunities.
What’s your stress level?
Recently, the OCC broke down community banks into three groups according to their level of exposure to weak CRE loans, and is closely watching the group with the greatest perceived CRE risk. Banks in this group are expected to establish a solid plan for assessing and managing their risk. Regulators also want to see banks stress-test their portfolios and make necessary adjust- ments, such as reducing their concentration of CRE loans, tightening underwriting standards for new loans, increasing loan loss reserves, or boosting capital.
The interagency guidance urges banks to develop risk management programs that include these key elements:
Regulators are particularly concerned about the last element. Stress testing uses financial modeling and other techniques to estimate the impact ona bank of certain stresses or “shocks.” What would happen, for example, if interest rates went up
(or down) by 2%? What would happen if vacancy rates rose or construction costs increased by various amounts?
For more information on regulatory concerns, see document
FIL-22-2008 on the FDIC Web site (fdic.gov, under “News & Events / Financial Institution Letters”).
The key to effective stress testing is to create models that go beyond individual stress factors and examine the potential impact of various combinations of influences.
Once you understand your portfolio’s ability to withstand these stresses, you can identify risk mitigation strategies that will help cushion theblow. These include adjusting capital allocation levels, reducing your concentration of high-risk loans and beefing up your underwriting standards.
Unfortunately, many community banks fail to give stress testing the attention it deserves. In testimony last year before the Senate Committee on Banking, Housing and Urban Affairs, Comptroller of the Currency John Dugan expressed concern about inadequate stress testing by banks. Duganobserved that, “despite our previous guidance, a number
of banks with CRE concentrations have not extended their stress testing of income-producing properties beyond interest rates to other businessvariables that affect risk, such as vacancy rates, lease rates, and expense scenarios.”
Why banks shy away
One possible reason that community banks have been slow to implement stress testing is the misconception that it requires highly sophisticated —and, therefore, expensive — financial models. But depending on your bank’s particular risk profile, it may be sufficient to develop a few simple “whatif ” scenarios that stress two or three variables. You can use these scenarios to test individual loans or groups of loans.
The right strategy for your bank depends on its size and resources, along with the nature and complexity of its CRE activities. The prescribed level ofstress testing is driven by a variety of factors, including the extent to which your CRE portfolio is diversified and the level of exposure, in terms of dollars, of variousportfolio segments.
As you review your CRE activities, ask what factors might cause borrowers to default on their loans. Then design a stress-testing program thatfocuses on those factors. Keep in mind that, in evaluating your stress-testing program, regulators will consider your bank’s resources. If yourresources are limited, it may be acceptable to concentrate your efforts on the areas where you’re most vulnerable.
Averting a crisis
One reason that the residential mortgage crisis has been so severe is that many financial institutions, lawmakers and even regulators ignored or atleast downplayed the warning signs until it was too late. By evaluating and managing their risks, community banks have an opportunity to avert —or at least mitigate — a similar crisis in the CRE industry.
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