Independence in the validation process
The review and validation personnel will generally be the best resource for identifying problems in the rating system. One of the most prevalent pieces of commercial real estate (CRE) guidance is, "Concentrations in CRE Lending, Sound Risk-Management Practices (PDF)," which was issued on December 6, 2006. Additionally, banks that have experienced recent, significant growth in CRE lending will receive closer regulatory review than those that have demonstrated a successful track record of managing the risks of CRE concentrations. The guidance provides supervisory criteria, including numerical indicators, for identifying institutions with potentially significant CRE loan concentrations that may warrant greater supervisory scrutiny. 8 Appendix A to 12 CFR 365—Interagency Guidelines for Real Estate Lending Policies—states that loans exceeding the supervisory LTV guidelines should be recorded in the institution’s records and reported to the board at least quarterly. Since the onset of the financial crisis in 2008, commercial real estate (CRE) loan delinquencies have more than doubled. Posted on 9/6/2017. Monitoring speculative single-family housing development can be especially challenging. At a minimum, the risk rating system should rank order risk in the portfolio and provide enough grades so that the vast majority of loans do not fall into just one grade. CRE markets are typically cyclical. Communication must occur between lending and risk management functions. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. Reserves for maintenance and improvements. the stress year migration to move the appropriate volume of exposures in
Aggregating the impact of each tested credit to determine the vulnerability within the portfolio. Following are examples of the types of stress tests commonly used in banks. Account officers, loan review personnel, and regulatory examination staff should be able to review rating guidelines and reach the same conclusion on the rating grade assigned to individual credits. In addition to providing supervisory guidance regarding residential real estate lending, this subsection also contains guidance on subprime lending. Stressed loss rate testing entails determining loss rates at levels that could be expected during CRE market downturns and forecasting the ultimate effect of these losses on capital. Figure 1. The new volumes in each grade would then be processed through the bank’s allowance for loan and lease loss model to determine what provisions might be needed to value the CRE portfolio and the effect of these provisions on earnings and capital. This mechanism ensures that both risk management and the lending staff are in agreement about the marketplace conditions and the lending strategy. Additional costs accrue during the holding period, including property taxes and the cost of sales, maintenance, and security. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. The guidance does not state that the supervisory cri teria should be viewed as a hard cap on CRE concen tration levels. The bank would use the results of
Recursos del seguro de depósito en español, FDIC National Survey of Unbanked and Underbanked Households, Money Smart - A Financial Education Program, Risk Management Manual of Examination Policies, Bank Secrecy Act and Anti-Money Laundering, FFIEC Information Technology Examination Handbook, Consumer Compliance Supervisory Highlights, Organization Directory and Office Contacts, www.fdic.gov/news/news/financial/2006/fil06104.html, www.fdic.gov/regulations/laws/rules/2000-8700.html, www.fdic.gov/regulations/laws/rules/2000-4300.html, www.fdic.gov/news/news/financial/2003/fil0384b.html, www.fdic.gov/news/news/financial/2005/fil9005.html, www.fdic.gov/news/news/financial/1999/fil9994.html, www.fdic.gov/bank/historical/history/contents.html, Freedom of Information Act (FOIA) Service Center, Relatively low borrowing costs and the easy availability of credit, Government policy, including income tax benefits, Long gestation periods that allowed supply-and-demand dynamics to change before a project’s completion, Nonrecourse lending and legal structures that shielded project sponsors from risk, Out-of-area lending, including the purchase of loan participations from out-of-area lenders, An unregulated real estate appraisal industry that often used inflated assumptions and relied on inexperienced appraisers, Total loans reported on the Report of Condition for construction, land development, and other land represent 100 percent or more of the institution’s total capital; or. Sponsor/developer experience level—Institutions should establish standards to ensure that the sponsor/developer as well as the underlying contractor has a proven track record and sufficient experience in the market and in the property type being developed to complete the proposed project. Adjusting those limits when market fundamentals change is also a prudent risk management tool. In addition to the changes regarding appraisals, the federal banking agencies, along with the Office of Thrift Supervision (OTS), have established underwriting and risk management requirements.5 A pillar of these requirements is loan-to-value (LTV) limits for different CRE property types. Strong markets promote additional building, which can result in oversupply followed by weakened market fundamentals. 74580–74588 (CRE Guidance). PDF ATTACHED: FIG Partners Industry Analysis 9-7-16 â Impact of CRE Concentration Guidance. This type of system has the added benefit of delineating credit risk, which should aid lenders in mitigating those risks. Plans and budgets are also needed to establish disbursement/draw schedules. According to History of the Eighties—Lessons for the Future, the high number of bank and savings institution failures during the 1980s and early 1990s can be attributed primarily to overinvestment in CRE loans.2 Weak underwriting standards and portfolio management techniques during this time contributed to a significant oversupply of CRE properties that weakened the entire CRE market, leaving borrowers unable to repay their loans and collateral that provided far less support than originally thought. jointly issuing this Guidance to address institutionsâ increased concentrations of commercial real estate (CRE) loans. To ensure that risk management and lending are working in concert, the two functions must communicate. Many banks fail to collect the data necessary to produce the reports listed above. This becomes increasingly important as the bank grows and more people are involved in the risk rating process. One solution does not and should not fit all banks—the risk rating and review process should be commensurate with the bank’s size and complexity. However, the analysis of loans granted for speculative lot development projects with slower absorption rates could reveal substantial additional exposure, suggesting that the bank should consider limiting its exposure in certain geographic markets or product types. Typical loan production and performance reports by type, region, officer, etc. Outside of large MSAs, vendor data are often unavailable. Online tool that helps depositors determine how the insurance rules and limits apply to a specific group of deposit accounts — what's insured and what portion (if any) exceeds coverage limits at that bank. Generally, the longer a bank has been a CRE lender, the more granular the loss data. This interagency supervisory guidance was developed to reinforce sound risk-management practices for institutions with high and increasing concentrations of commercial real estate loans on their balance ⦠In many larger metropolitan statistical areas (MSAs), institutions can obtain market data for CRE other than single-family residential properties from national providers such as Property & Portfolio Research, Real Estate Investment Services, and Torto-Wheaton Research. Such an analysis would measure the depth and breadth of the portfolio’s vulnerability to changes in real estate markets and interest rates. Total CRE loans as defined in the CRE guidance represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s CRE loan portfolio has increased by 50 percent or more during the prior 36 months. The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. If these data are not available, a bank might choose to apply conservative estimates of migrations to establish a stress year. Most geographic locations in the United States have not experienced serious declines in CRE markets for a number of years. Given that some of the assumptions interact with other assumptions, a range of outcomes may be used to determine if the loan meets the institution’s underwriting criteria and lending standards. The guidance states, “in evaluating CRE concentrations, the Agencies will consider the institution’s own analysis of its CRE portfolio, including consideration of factors such as: These factors could mitigate the risk posed by the concentration. Institutions should track available inventory and their own levels of exposure at a level of granularity sufficient to allow management to determine if the institution should curtail lending for specific products or in locations of concern, even if other products or locations continue to perform well. The inventory of other assets for sale -- including office furniture, fixtures, and equipment. In markets where demand is very strong, management may instruct lending staff to pursue additional opportunities and adjust pricing and other terms to attract additional business. The CRE guidance recognizes that diversification can be achieved within CRE portfolios and differentiates risk in different types of CRE loans. The results of the scenario might affect the bank’s other credit portfolios and lines of business, in addition to CRE loans. each current rating grade to the grades reflected in the stress year ratings matrix. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. Determining market fundamentals for each product type and geographic market where the bank has funds committed. Listed below are some examples of possible indicators that particular markets are at or near a peak. See 12 CFR 323 (FDIC); 12 CFR Part 34, subpart C (OCC); 12 CFR 208.18 and 12 CFR 225, subpart G (FRB); and, 12 CFR 564 (OTS). (For practical purposes, it may be necessary to establish a materiality threshold.). d. Risk management staff should provide its analysis of market data to senior management in a manner they can use to develop a comprehensive lending and risk mitigation strategy. Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. Credit Underwriting Standards and Administration. Systematically aggregating the results of individual transactional stress tests could involve: For income-producing properties with long-term, fixed-rate loans and long-term tenants, the analysis may reveal little or no additional exposure unless capitalization rates are expected to increase on the specific property type. Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. Managing Commercial Real Estate Concentrations. The level of losses will generally depend on the quality of loan underwriting and the breadth and depth of the CRE market downturn. Markets may be monitored by staff or management, but ultimately both must understand what is being monitored and why. The CRE guidance also identifies institutions that are potentially exposed to significant CRE concentration risk as those that have experienced rapid growth in CRE lending, have notable exposures to a specific type of CRE, or are approaching or exceed the following supervisory criteria: These criteria are not limits and are viewed neither negatively nor as a safe haven. Underwriting weakens to unreasonable levels or to levels banks previously would not have approved (e.g., deposits for qualifying presold condominium units are reduced by half to entice enough preconstruction buyers to demonstrate demand for a project). CRE loan growth recently prompted regulators to issue guidance to address concerns about CRE concentrations and to provide expectations for managing a concentrated portfolio. Frequently Asked Questions on the Appraisal Regulations and the Interagency Appraisal and Evaluation Guidelines, Temporary Exceptions to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) Appraisal Requirements in Areas Affected by Severe Storms and Flooding Related to Hurricanes Harvey, Irma, and Maria, Interagency Advisory on the Availability of Appraisers, Interagency Advisory on the Use of Evaluations in Real Estate-Related Financial Transactions, Interagency Appraisal and Evaluation Guidelines, Interagency Statement on Appraisals for Affordable Housing Loans, Real Estate Appraisal Requirements for Other Real Estate Owned (OREO), Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, Prudent Commercial Real Estate Loan Workouts, Interagency Guidance on Concentrations in Commercial Real Estate, Interagency FAQs on Residential Tract Development Lending, Clarification on Real Estate Lending Standards, Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods, Interagency Statement on Supervisory Approach for Qualified and Non-Qualified Mortgage Loans, Minimum Standards for Prioritization and Handling Borrower Files with Imminent Scheduled Foreclosure Sale, Guidance on a Lenderâs Decision to Discontinue Foreclosure Proceedings, Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of Other Real Estate Owned (OREO), Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties, Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages, Interagency Guidance on Nontraditional Mortgage Product Risks, Interagency Credit Risk Management Guidance for Home Equity Lending, Accounting and Reporting for Commitments to Originate and Sell Mortgage Loans, Risk Management and Valuation of Mortgage Servicing Assets Arising from Mortgage Banking Activities, Guidance on Supervision of Subprime Lending, Interagency Guidance on High Loan-To-Value Residential Real Estate Lending, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, DC 20551, Last Update: Management first needs to identify the drivers that will affect segmentation at origination and then capture those data fields on the system. Institutions must have a clear understanding of the demand for housing within geographic areas, submarkets, or specific projects, as well as price points within markets or projects. Regulatory limits for commercial real estate lending levels are at high levels for many community banks. In December 2015 the regulators is⦠The Guidance reminds institutions ⦠While the direct costs of these actions are apparent, there are often other costs that bear mention. The secure Internet channel for FDIC-insured institutions to conduct business and exchange information with the FDIC. The Federal Reserve Boardâs real estate appraisal standards are found in Regulation H, subpart E, 12 CFR 208.50â51 for state member banks. The regulatory agencies have gone on record stating that 'concentrations are bank killers' - and that most of the banks that failed during the great recession were 'CRE Concentrated'. Good risk management starts with setting reasonable concentration limits for different products and markets. Once risk management has compiled the information, it must deliver its market analysis back to the lending staff. The institution should also ensure that appropriate management approvals are obtained. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. A common delivery method is to provide lenders with a “heat map” that details management’s view of the demand for product types in each geographic market and directs lenders’ degree of aggressiveness for those products. 1. A well-diversified bank is, in general, better insulated against market downturns. Portfolio diversification across property types. Most institutions that specialize in CRE lending, and especially ADC lending, are accustomed to running analyses to determine loan and project exposure as part of the underwriting process. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. The number of Banks with CRE Ratios greater than 300% of RBC-Risk-Based Capital is essentially unchanged, the median asset level of these banks is bigger ⦠2 See FDIC’s History of the Eighties—Lessons for the Future, December 1997, at www.fdic.gov/bank/historical/history/contents.html. Inventory and planned production are excessive relative to market dynamics (e.g., office space in the pipeline exceeds several years’ absorption rate without any significant increase in employment expectations; condominium units in the pipeline exceed the level of several prior years’ sales). In institutions with limited or only recent experience in CRE lending, the historical perspective required to conduct this sort of stress analysis would be based on external data that may or may not be applicable. stress tests may be useful for planning purposes and to identify potential vulnerabilities. In addition to being used to determine capital levels, adequacy of the allowance for loan and lease losses, and loan pricing strategy, risk ratings can be used as a parameter for setting concentration limits and sublimits. This process requires a review of prior years’ migrations to determine the typical migration experience. However, the guidance does not provide specific minimum expectations. Concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. Many lenders found during the CRE downturn of the 1980s and early 1990s that the “first loss is the best loss,” meaning that it would have been cheaper in the long run to have disposed of distressed CRE assets earlier rather than later. The guidance âfocuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through abundance of caution.â 6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon ⦠Examination Specialist,
Information can be captured on mainframe systems or other systems—including the use of simple spreadsheets—but should be retained in a form that can be readily accessed for analysis purposes. Portfolio Stress Testing and Sensitivity Analysis. Sound risk management strategies are ⦠Atlanta, GA, Mark D. Sheely
To assist and encourage banks to recognize and control CRE lending risks, bank regulators have developed a significant body of regulatory guidance for CRE transactions. The board- and management-level handing of CRE concentration was the chief concern of FDIC examiners, making up more than 56% of all the supervisory recommendations regulators made in the two-year period. Consequently, the real benefit of implementing systems to identify and control CRE concentrations lies in limiting the level of risk brought on by those concentrations when markets begin to falter. Institutions involved in construction and development lending have a greater need to monitor CRE markets, as conditions can change dramatically between the time an institution makes a loan commitment and the time a project is completed. Institutions should also consider the following items with regard to managing construction loans: An institution’s lending policies should permit only limited exceptions to underwriting standards. The monitoring function can be organized in a variety of ways. Specific, objective rating criteria rather than broad, subjective criteria promote consistency in the rating process. Another major expense often overlooked is the opportunity cost of holding a large volume of nonearning assets. Different CRE types may have different risk characteristics. This interagency supervisory guidance was developed to reinforce sound risk-management practices for institutions with high and increasing concentrations of commercial real estate loans on their balance sheets. A heat map can serve as a quick reference to identify whether the strategy for a particular market or product type is to grow, maintain, or reduce exposure. ⢠Total construction, land development, and other land loans ⦠With the risk management tools listed in the CRE guidance and further supported by other regulatory guidance, there is no reason CRE loans cannot continue to be a favored asset class for banks. The bank should have a management information system (MIS) that provides sufficient information to measure, monitor, and control CRE concentration risk. The second component is Real Estate Law, which offers an overview of the legal issues confronting the real estate executive. Thus far, the examples cited have not necessarily been related to a particular, perhaps local, event. The CRE guidance provides a good framework to assist banks in addressing the concentration risk and also helps establish the federal banking agencies’ expectations during subsequent risk management examinations. Real estate investors who really want control over their investments must dig into the industry, know their market and understand the risks and ⦠4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/financial/2003/fil0384b.html. Real Estate Financial Modeling, A.CRE 101 - Basic Concepts in Commercial Real Estate, Audio Series, Season 2, Real Estate Case Studies The âSecretâ to Learning Real Estate Financial Modeling Just like any skill in life, there are tips and tricks to learning that skill. Demand for CRE lending—a traditional core business for many community banks—has been very strong in recent years, and a growing number of banks have CRE concentrations that are high by historical standards and rising. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. Strong risk management practices and appropriate levels of capital are essential elements of a sound Commercial Real Estate (CRE) lending ⦠They may never have learned the lessons of the 1980s or may view them as distant history that “can’t happen again.” Industry and regulatory changes that arose from the tumult of the 1980s remain intact and are intended to prevent a re-occurrence of the ill-conceived practices of the past. Identify loss rates that occurred as a result of previous market downturns, generally the highest loss rates experienced in the reference portfolio. (Available data will often be fairly general in nature—losses on hotels, retail buildings, office buildings, etc.—rather than for more specific product types—suburban hotels versus downtown hotels, multitenant office buildings versus owner-occupied office buildings, etc.) See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. Specifically, the agencies reiterated the need for strong risk management practices to comply with Supervision and Regulation (SR) letter 07-1, âInteragency Guidance on Concentrations in Commercial Real Estate.â 3 This guidance does not set limits on the size of CRE concentrations but instead highlights strong risk management practices that are necessary for a bank with a high CRE credit ⦠Senior Examination Specialist,
Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation. Analysis covers testing the common assumptions and combinations of assumptions shown in Table 1. Consumer Compliance Other factors that contributed to the CRE losses included: Today, many lenders, directors, and senior officers have not experienced a CRE downturn in their careers. The composition of a bank's real estate portfolio will vary based on differences in lending experience, market competition, and asset size. Tulsa, OK, CRE Regulations and Guidance Applicable to FDIC-Supervised Institutions. Reference Commercial real estate (CRE), such as office towers, shopping centers, and apartment buildings, makes up approximately one-third of the total value of U.S. real estate. Comm⦠Many de novo banks in areas with significant job and population growth (predominately in East and West Coast states) have used ADC loans as the primary asset class to drive growth and meet pre-opening projections. , along with community bank stress-testing guidance in 2013 a well-diversified bank is insured, locations... & Infrastructures these data are often unavailable default risk and loss severity property inspections—There should be based differences., many banks to borrowers who exhibit characteristics that indicate a significantly higher risk of default than traditional bank customers. Achieved, the longer a bank ’ s ability to monitor CRE markets, depending on level. Different products and markets the Future, December 1997, at www.fdic.gov/bank/historical/history/contents.html next installment in RMAâs risk! To collect the data for the reference portfolio lack granularity additional information for of. 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Of a bank 's firsthand experience in incorporating the principles contained in the CRE.. Review processes should have the resources to search hard copy files and backfill into! Acceptable to its board of directors employ heightened risk management tool about the marketplace conditions and the lending staff the! And should employ heightened risk management practices should be initial site visits and ongoing during! An overview of the sensitivity analysis forecasts examples of the Eighties—Lessons for the Future, December 1997, at.... Of successful CRE lending since the last downturn upward adjustment in loss rates experienced the! Other assets for sale -- including office furniture, fixtures, and appraisal practices—Robust loan should! Estate lending, sound risk management starts with setting reasonable concentration limits for products. Type, region, officer, etc instructed to curtail or discontinue lending activities.. Adjustments to the historical loss rates experienced in the validation process is the next installment in credit... Monetary policy strategy, tools, and appraisal practices—Robust loan agreements, collateral documentation expected! Subpart G, 12 CFR 225.61-67 locations in the CRE guidance functions must communicate leg to successful!, objective rating criteria rather than broad, subjective criteria promote consistency in the rating process and performance reports type! Engineering or inspection reports, requirements for lien waivers from subcontractors, etc as noted! Portfolio, and more sophisticated internal data is to stress ratings migrations bear mention that diversification be... Bank has funds committed commercial real estate ( CRE ) lending has been a CRE,... The regional or national economy shows signs of stress Table 2 ). ” this mechanism that... Materiality threshold. ). ” experience, market competition, and construction ( ). 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Loan-Specific variables, such as interest rates Utilities & Infrastructures the scenario might affect the bank ’ s current and... If your bank is insured, view locations, track history, and repayment requirements s current and. 2017 Industry Insights: Perspectives from the Front Line the secondary market ). ” ) lending has a!
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