Last December, one federal agency began to grow increasingly concerned about commercial real estate loans. The Federal Deposit Insurance Corporation (FDIC), an independent agency created by Congress to maintain the stability of the nation's financial system and public confidence, didn't seem too confident about the concentration of commercial loans in the hands of a few lenders.
The agency issued letters to financial institutions warning banks and other lenders with high concentrations of commercial real estate loans, and the guidance lays out standards for banks to face increased regulatory oversight.
“Commercial brokers should be aware of the risk management analyses recommended by federal regulators so they can advise their clients on the best strategies for working with lenders.”
The standards included the 100/300 rule, which states that a lender's construction, land development, and other land loans that make up more than 100% of an institution's Tier 1 capital and allowance for credit losses (ACL) may be subject to increased scrutiny. The same rule applies to lenders with commercial real estate loan concentrations that exceed 300% of their Tier 1 capital and ACLs. According to the Federal Reserve Bank of St. Louis, roughly one-third of U.S. lending institutions have individual concentrations that exceed the 300% benchmark.
The criteria also include a 50% or greater surge in outstanding balances in a commercial loan portfolio over the past 36 months.Given the aggressive approach the Fed has demonstrated thus far, this is an early warning that greater scrutiny of banks' risk, liquidity, credit management, reserves and capital adequacy will be coming.
Commercial brokers should be aware of the risk management analysis recommended by federal regulators so that they can advise their clients on the best strategy for dealing with lenders. Risk management regulations also help brokers determine which lenders are best to approach when seeking a loan.
crisis management
The FDIC guidance emphasizes that financial institutions need to pay close attention to key areas and ultimately strengthen their credit risk management practices. Key areas for banks and other lenders include establishing stable and reliable sources of funding with robust liquidity contingency plans. They should also have access to the Federal Reserve's discount window, a program that allows for immediate access to funds, as a potential source of liquidity.
Key Point
Strengthening the Financial Condition of Commercial Lenders Lenders should expand their credit risk management operations. Financial institutions should establish stable and reliable sources of funding with liquidity contingency plans. Access to the Federal Reserve's discount window is a large source of potential liquidity. Maintaining adequate levels of cash and cash equivalents is important for lenders. Financial institutions should have access to stable and diversified funding mechanisms. Lenders should be able to demonstrate that their capital levels and credit loss reserves are adequate.
Maintaining adequate levels of cash and cash equivalents alongside stable and diversified funding mechanisms is key. Lenders should ensure that their valuation policies and procedures capture changes in real estate values. They should also ensure that capital and ACL levels are adequate and that they have defined and prepared workout processes to deploy in the event that credit losses turn out to be larger than expected.
Institutions with high commercial real estate concentrations, particularly office lenders, are required to significantly increase their capital reserves to provide adequate protection against unexpected losses. By implementing management information systems that provide adequate data on concentrations and related market conditions, institutions can better protect themselves against commercial real estate risks.
best practice
Risk is a constant changing subject for any financial institution. Every situation is different. By keeping a few risk management best practices in mind, banks and other lenders can better prepare for the increased regulatory scrutiny that will come.
Regular analysis of the recoverability of commercial loans and all other exposures, at least quarterly, will provide financial institutions with a better understanding of their current portfolio.Another area of focus is analysis to ensure that ACLs are maintained at appropriate levels to cover expected credit losses on individually assessed loans and the rest of the loan portfolio.
Maintaining a robust credit monitoring and risk scoring system helps identify deteriorating credit trends early in the process. Finally, financial institutions need to effectively manage interest reserves and contract terms, and ensure that loan appraisals and documented reviews accurately reflect borrowers' circumstances.
In accordance with generally accepted accounting principles, management is required to consider the effects of historical events, current conditions and reasonable and supportable forecasts in estimating expected credit losses. This estimate requires expectations from relevant forward-looking information and reasonable and supportable forecasts.
Next steps
In light of this information from the FDIC, banks should be reminded of the importance of maintaining up-to-date financial statements from borrowers, including property cash flow statements, rent ledgers, guarantor personal statements, tax return data, and other income property performance information.
Financial institutions are reminded to focus on their overall financial analysis, including maturity dates of outstanding loans, lease expiration dates, and concentrations of individual property owners, builders and developers within the loan portfolio. Brokers and their clients should be aware that federal regulators can request this information and be prepared to assist lenders in this process in any way possible.
Lenders should also re-evaluate the appropriateness of appraisals and valuations performed under previous economic and market conditions, and update collateral valuation information as market and individual property conditions change. Banks should ensure that they are conducting meaningful stress tests.
Finally, although not explicitly mentioned, a strategic operating plan is essential to inform regulators of the bank's future plans for commercial lending, liquidity, and capital. Lenders need to be clear about their ability to restructure if a loan defaults. The biggest gap for most banks is tracking the financial standing of borrowers and guarantors, real estate cash flow statements and rent ledgers, and forward-looking valuations.
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Brokers need to understand what regulators are looking for from lenders involved in commercial real estate lending, and lenders need to ensure they have the resources to collect what regulators require, now and in the future, as the environment continues to evolve. Financial institutions that want to be successful in commercial lending need to take steps now to eliminate risk and stabilize their future in the industry.
Brokers and their clients also need a proactive approach. Brokers need to work with lenders to provide them with all the information they need to help borrowers secure the loans they need and navigate an increasingly complex and regulated system.
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