By: Tommy Troyer, Senior Consultant and Loan Review Manager
Over the last several months, it has become increasingly difficult to miss the fact that the federal regulatory agencies (the FDIC, Federal Reserve, and OCC) believe that credit risk is on the rise across the banking industry and particularly within Commercial Real Estate (CRE) portfolios. While industry-wide developments are of course not necessarily reflective of the situation of any single bank, it is the case that regulatory concerns about building credit risk in CRE portfolios makes it more likely that your bank’s CRE policies, underwriting, and portfolio management will be closely scrutinized in your next safety and soundness exam. Note that in this context, CRE refers to what are sometimes called non-owner occupied commercial real estate loans: loans for which the sale of the property, take-out financing, or third-party rental/lease income are the primary sources of repayment.
Recent Comments on Increasing CRE Risk
On December 18, 2015, all three federal bank regulatory agencies issued the interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, an existing guidance on CRE lending. In fact, the statement itself contains no new guidance or regulatory expectations. Its purposes, instead, appear to be to “remind financial institutions of existing regulatory guidance on prudent risk management practices” for CRE and, perhaps more importantly, to highlight the belief that credit risk in CRE portfolios is increasing and must be carefully monitored and managed. The guidance highlights several reasons to believe that CRE portfolios may experience some strain over the next several years. These include both market factors (historically low capitalization rates are cited) and findings from recent exams (easing of underwriting standards along several dimensions, increasing frequencies of underwriting policy exceptions, and insufficient monitoring of market conditions).
The new interagency statement is far from the only suggestion of increased concern regarding the CRE market. The OCC’s Semiannual Risk Perspective for Fall 2015 cites easing underwriting standards, increasing CRE concentrations (especially in multifamily), and for community banks, strong growth in CRE lending as possible risks. The December 2015 – January 2016 RMA Journal includes the final installment of the publication’s annual rundown of “Today’s Top Credit Risk Issues.” Multifamily lending makes the list, suggesting that the Risk Management Association, a respected industry group unaffiliated with any financial regulators, also sees notable risk in the CRE market.
The fact that the CRE market remains competitive in many areas, combined with low interest rates, has thus far meant that several traditional but lagging indicators of credit risk (for example, delinquency and non-accrual rates) have not yet shown signs of weakening. Nonetheless, as has been demonstrated in past credit cycles, the risk factors cited above can often lead to increases in credit risk that do eventually result in deteriorating asset quality and increasing charge-offs.
Prudent CRE Risk Management for Community Banks
The good news is that the keys to effectively managing risks in the CRE portfolio are not mysteries and are achievable for any disciplined and committed community bank. The recent interagency statement provides a good summary. It notes that, in part, banks that successfully manage CRE risk:
- Establish and adhere to appropriate policies, underwriting standards, and concentration limits
- Conduct accurate cash flow analysis on the project, borrower, and global levels at underwriting and on an ongoing basis
- Effectively monitor market developments (supply and demand, vacancy and rental rates, etc.)
- Implement appropriate appraisal review and collateral valuation processes
In addition to the factors described above, two additional critical features of CRE risk management, CRE Stress Testing and Independent Loan Review, are mentioned. These processes can be performed internally by community banks, but due to resource and other constraints may be both more efficient and more effective if outsourced.
Stress Testing the CRE Portfolio
The interagency statement notes that “market and scenario analyses” that “quantify the potential impact of changing economic conditions on asset quality, earnings, and capital” are an important aspect of CRE risk management. This is a reference to stress testing the CRE portfolio. Further, the 2006 interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices states that any institution with a CRE concentration “should perform portfolio-level stress tests.” Even if your bank does not meet the concentration thresholds defined in the 2006 guidance for identifying institutions with “potentially…significant CRE concentration risk,” stress testing the CRE portfolio can have a number of important benefits. By quantifying the impact of several adverse scenarios on asset quality, earnings, and capital, a CRE stress test can inform your bank’s strategic and capital planning processes, your internally established credit concentration limits and practices, and your credit policy and underwriting requirements.
Young & Associates, Inc. offers a CRE Portfolio Stress Testing service that provides an insightful and efficient stress testing solution. Our service uses data specific to your bank’s portfolio to stress your CRE portfolio across several factors. Our report will assist in quantifying the possible impact to earnings and capital that could result from decreases in collateral value, property net operating incomes, or increases in interest rates. In the current environment in which interest rate increases are likely over the next several years and decreases in collateral values are at least a distinct possibility, understanding your bank’s possible exposure is key to maintaining a safe and sound bank and demonstrating effective risk management to your examiners. Our CRE Stress Testing service is performed remotely, meaning that no travel expenses are associated with the service. More importantly, once the project has been discussed and you have provided a response to our initial data request, bank management can remain free to work on the many other initiatives that require attention, while we make use of our existing systems and expertise, making the stress testing process an efficient one. Our service includes a detailed report documenting the results of the stress test and, if desired, a phone presentation of the findings to management or the board.
Independent Loan Review
An effective independent loan review function is critical to assessing asset quality in the CRE portfolio, determining the accuracy and effectiveness of both underwriting and the ongoing monitoring of CRE credits, and identifying whether exceptions to credit policies or underwriting standards are being appropriately identified and approved by the bank. Any issues identified by loan review can be proactively addressed by the bank, helping to ensure risk mitigation is in place before the issues are identified by examiners or are revealed by deteriorating asset quality.
Most community banks find that their size and the requirement that loan review be performed by a qualified, independent party means that outsourcing loan review is the best option. Young & Associates, Inc. has extensive experience providing loan reviews for community banks. Our loan review of a sample of your CRE portfolio may identify individual credits of concern, but more importantly, will provide perspective regarding whether your credit standards, credit analysis, and ongoing monitoring of existing credits are adequate for the nature of your CRE portfolio. In this way, our findings not only inform management and the board about existing risks in the portfolio, but provide recommendations for effectively managing that risk. We can perform loan reviews on-site or, if your technological capabilities allow, remotely, allowing you to reduce or eliminate the travel expenses associated with the loan review.
For information regarding Young & Associates, Inc.’s CRE Stress Testing service, please contact Kyle Curtis at 1.800.525.9775 or click here to send an email. For information regarding Young & Associates, Inc.’s Independent Loan Review service, please contact Tommy Troyer at 1.800.525.9775 or click here to send an email.