Why it matters

In a statement expressing concern about the growth of commercial real estate (CRE) lending, the federal banking agencies stressed the need to utilize "prudent risk-management practices." The Board of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency explained in FIL-62-2015 that they have observed "substantial growth" in CRE asset and lending markets, increased competitive pressures, rising CRE concentrations in banks, and an easing of CRE underwriting standards. To counter potential failure, the regulators advised banks to stay on top of the trend, emphasizing existing guidance for CRE risk management. "Financial institutions should maintain underwriting discipline and exercise prudent risk-management practices to identify, measure, monitor, and manage the risks arising from CRE lending," the agencies wrote. "Financial institutions should have risk-management practices and maintain capital commensurate with the level and nature of their CRE concentration risk." Examiners will be looking closely at CRE lending in the coming year, the joint statement noted, and institutions with inadequate practices may be required to tighten their underwriting standards, raise more capital, or create plans for better CRE portfolio monitoring.

Detailed discussion

The federal banking agencies—the Board of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC)—ended 2015 with a warning to financial institutions: don't forget regulatory guidance on prudent risk management practices for commercial real estate lending (CRE) activity during all stages of the economic cycle.

A CRE loan refers to a loan "where the use of funds is to acquire, develop, construct, improve, or refinance real property and where the primary source of repayment is the sale of the real property or the revenues from third-party rent or lease payments," the agencies explained in FIL-62-2015. CRE loans do not include ordinary business loans or lines of credit in which real estate is taken as collateral.

Why the concern? The regulators have observed "substantial growth" in many CRE asset and lending markets combined with increased competitive pressures that are contributing to historically low capitalization rates and rising property values. Between 2011 and 2015, multifamily loans increased 45 percent at insured depository institutions, according to the agencies, and composed 17 percent of all CRE loans held by financial institutions. The result: an increase in CRE concentrations at many institutions.

At the same time, examiners have noticed an easing of CRE underwriting standards, such as less restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. Coupled with a rise in exceptions to underwriting policies for CRE loans and insufficient monitoring of market conditions to assess the risks associated with CRE concentrations, the Fed, FDIC, and OCC felt the need to remind banks about their regulatory obligations.

To avoid weak risk management and remain consistent with supervisory expectations, the agencies offered financial institutions a refresher on existing guidance. For example, financial institutions should have established adequate and appropriate loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a designated committee.

Lending strategies (including plans to increase lending in a particular market or property type) should be carefully considered and reevaluated in light of changing market conditions, with strategies in place to ensure capital adequacy and allow for loan losses, consistent with the level and nature of inherent risk in the CRE portfolio.

The agencies recommended that the CRE portfolio undergo market and scenario analyses to quantify the potential impact of changing economic conditions on asset quality, earnings, and capital, with additional analyses conducted on global cash flow based on reasonable rental rates, sales projections, and operating expenses to understand whether the borrower has sufficient repayment capacity to service all loan obligations.

Boards and management need to be kept apprised of the need to change lending strategies and policies in light of market conditions, with continuing assessments of the borrower and the project during different stages of the loan, from interest only to amortizing payments and periods of rising interest rates. Procedures should be in place to monitor potential volatility in the market, the regulators said, such as the supply and demand for lots, retail and office space, and multifamily units.

"[F]inancial institutions should review their policies and practices related to CRE lending and should maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk," the agencies wrote. "In particular, financial institutions should maintain underwriting discipline and exercise prudent risk management practices that identify, measure, monitor, and manage the risks arising from their CRE lending activity."

Supervisors from the banking agencies will pay "special attention" to potential risks associated with CRE lending during 2016, the Fed, FDIC, and OCC warned.

"When conducting examinations that include a review of CRE lending activities, the agencies will focus on financial institutions' implementation of the prudent principles in the Concentration Guidance as well as other applicable guidance relative to identifying, measuring, monitoring, and managing concentration risk in CRE lending activities," the regulators said. "In particular, the agencies will focus on those financial institutions that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals."

If a financial institution is found to have inadequate risk management practices and capital strategies, examiners may require the bank "to develop a plan to identify, measure, monitor, and manage CRE concentrations, to reduce risk tolerances in their underwriting standards, or to raise additional capital to mitigate the risk associated with their CRE strategies or exposures."

To read FIL-62-2015, click here.

To read the agencies' joint Statement on Prudent Risk Management for CRE Lending, click here.