Supervisory Insights, Fall 2019 was released Monday, December 23rd (technically winter, but written in the fall). The focus of the issue is commercial lending and, specifically, “Commercial Real Estate Loan Concentration Risk Management” and “Leveraged Lending: Evolution, Growth and Heightened Risk”. Why this choice? I’m speculating (and it could be any number of reasons including one analyst just happens to have an idea), but rewind to Supervisory Insights, Summer 2012 and page 9 “Stress Testing Credit Risk at Community Banks”.
SI Summer 2012 starts with how the “recent banking crisis illustrates how rapidly conditions can deteriorate and subject banks to considerable strain.” It suggests stress testing takes a larger role with the size and complexity of an institution. True enough, at the time. Types of stress testing mentioned in the publication are:
· Transactional Sensitivity Analysis
· Stressed Portfolio Loss Rates
· Scenario Analysis
· Loan Migration Analysis
· Reverse Stress Testing
An interesting point to make is that these types of stress testing were also highlighted in the 2006 CRE Guidance. Back to the question “Why this choice?”. Because conditions can deteriorate rapidly. Here’s the first takeaway:
“After shrinking following the 2008 financial crisis, the dollar volume of CRE lending at all IDIs began to grow again in 2013.”
Volume has been slowing since 2015, but as of June 2019, total volume held by all insured depository institutions (IDIs) is at an all-time high. More than 98% of all IDIs hold CRE loans and “holding a significant level of these credits could heighten an IDI’s vulnerability to a CRE market downturn.” One flag raised is that ALLL for IDIs with growing CRE portfolios (those they refer to as concentrated IDIs) is lower than other IDIs (.99% vs. 1.19%). They don’t mention the change in ALLL to CECL, but one can’t help wonder if there will be an impact to those CRE concentrated IDIs come January 2023.
Second: “Adopt and maintain written policies that establish appropriate limits and standards for extensions of credit secured by real estate.”
This sounds repetitive or even obvious. But in our consulting engagements we find inconsistency. Certainly, many FI’s have policies and procedures in place that are unique to their institution, address the need, and are regularly updated. We do find instances of “shared” policies. These policies may cover the requirement in a general way. However, examiners are looking for bank-specific language. The FIL “…requires FDIC-supervised IDIs to monitor conditions in the real estate market in their lending areas to make sure that their policies continue to be appropriate for current market conditions.” Stating you will monitor the conditions isn’t enough. What will you monitor and how?
The third takeaway: “Portfolio-level sensitivity analyses can help IDIs assess the extent of potential exposure to a downturn in CRE markets.”
Analysis requires data and programmed systems. It’s not practical to attempt even spreadsheet analysis given the variables of a CRE loan. Sensitivity analysis appears in the guidance in many areas, including IRR. And the FIL suggests management information systems (MIS) are an important tool for meeting the requirement. The FIL also identifies MIS as necessary to for the board to oversee the CRE portfolio. But meeting the requirement doesn’t stop at reporting. Many institutions are called out for 1) not integrating the results in their CRE program – that is using the results to adjust lending criteria – and 2) failing to “fully consider the results for budgeting, capital planning, and strategic planning purposes. To put this into perspective, the FDIC states that, of the IDIs reviewed, over 40% were handed recommendations related to sensitivity analysis.
CRE volume is at an all-time high, policies are inadequate, and sensitivity analysis needs a greater emphasis as part of a quality CRE program. To reiterate, conditions can deteriorate rapidly and this isn’t the first time the topic has been emphasized (see SI Summer 2020 and 2006 CRE Guidance.) This SI issue is sending a clear message: If you do nothing else before your next exam (and you are in the CRE lending business 1) document an awareness of your concentration of CRE, 2) update your policies and, 3) implement an analysis protocol and integrate it into your lending criteria.
Tom Parsons is national sales manager for NXTsoft Omnilytics, who’s product offerings include Credit Stress Analytics (with modules for CRE, Commercial and Ag Lending as well as CECL modelling). Tom can be reached at tparsons@nxtsoft.com