In the ancient world kings and emperors regularly sought advice from the Oracle at Delphi when making important decisions. The Oracle would respond to questions, sometimes in poetry, other times in prose, in a manner that sometimes required some interpreting. For example, King Croesus of Lydia asked about the wisdom of his taking on the Persian empire. The Oracle replied that “If you attack you will destroy a great kingdom.” Proving that one should always ask for details, Croesus lost the battle and the Persians, under Cyrus the Great, conquered his kingdom.
Some say that the closest thing we have to the Oracle at Delphi today is the triumvirate of the federal banking regulators, the Federal Reserve, the FDIC and the OCC. The “Oracle” prognosticates and bankers guide their business activities accordingly. Well, perhaps. There was that prediction back in 2006 called “Concentrations in Commercial Real Estate Lending, Sound Risk Management Policies” when the regulators pointed out that CRE concentration levels at community banks had increased from 156% of total risk based capital in 1993 to 318% in the third quarter of 2006. They noted that some banks had begun to relax underwriting standards as a result of strong completion for such loans. Overall, the guidance was a “soft” sort of warning that bankers needed to make sure they understood how to manage the risk they were undertaking. A year or so later the economy was collapsing and banks beginning to fail.
Admittedly, sometimes the pronouncements by the federal regulators are about as difficult to interpret as those from the Oracle of Delphi. Looking back now, however, it looks as if the regulators had been pretty prescient about what was about to occur. Interestingly, or perhaps ominously, the regulators have decided to update their guidance in a document entitled “Statement on Prudent Risk Management for Commercial Real Estate Lending” published in December of 2015. In it they note that many CRE asset and lending markets are experiencing substantial growth, and that bank CRE concentrations are rising. They also reported an easing of CRE underwriting standards, and observed a greater number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risks associated with these concentrations.
They go on to state the obvious which is that “financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure.” The last time the regulators spoke out about CRE concentration risk they received a pretty strong pushback by bankers. It turns out, however, that the regulators were correct in their criticism. CRE lending has rebounded since the recession and is now above pre-2007 levels. Senior bank management and bank boards should expect that their management of CRE will be under increased scrutiny during safety and soundness examinations in 2016. Examiners will be looking to see if the bank has adopted appropriate:
- loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a designated committee;
- lending strategies, such as plans to increase lending in a particular market or property type, limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate in light of changing market conditions; and
- strategies to ensure capital adequacy and allowance for loan losses that supported an institution’s lending strategy and were consistent with the level and nature of inherent risk in the CRE portfolio.
In addition, examiners will be placing a great deal of attention on whether the bank’s underwriting includes a global cash flow analyses based on reasonable (not speculative) rental rates, sales projections, and operating expenses to ensure the borrower had sufficient repayment capacity to service all loan obligations. One of the hallmarks of the reviews conducted by the FDIC Office of Inspector General after the multitude of bank failures over the last eight years has been the fact that banks had become project focused and not borrower focused. Their underwriting was only focused on a particular project and completely disregarded the overall financial picture of the developer and guarantors. It is a certainty that any bank that does not focus on the global cash flow of a borrower is simply inviting regulatory criticism.
Bank examinations will also be looking at whether banks have conducted stress testing on the CRE loan portfolio to see how a downturn will affect the loan portfolio and the bank’s capital. Finally, they will also be looking to see if boards and senior management are being provided with the information to assess whether the lending strategy and policies continued to be appropriate in light of changes in market conditions. This last point cannot be emphasized enough, the regulators want and expect the boards to be focused on making sure that risk is being managed properly. Again, you can expect that management will be downgraded if the examiners are not satisfied on this point.