In April, a paper titled “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance” was issued. Written by Keith Friend and Harry Glenos, both with the OCC and Joseph B. Nichols of the Federal Reserve Board, the paper contains six parts that discuss the changes in CRE concentrations over time, their impact on bank failures and Bank’s Market Capital Ratio, and the Impact of the 2006 Interagency CRE Guidance and Market Conditions on CRE loan growth. The paper is chockfull of details, statistics, charts, and graphs and should be a must read if your bank engages in CRE lending. I’d like to point out some of the comments that I found particularly interesting:
- In 2006, 31% of all commercial banks exceeded at least one of the concentration levels specified in the supervisory criteria. These institutions held $378 Billlion in outstanding CRE loans which was almost 40% of all outstanding CRE loans industry wide. Banks that exceeded both supervisory criteria failed at a rate of 23%. Banks for which neither of the criteria was exceeded failed at a rate of only 0.5%.
- Banks that exceeded the Construction criteria failed at a rate of 13% and those that exceeded the Construction criteria alone accounted for an estimated 80% of the losses to the FDIC fund from 2007 to 2011. Of the “survivors” approximately 60% were in poor condition and received a CAMELS rating of 3, 4, or 5.
- Banks with total CRE growth greater than 50% (ignoring the other components) failed at a rate of 9.9%.
- Bank holding companies whose Construction concentrations were below 100% experienced a capital decline that was 3.6 percentage points less than those whose concentration exceeded 100%.
- Since then there has been significant reductions in the number of banks close to or above one of the thresholds. By the fourth quarter of 2011, the supervisory criteria applied to only 11% of institutions which held $298 Billion, or 34% of all outstanding CRE loans.
- The average construction concentration ratio fell from 77% in 2008 to 38% in 2011 primarily due to shrinking portfolios. The total CRE ratio declined from 177% to 141% over the same time period not nearly as dramatic of a decline as the construction ratio.
- A “non-trivial number of banks exceeding the supervisory criteria in 2007 continued to increase their CRE concentrations though 2011”. The authors believe that there is a core group of banks that specialize in or are particularly dependent upon CRE lending.
The paper reiterates the spirit of the 2006 Guidance which was not to place “hard caps” of 100/300% onto banks, although during the comment period of this Guidance many institutions were afraid that would be the case. History has proven that regulators did not have that intention. The Guidance was meant to identify institutions that should have enhanced credit risk management practices, including stress testing, in place.
The paper does validate regulator’s concern for the buildup of CRE risk exposures on bank’s books over the previous two decades because “the recession also revealed that, while good risk-management practices and above-average capital are essential to mitigate risks associated with high CRE concentrations, they may not be sufficient to prevent bank failure.”
To download the full paper visit the OCC website.