Guidance on Evaluating Concentrations in CRE

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Guidance on Evaluating Concentrations in CRE Powered By Docstoc
                    of Interagency Guidance on

         Concentrations in Commercial Real Estate
            Sound Risk Management Practices

Denise Dittrich                    January 30, 2007
Federal Reserve Board

   Proposed guidance issued in January 2006

   Considerable feedback from the industry

   Final guidance issued by the Federal Reserve, OCC and
    FDIC on December 12, 2006

   OTS separately issued similar CRE guidance

     Why are Supervisors Concerned
     about CRE Concentrations?

   CRE lending is a significant business line for many
    small to medium-sized institutions
   CRE has historically been highly cyclical which led to
    large losses in the banking industry
   CRE concentration ratios are at record levels
   Rising interest rates could affect debt service coverage
    ratios and property values
   Risk management practices and strategic and capital
    planning have not always kept pace with growth in
    CRE lending
                                     Trend in CRE Concentrations by Asset Size
                                               All Commercial & Savings Banks
                                         (Total CRE Loans / Total Risk-based Capital)


                               Total Assets < $100 Mn
                               Total Assets $100 Mn - $1 Bn
                               Total Assets $1 - $10 Bn
          250                  Total Assets > $10 Bn





                1992    1993      1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005 2006Q3

            Source: Call Report
    What’s Different From the Past?

   More disciplined underwriting
   Regulatory lending standards
   Appraisal profession better regulated
   Transactions not tax driven
   More liquid CRE markets
   Better market data

    What’s Happening Now?

   Frothy CRE markets – cap rates, prices, debt service
   Slowing housing markets – residential construction
   New sources of market liquidity – CMBS, hedge funds
   Plus, lender surveys reveal:

       Declining underwriting standards
       Hyper competition
       Expectations for declining asset quality

      A Tour of The Guidance

   Directed to institutions with significant CRE lending

   Applies to banks but principles are broadly
    applicable to bank holding companies and their
    non-bank subsidiaries

   Outlines key risk management expectations

   Reinforces and builds upon existing regulations and
    supervisory guidelines

    Focus of the Guidance
   Focus is on concentrations in types of CRE loans that expose
    institutions to cyclical conditions in real estate markets, includes:

        “Non-owner occupied loans” where repayment is dependent
         on the rental income or sale or refinancing of the real estate
         held as collateral
        Residential and commercial construction and development

   Excludes “owner-occupied” RE loans where repayment is from
    cash flow from operations
      Consistent with Call Report changes

   Excludes real estate taken as a secondary source of repayment or
    in an abundance of caution
    Supervisory Monitoring Criteria

   Guidance establishes numerical criteria for identifying
    institutions with potentially significant CRE concentration risk

   Using Call Report data, supervisors will focus on institutions

        (1) Construction & land development loans ≥ 100% of
         capital; or

        (2) Total CRE loans ≥ 300% of capital and ≥ 50% growth in
         CRE portfolio over last 36 months

    Purpose of Supervisory Criteria
   Used to identify institutions with potential concentration risk

        Criteria should not be viewed as limits on lending

   There is no “safe harbor” if other risk indicators are present,
    such as:

        Rapid growth in CRE lending
        Significant growth in CRE credit concentrations
        Concentrations in certain property types

   Criteria is only to be used as a starting point for conducting
    further analysis

    Purpose of Supervisory Criteria (cont.)

   Institutions meeting criteria would be expected to be
    able to demonstrate the risk characteristics of their
    CRE portfolio by property type, market, and borrower

   Institutions are expected to perform their own
    assessment of CRE concentration risk

   Examiners will avoid an extended discussion on
    segmentation of individual loans, focus should be on
    the portfolio management

      Implementation of Guidance
   Effective as of December 12, 2006

   This is not a “one size fits all” process

   Examiners will use a risk-based approach and exercise
    examiner discretion

   Examiners will be flexible with institutions on the timeframe
    for meeting risk management expectations

   Agencies will provide training to examiners on proper
    implementation of the guidance

    Expectations for Risk Management
   Guidance applies to institutions of all sizes

   Sophistication of risk management systems will vary
    with CRE portfolio’s risk characteristics, size and

   Evaluation of risk management systems will consider
    varying risk profiles of loans secured by different
    property types

   Relatively simple systems may work for some banks

     Expectations for Risk Management

   Board and management oversight

   Management information systems

   Market analysis

   Portfolio stress testing and sensitivity analysis
   Credit underwriting standards

    Board and Management Oversight
   The Board has ultimate responsibility for risk assumed
      Approve overall CRE strategy and risk tolerance levels

      Monitor how the strategy is progressing and if its policies are
        being complied with
      Approve contingency plan

   Management is responsible for implementing the CRE strategy
    on a day-to-day basis in compliance with board approved
      Design operating policies and procedures that enable it to
        identify, manage, monitor, and control CRE risks
      Provide the board with reports showing strategic targets
        including portfolio risk levels

    Management Information Systems

   Identify key data elements relevant to portfolio

   Produce reports relevant to board and management
    oversight of strategy and policy implementation

   Provide useful stratifications including loan type, property
    type, geographic location, risk grade, delinquency status

   Provide for systematic review and evaluation of portfolio
    risk levels and changes

   Facilitate portfolio level stress testing of alternative
    Market Analysis
   Provide management with sufficient information on
    current market conditions and factors that could influence
    those conditions in the future

   Incorporate data and anecdotal information to develop a
    reasoned view of market conditions and prospects

   Should utilize multiple sources of information for a
    balanced view

   Should be integrated into the strategic plan development
    and risk management

    Market Analysis (cont.)
   Types and sources will vary depending on composition of
    portfolio and markets served

   Frequency of updates depends on size, scope and
    complexity of portfolio and stability of market conditions

   Analysis may contribute variables for stress testing

    Portfolio Stress Testing and Sensitivity
   Analysis will assist management and the board in understanding how
    changes in relevant economic or market factors could affect the
    portfolio or key portfolio segments

   Sophistication of process will vary with complexity of the portfolio

   Analysis should measure the effect on earnings and capital and
    portfolio quality

   Results should be considered in strategic planning and risk

   Results should be updated periodically and shared in writing with
    senior management and the board

    Underwriting Standards
   Lending policies should reflect the level of risk that is acceptable
    to the board
   Underwriting criteria should be clear and measurable
       Maximum loan amount by type of property
       Loan terms
       Pricing
       LTV limits
       Collateral valuation
       Debt service coverage

   Tight control over policy exceptions

   Review and amend standards, as needed, based on results of
    market analysis
    Evaluation of Capital Adequacy
   Guidance does not imply that banks will necessarily need
    to increase capital just because they have a concentration

   Institutions should consider the level of capital support for
    CRE concentrations in their strategic, financial and capital

   Supervisors will take into account inherent risk and quality
    of risk management practices

    Points of Emphasis
   Supervisory criteria are not limits, rather they are to be
    used as supervisory monitoring tools
   Banks should perform internal risk assessments
   Board and management oversight is critical
   Expectations for risk management practices will be
    commensurate with risk profile of institution
   Capital adequacy will be evaluated on a case-by-case
   Guidance does not supercede the Agencies’ real estate
    lending and appraisal standards