Proposed Changes to Risk-Based Capital Framework for Banks: Potential Effect on Risk-Weighting of Commercial Real Estate (CRE) Loans

Morrison & Foerster LLP

Background. As part of an international effort to recalibrate how banks calculate their risk‑based capital, U.S. bank regulatory agencies (the “Agencies”) recently proposed major changes to how banks would be required to risk-weight their loans, including CRE loans.[1] If adopted, the proposal could ultimately affect how banks underwrite and price CRE loans.

According to the Agencies’ estimates, the proposal would slightly decrease risk-weighted assets attributable to retail and commercial real estate exposures and slightly increase risk-weighted assets attributable to corporate, residential real estate, and securitization exposures. The proposal is highly controversial and is expected to generate comments from across the industry.

The comment period for the proposal ends on November 30, 2023. The Agencies do not anticipate making a final rule effective before July 1, 2025. The proposal contemplates a three‑year phase-in period (i.e., through June 30, 2028) for most of its provisions.

Current Risk-Based Capital Framework: All U.S. banks calculate their risk-weighted capital using the so-called “standardized approach.” That is to say, the risk-weighting applied to specific categories of loans is set by regulation. In addition, a designated group of the largest banks, known as “advanced approaches banks,” also risk-weight their loans using internal modeling—the so-called “internal ratings-based approach.” Generally, advanced approaches banking organizations are the largest U.S. banking organizations and the bank subsidiaries of those firms.[2] Advanced approaches banks are required to use both the standardized approach and the internal ratings‑based approach and then determine their risk-based capital using the least favorable of the two approaches.

Risk-Weighting of CRE Loans under the Standardized Approach[3]

  • CRE loans are generally assigned a 100% risk weight; and
  • Acquisition, development, and construction (ADC) CRE loans designated as high‑volatility CRE (HVCRE) loans[4] are assigned a 150% risk weight.

Summary of the Proposal

The proposal applies only to banking organizations with $100 billion or more in total assets (“Covered Institutions”). Smaller institutions would continue to calculate risk-based capital using the existing standardized approach.

Under the proposal, Covered Institutions would be required to use both the existing standardized approach and a newly crafted regulatory “expanded risk-based approach” and be subject to the greater of the resulting ratios for their minimum risk-based capital requirements. The internal ratings-based approach for credit risk would no longer be used.[5] The new expanded risk-based approach is intended, among other goals, to be more risk-sensitive and to limit variation in capital requirements among similarly situated financial institutions.

Proposed Risk Weights for CRE Loans

The proposal would apply the same risk weights provided in the existing standardized approach to HVCRE loans. ADC loans that are not HVCRE loans would be risk-weighted at 100%, as is currently the case under the standardized approach.

Certain other CRE loans would be subject to a range of risk weights based on certain credit drivers. These “Regulatory CRE exposures” are those that meet the following criteria:

(i) the loans are primarily secured by fully completed real estate;

(ii) the loans are fully secured by a first lien;

(iii) the loans are made in accordance with prudent underwriting standards, including loan-to-value (LTV) standards;

(iv) the loans are underwritten pursuant to credit policies that account for the ability of the borrower to repay in a timely manner based on clear and measurable underwriting standards that enable the banking organization to evaluate these credit factors; and

(v) the property is valued in accordance with proposed LTV requirements.[6]

The applicable risk weights for regulatory CRE exposures, where repayment is dependent on the cash flows generated by the property, would range from 70% to 110% depending on the applicable LTV ratio. For regulatory CRE exposures not dependent on such cash flows, (i) if the applicable LTV ratio is 60% or less, these loans would be assigned the lesser of the risk weight applicable for credit extended to the particular borrower, or 60% and (ii) if the applicable LTV ratio is more than 60%, these loans would be assigned the risk weight for credit extended by the bank to the particular borrower (or 100% if insufficient information is available).

Final Observations

Financial institutions carefully ration their capital. The higher the risk weight for a CRE loan, the more capital that a bank will need to apportion to that loan. In turn, the risk weight will likely influence pricing. Directly or through CRE industry interest groups, the real estate industry should carefully follow the proposal described in this client alert as it evolves and takes final shape under the weight of public comment and discourse.

[1] See our Client Alert on the capital proposal.

[2] In general, advanced approaches banking organizations are those that (i) are U.S. global systemically important, (ii) have over $700 billion in total assets, or (iii) have $100 billion or more in total assets and over $75 billion in cross-jurisdictional exposures, as well as their bank subsidiaries.

[3] All risk-weights in this client alert are for performing loans.

[4] See our Client Alert on how HVCRE loans are so designated .

[5] Banking organizations may still be permitted to use internal models to measure market risk.

[6] In addition, the exposure cannot be a regulatory residential real estate exposure, defaulted real estate exposure, ADC exposure, pre-sold construction loan, statutory multifamily mortgage, or HVCRE exposure (each of which is defined in the proposal).

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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