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 postmortem 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.”

How Forward-Looking Risk Analytics Became an Essential Community Bank Tool

Actions by regulators in the waning months of 2015 should serve as notice to community banks that ignoring forward looking analytics will lead to lower CAMELS scores, more examiner scrutiny and higher regulatory capital requirements. The new current expected credit loss model (CECL), which is expected early this year, is also a forward-looking tool.

Amid signs that community banks are again accumulating higher concentrations of risky commercial real estate loans, regulators are reminding banks that stress testing is indeed required to manage concentration risk in their portfolios and to develop realistic scenarios for interest rate risk management. (See “Regulators to Banks: CRE Lending May Lead to More Required Capital,” p. 1).

The large banks have already adopted forward-looking risk analytics and are using the results with regulators. Although community banks are not subjected to the same stress testing requirements as the large banks, the regulatory trend is in the same direction. Those community banks that fail to incorporate new analytics into their risk management systems will find it increasingly difficult to communicate effectively with regulators, who are using forward-looking risk analytics themselves.

Regulatory Paper Trail

The Federal Deposit Insurance Corp. quietly began training its examiners for a new “forward-looking supervisory approach” as early as 2009. Examiners were taught to “carefully assess the institution’s overall risks, and base ratings not on current financial condition alone, but rather on consideration of possible future risks.” The FDIC said it would use both on-site and off-site reviews and “accurate metrics” to identify risk in balance sheets.

The FDIC’s 2015 annual performance plan discussed the need “to implement more forward-looking supervision techniques” for well-rated banks, including those with CAMELS composites of 2, so it could spot deficiencies before they require formal action.

The FDIC has also proposed changing the way it assesses deposit insurance for community banks. The forward- looking proposal counts construction and development loans as higher risk under a new loan mix index, which could lead to higher assessments.

The Federal Reserve hinted early in 2015 that it was using forward-looking risk analytics to ferret out weaker community banks. The Fed ended the year by announcing it had made its supervision framework “more forward- looking and data-driven.” The new program includes the use of forward-looking metrics to target high-risk banks “for enhanced supervision,” while identifying “low-risk” banks that would merit more of a “streamlined supervisory approach.”

The Fed program will include an outlier list and a watch list that would identify banks “with expanded or new areas of risk-taking” and flags those in the early phases of financial trouble. The algorithms used in the data modeling were first tested on community banks, the Fed wrote, but they are now being expanded and customized for all banks. Some metrics are still being developed and full implementation is not expected until 2017.

OCC Embraces Forward-Looking Analytics

The OCC issued a memo to examiners in 2011, noting that one of the tenets of good forward-looking supervision is assigning an adverse rating to the management component of a CAMELS composite before a bank had deteriorated financially, a 2013 OCC audit revealed. The memo noted that the M score should focus on actions and results, not commitments.

Of all the regulators, the OCC has been the most vocal in advocating for forward-looking community bank analytical tools. It issued guidance for community bank stress testing in 2012, reiterating that “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis” was a key part of sound risk management for community banks. In June 2012, the OCC also issued revised guidance on capital planning. The document said capital planning must be “forward-looking in incorporating changes in a bank’s strategic focus, risk tolerance levels, business plans, operating environment, or other factors that materially affect capital adequacy.”

Then, in December of 2015, the OCC announced that it had updated its guidance for its Risk Assessment System to clarify the “forward-looking elements” of both the system and CAMELS. The guidance “broadens the concept of risk” to include its impact on a bank’s projections. It also expands the definition of strategic and reputation risk assessments to include both the quantity and quality of risk management. The guidance notes that under the new definitions, “financial condition includes impacts from diminished capital and liquidity,” and that capital includes potential impacts from losses, reduced earnings and market value of equity.

Community banks need to be proactive to ensure they are ready for examiners armed with forward-looking risk analytics. Even if your bank doesn’t have CRE concentrations, use forward-looking risk analytics to stress test your capital, your strategic plans and any potential acquisition you might be considering. Present the results to regulators. Invictus’ clients that have used stress testing results with examiners have seen their capital requirements decrease and their management piece of their CAMELS composite increase.

Forward-looking risk analytics are here, and their use will only expand. Embrace them to smooth the regulatory path, and give your bank a competitive edge in the marketplace.

Editor’s Note: This Bank Insights article is adapted from a forthcoming Invictus Consulting Group white paper. For more information on Invictus’ forward-looking risk analytics and how they can help your bank, please contact George Dean Callas at