Samantha: Hello,this is Samantha Shares.
This episode covers an advisory Letter issued by the F D I C on Managing
Commercial Real Estate Concentrations in a Challenging Economic Environment.
These principles apply to all financial institutions which
is why we are sharing it here.
Both were issued December eighteenth.
The following is an audio version of that advisory and the press release.
This podcast is educational and is not legal advice.
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And now the advisory letter.
Summary:
The F D I C is issuing this advisory to reemphasize the importance of strong
capital, appropriate Credit loss allowance levels, and robust Credit risk-management
practices for institutions with commercial real estate (C R E) concentrations.
It also conveys several key risk management practices for institutions
to consider in managing C R E loan concentrations in the current
challenging economic environment.
Additionally, the advisory reemphasizes the importance of effectively managing
liquidity and funding risks, which can compound lending risks, particularly
for C R E-concentrated institutions.
This advisory replaces the TWO THOUSAND EIGHT advisory: Managing Commercial
Real Estate Concentrations in a Challenging Environment (issued March
SEVENTEENTH , TWO THOUSAND EIGHT).
Statement of Applicability: The contents of, and material referenced
in, this letter apply to all F D I C-supervised financial institutions.
Editorial note: N C U A examiners often refer credit unions to F D I C guidance.
Highlights:
The F D I C is issuing this letter to reemphasize the importance of strong
capital and credit loss allowance levels, as well as robust credit risk
management practices, for institutions with concentrated C R E exposures.
Institutions with significant C R E concentrations are advised to consider
the risk management principles discussed in the joint Guidance on Concentrations
in Commercial Real Estate Lending, Sound Risk Management Practices (issued December
6, two thousand and six6), and the Interagency Policy Statement on Allowances
for credit Losses (Revised April twenty seven, two thousand and twenty three).
The advisory also identifies key risk-management actions for financial
institutions with significant C R E concentrations to manage through
changes in market conditions:
Maintain strong capital levels,
Ensure that credit loss allowances are appropriate,
Manage construction and development (C AND D) and C R E loan portfolios closely,
Maintain updated financial and analytical information,
Bolster the loan workout infrastructure, and
Maintain adequate liquidity and diverse funding sources.
Institutions are encouraged to continue making C R E credit available in their
communities using prudent lending standards that rely on strong underwriting
and loan administration practices.
The full text of the letter follows.
Managing Commercial Real Estate Concentrations in a
Challenging Economic Environment
This advisory to insured state non-member banks and savings associations
reemphasizes the importance of strong capital, appropriate Credit loss allowance
levels, and robust Credit risk-management practices when managing commercial
real estate (C R E) concentrations.
This advisory replaces an advisory issued in TWO THOUSAND EIGHT1 that
emphasized these same points during a time when C R E market conditions had
weakened, most notably in the construction and development (C AND D) sector.
This advisory conveys several key risk management practices for F D I
C-supervised institutions to consider in managing C R E loan concentrations in the
current challenging economic environment.
The advisory also continues to emphasize the importance of effectively managing
liquidity and funding risks, which can compound lending risks, particularly
for C R E- concentrated institutions.
This advisory does not create new risk management principles;
however, it does update and build upon previously issued guidance.
Previous Challenging Economic Environments
The F D I C recognizes that financial institutions play a critical role in
the economic vitality of the communities they serve by providing Credit for
businesses, often for C R E purposes, including real estate development.
However, concentrations in C R E lending add dimensions of
risk that warrant attention.
C R E lending concentrations, combined with weak risk management practices,
contributed significantly to past asset quality problems and bank failures.
One example is the banking and thrift crisis of the 1980s and early 1990s.2
Bank decisions to loosen C R E lending standards during the 1980s were based
primarily on the assumption that real estate values (collateral values)
would continue to rise in the future as they had in the then recent past.
Another example is the banking crisis of TWO THOUSAND EIGHT to twenty thirteen
which impacted the many financial institutions that had greatly increased
their holdings of, and concentrations in, in particular, loans to finance
the development and construction of real estate (C AND D loans) in the
period leading up to the crisis.
In these crises, when C R E markets deteriorated, poor management
of C R E lending concentrations led to increased Credit losses.
Further, many C R E- concentrated institutions that failed also relied
on funding sources other than stable deposits and had lower levels of capital.
Current Challenging Economic Environment and Real Estate Conditions
Recent weaknesses in the current economic environment and in fundamentals
related to various C R E sectors have increased the F D I C’s overall concern
for state nonmember institutions with concentrations of C R E loans.
C R E market and lending conditions have been significantly influenced by
governmental and societal responses to the pandemic, rapidly rising interest rates,
and the prolonged inverted yield curve.
Also, C R E investment property capitalization rates have not kept
pace with recent rapid increase in long-term interest rates, which
leads to concerns about general over-valuation of underlying collateral.
C R E vacancy rates are rising, most notably in the office
sector, but also in multi-family.
Office vacancy rates are affected by the demand for traditional
office space, which has slowed due to the popularity of remote work.
Office attendance is approximately 50 percent of its pre-pandemic level.
In addition to large amounts of available space, high levels of office
loans and office leases are maturing or expiring in the next few years.
The multi-family sector vacancy rate is also high in some markets, due
in part to potential overbuilding.
Rapid absorption of multi-family space experienced in twenty twenty
one has since slowed, while the pace of new construction remains brisk.
Refinancing office and multi-family loans could be challenging in an environment
of pressured rent growth, higher interest rates, and lower property values,
particularly for those institutions with C R E concentrations in areas with
surplus office and multi-family space.
The F D I C’s concern also extends to the subset of banks with elevated C AND
D concentrations, which subset has risen in recent quarters, but remains well
below the two thousand and seven peak.
Banks with significant exposure to C AND D loans had substantial Credit
losses during the TWO THOUSAND EIGHT-two thousand thirteen banking
crisis, and banks currently engaged in C AND D lending could be affected
by weaknesses in the current economic environment and real estate fundamentals.
The F D I C continues to be concerned that institutions with concentrated C
R E exposures may be vulnerable to real estate downturns and is reminding such
F D I C-supervised institutions of the importance of ensuring that Credit risk
management practices are strong, reliable funding sources are in place and liquidity
contingency plans are robust, property valuation policies and procedures capture
changes to property values, capital and allowance for Credit losses (A C L) levels
are appropriate, and workout processes are well-defined and ready to be deployed.
It is strongly recommended that, as market conditions warrant, institutions with C R
E concentrations (particularly in office lending) increase capital to provide
ample protection from unexpected losses if market conditions deteriorate further.
Managing C R E Concentrations
In December two thousand six, the F D I C and the other prudential regulators
issued Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices (C R E Guidance).
Institutions with significant C R E concentrations are reminded that
strong risk management, governance, capital, and appropriate ACL levels
are needed to help mitigate risks.
Institutions with overall Credit risk management processes that reflect
consideration of the principles of the two thousand six C R E Guidance
are better positioned to manage through adverse economic environments.
The principles in the two thousand six C R E guidance remain relevant,
particularly in challenging economic environments, and particularly for
institutions engaged in significant C R E lending strategies to help them remain
healthy and profitable while continuing to serve the Credit needs of the community.
The F D I C has identified six key risk-management actions to help
institutions with significant C AND D and C R E concentrations manage
through changes in market conditions:
Maintain Strong Capital Levels
Capital provides institutions with protection against unexpected losses,
particularly in stressed markets.
Institutions with significant C AND D and C R E exposures may require
more capital because of uncertainty about market conditions causing an
elevated risk of unexpected losses.
As market conditions warrant, proactive directorates and management take steps
to increase capital levels to support significant C R E concentrations and
mitigate the impact of potential loss.
Maintenance of an appropriate level of capital to protect an institution
from unexpected losses related to C AND D and C R E concentrations
is an important consideration when contemplating cash dividends.
Ensure that Credit Loss Allowances are Appropriate
Institutions are expected to determine their A C L’s in accordance with
U S generally accepted accounting principles (GAAP) and regulatory
reporting instructions, relevant supervisory guidance, their
stated policies and procedures, and management’s best judgment.
Prudent Credit management includes periodic, at least quarterly, analysis
of the collectability of C R E and all other exposures and maintenance of A
C L’s at a level that is appropriate to cover expected Credit losses on
individually evaluated loans, as well as expected Credit losses in
the remainder of the loan portfolio.
In reviewing their A C L methodology, institutions with significant C AND D
and C R E concentrations are advised to consult recent supervisory guidance.
In accordance with GAAP, management should consider the effects of past
events, current conditions, and reasonable and supportable forecasts on the
collectability of the institution’s loans.
Specifically, GAAP requires management to use relevant forward-looking
information and expectations drawn from reasonable and supportable forecasts
when estimating expected Credit losses.
While historical loss information generally provides a basis for an
institution’s assessment of expected Credit losses, management should consider
whether further adjustments to historical loss information are needed to reflect
the extent to which current conditions and reasonable and supportable forecasts
differ from the conditions that existed during the historical loss period.
Manage C AND D and C R E Loan Portfolios Closely
Consistent with Parts 3 6 4 and 3 6 5 of the F D I C Rules and Regulations and
their appendices, institutions should maintain prudent lending standards
and Credit administration practices that consider the risks of material
C AND D and C R E concentrations.
This includes management information systems that provide the board and
management with relevant data on concentrations levels and related market
conditions, including for concentration or market segments, as appropriate.
Portfolio and loan level stress tests or sensitivity analysis can be an invaluable
tool in identifying and quantifying the impact of changing economic conditions
and changing loan level fundamentals on asset quality, earnings, and capital.
Applying adverse scenarios while conducting stress tests or sensitivity
analysis helps banks adjust risk management processes, capital planning,
liquidity management, collateral valuation processes, and workout procedures to
prepare for Credit risk problems before they impact earnings and capital.
Additionally, appropriate risk management practices include maintaining
a strong Credit review and risk rating system12 that identifies
deteriorating Credit trends early.
It is important for institutions to effectively manage interest reserves
and loan accommodations,14 reflecting the borrower’s condition accurately in
loan ratings and documented reviews.
Maintain Updated Financial and Analytical Information
Prudent institutions with C R E and/or C AND D concentrations
maintain recent borrower financial statements, including property cash
flow statements, rent rolls, guarantor personal statements, tax return data,
and other income property performance information to better understand their
borrowers’ ability to repay and overall financial condition and enable timely
identification of adverse trends.
Such institutions emphasize global financial analysis of obligors,
including in relation to pending loan maturities and lease expirations,
as well as the concentration of individual property owners, builders,
or developers in a loan portfolio.
As real estate market and individual property conditions change, it is
important for management to consider the continued relevance of appraisals
and evaluations performed during prior economic or market and interest rate
conditions, and update collateral valuation information as necessary.15
Maintaining updated financial and analytical information provides key
inputs to foster meaningful stress testing or scenario analysis described above.
Bolster the Loan Workout Infrastructure
Well prepared institutions ensure they have sufficient staff and appropriate
skill sets to properly manage an increase in problem loans and workouts.
Likewise, institutions that have a ready network of legal, appraisal,
real estate brokerage, and property management professionals to handle
additional prospective workouts are better situated for more positive outcomes.
Maintain Adequate Liquidity and Diverse Funding Sources
Since liquidity and funding risks may be compounded in challenging interest
rate and economic environments, it is important for institutions to have a
comprehensive management process for identifying, measuring, monitoring, and
controlling liquidity and funding risks.
Recent industry events have underscored risks related to relying on funding
concentrations, such as high levels of uninsured deposits, and the importance
of robust liquidity risk management and contingency funding planning.
Institutions that have identified appropriate levels of cash and cash
equivalents, that have identified and are able to use a stable and diverse
range of funding mechanisms, and that have identified and tested sources
of contingent liquidity, including establishing and testing access to
the Federal Reserve Discount Window, are better positioned to profitably
support C R E concentrations.
As with any asset exposure, significant C R E concentrations
can lead to losses and capital deficiencies in a stressed environment.
The F D I C’s examiners recognize the challenges facing institutions in the
current C R E environment, and will expect each board of directors and management
team to strive for strong capital and appropriate A C L levels, and to implement
robust Credit risk-management practices.
Institutions are encouraged to continue making C AND D and C R E Credit available
in their communities using prudent lending standards that rely on strong underwriting
and loan administration practices.
The Appendix includes selected F D I C regulations, supervisory guidance,
and other relevant information for additional details about
matters discussed in this advisory.
Refer to the F D I C’s regulations, supervisory guidance, and other
information for additional details about matters discussed in this Advisory.
This concludes the F D I C advisory Letter on managing commercial
real estate concentrations in a challenging economic environment.
F Y I, the co author of the NCU A's Commercial loan rule is a member of our
team at Credit Union Exam Solutions.
If your Credit union could use assistance with your exam, reach out to Mark Treichel
on LinkedIn, or at mark Treichel dot com.
This is Samantha Shares and we Thank you for listening.