This past December, the regulatory community telegraphed their intentions of focusing bank examinations on commercial real estate (CRE) concentrations in 2016: “During 2016, supervisors from the banking agencies will continue to pay particular attention to potential risks associated with CRE lending” (SR 15 17, Dec 2015). They cited intense CRE loan originations, competitive pressures, and concomitant loosening of underwriting standards (higher underwriting exceptions, less restrictive loan covenants, etc.) to explain their renewed attention to the CRE Concentrations guidance issued in 2006.
This special attention is starting to impact banks in the form of more “Matters Requiring Attention” (MRAs) in examinations and a greater number of enforcement actions. A recent article in SNL entitled, ”Banks with elevated CRE exposures in the crosshairs,” highlights several examples of banks held to higher than well-capitalized capital standards or specifically called upon to further develop CRE concentration risk management programs.
Since many banks are feeling this pressure (including ourselves), we thought it would be helpful to highlight the latest set of best practices. For help, we turned to the team over at Credit Risk Management Analytics (CRM) that probably helps more banks with this issue than any other firm.
The good news here is that the guidance on CRE Concentrations is quite mature. The regulatory agencies have outlined the controls and risk management practices that ought to be in place to address this heightened concern, and bank experiences with concentration control in light of the guidance offer a multiplicity of lessons. In this blog, we cull from this material and CRM’s experience to step you through what your bank may want to consider to better manage concentration risk.
What Banks Should Care
This guidance is for every lending institution—even if you are not currently in excess of the 300% / 100% CRE regulatory guidelines. The 2006 guidance specifically highlights that the supervisory criteria do NOT “constitute a ‘safe harbor’ for institutions if other risk indicators are present” (CRE Guidance, Dec 2006). The “prudent risk management practices that identify, measure, monitor and manage the risks arising from CRE lending activity” Regulatory guidance, SR 15 17, Dec 2015, can be applied to all bank exposures, and it can form the backbone of a firm-wide portfolio and risk management framework.
What To Monitor
CRE and construction & development (C&D) concerns were certainly the basis for the original guidance, and unlike some regulatory hot-buttons, recent experience has borne out the merits of this concern for banks of all sizes. A recent OCC study of the “great recession” period from 2007-2011 found a 46-fold increase in bank failure rates for institutions exceeding the CRE regulatory guidelines (An Analysis of the Impact of the Commercial Real Estate Concentration Guidance, April 2013).
Importantly, the concentration guidance pertains to all of a bank’s concentrations. Indeed, history is replete with variegated stressed asset classes that have caused a higher incidence of losses and bank failure rates. This can be seen graphically on CRM’s timeline below:
As such, the OCC explicitly indicates: “[A]lthough a concentration has not proven problematic in the past does not mean that it is precluded from becoming a problem in the future. For this reason, bank management needs to monitor and assess the potential risk arising from all of the bank’s credit concentrations” (emphasis ours) (Comptroller’s Handbook on Concentrations of Credit, Dec 2011).
Putting This Into Action
A good risk management program starts with understanding and monitoring the issue. To do this there are two simple rules on how to monitor your concentrations:
- product (e.g., Call Report code, collateral type),
- by geography,
- by industry (NAICS code with sector hierarchies),
- by correlations (grouping of lending lines that move closely with each other and/or with the general economy)
- Monitor (for each segment calculate the following):
- loan volume relative to risk-based capital,
- growth (1-year and 3-year, in particular) and
- asset quality: e.g.,
- Lagging indicators: criticized/classified rate, non-performing as a percentage of capital or loans, delinquencies, trouble debt restructuring percentage (TDR), etc.
- Leading indicators: underwriting exceptions, servicing exceptions, loan review downgrades, documentation exceptions, avg. credit score, loan-to-value ratio, debt service coverage ratio, etc.
- Loan Pricing: avg. rate, avg. spread, avg. floor, % with floors, % variable, etc.
- Forecast: Loss rate, probability of default (POD), loss given default (LGD), stressed losses, avg. debt service coverage ratio at time of stress, etc
While your bank likely does most of the above, CRM recommends going farther and ensure you retain global relationship, channel, appraiser and loan officer details during your concentration analysis. Not only is the Concentration Guidance the functional equivalent to an extension of the Loans-to-One-Borrower Guidance, but by allowing drill-down and drill-through to origination details you can better monitor potential systemic risk issues and spot trends early. Further, knowing origination details helps translate strategic concepts to tactical relevancy. You can effectuate change and mitigate risk at the relationship and project levels.
To give you a feel for what some of these reports might look like, CRM was able to provide a portion of their state-of-the-art Concentration Analysis reports.
Here is an example of Excel-based NAICS-code hierarchies:
And, an example of geographic concentration report (with Census Bureau context):
How to Incorporate ALLL and Stress Testing
While measuring risk-based capital, growth and asset quality across these various concentration segments is a great starting point, the guidance recommends:
- Incorporating this concentration analysis within the allowance for loan and lease loss (ALLL) calculations,
- using this analysis for credit concentrations within the 9 “regulatory” Q&E Risk Factors,
- use this analysis as the basis for documenting marketplace conditions and collateral value trends with respect to your Q&E and large concentrations, and;
- Utilizing both portfolio-wide and loan-level stress testing.
These additional steps will inform whether your bank is holding sufficient capital relative to current and future concentration risk.
When considering stress testing relative to CRE Concentrations, it is important to remember that there are two types of stress tests recommended by the regulatory community: loan-level and firm-wide stress tests. For example, the OCC highlights “Banks of all sizes will benefit by supplementing stress testing of significant individual loans with portfolio and firm-wide stress testing. The overall goal is to quantify loss potential and the impact on earnings and capital adequacy” (Comptroller’s Handbook on Concentrations of Credit, Dec 2011).
Bank-wide Stress Testing
It is often constructive to start with firm-wide stress tests: doing so will help (a) quantify aggregate loss potential and capital impact, (b) inform current ALLL reserves relative to this risk (think Q&E), and, (c) focus on individual pools of loans that may benefit from additional loan-level stress testing. In order to enable this trifecta benefit, be sure to retain loan-level stress test granularity so when you slice-and-dice your loan portfolio by the minimum segmentations highlighted above (i.e., product, industry and geography). You can also identify those pools of loans that might look okay today from an asset quality, capital and growth perspective but may drive elevated losses under stress.
Your firm-wide stress testing will be more effective and defensible if you can consider multiple scenarios. By way of example, CRM’s loss stress testing methodology (HERE) uses both (a) a bottom-up, parameter stress test (POD’s stressed probabilistically to a 1-in-10 year and 1-in-25 year event, LGD’s stressed using a Basel II Downturn Function, Correlation assumptions stress to capture potential contagion effects) and (b) a top-down, econometric stress test (based on a regression analysis of macroeconomic effects on asset-class-specific loss rates applied over the Federal Reserve’s DFAST forecast of baseline, adverse and severely adverse losses (with specific reserves stressed to historically observed severity levels).)
Once you have the baseline, adverse and severely adverse aggregate loss potential, it is very helpful for strategic planning and capital planning purposes to run these losses through your balance sheet and income statement in order to quantify and explain the prospective impact to your capital ratios. That is to say, you want to quantitatively support the answer to the question, “Do you have enough capital?”
While formally performing a DFAST or CCAR analysis is only required for banks larger than $10B in assets, smaller banks should perform similar exercises to add valuable risk management insights. To that point, because such analysis isn’t prescribed, banks have the latitude to simplify such analysis in order to make it cost and time effective. Such capital impact analysis based on firm-wide stress testing can often be the lynchpin to your enterprise risk management program or to defending significant capital actions to your boards or regulators. For non-DFAST/CCAR community banks, this additional analysis is recommended if you wish to maintain concentration levels above the guidance limits.
Loan-level Stress and Asset-class Extrapolation
If you have a sensitive concentration (i.e., elevated RBC %, recent growth, current asset quality metrics, or stressed losses), such pools of loans are ideal targets for loan-level stress. Debt-service overage ratio is a good proxy for losses for these loan-level stress tests, and in this fashion you may be able to use SAME project-level underwriting spreadsheets that your bank uses for a CRE project to either (a) conduct a sensitivity analysis for all loans within an asset class or (b) extrapolate sensitivity results across an asset-class. For example, CRM uses a handy Income Property Underwriting Spreadsheet that will analyze DSCR across various sensitivities of interest rates and vacancies to identify the conditions under which DSCR falls below 1.25x or 1.0x. If your bank has a small enough pool of loans, you can run the same analysis across all loans within a particular
If your bank has a small enough pool of loans, you can run the same analysis across all loans within a particular asset class. Alternatively, the regulatory community seems to be comfortable having banks calculate the sensitivities of a subset of results (perhaps with updated financials obtained through annual review or loan review) and then extrapolating these results across the loan category. As the OCC opines: “Lenders may conduct less complex stress tests by evaluating borrower ‘what ifs,’ using little technical support. As part of the initial and ongoing credit analysis, a bank can alter assumptions to assess the impact on the borrower. The lender can then aggregate the results at the portfolio and firm-wide levels.
At smaller, less complex banks, management often can review a limited number of the largest credits or use statistical techniques to extrapolate results across portfolios. For example, the lender could alter assumptions about office space rental rates. This would permit the bank to determine at what rental rate a project could no longer service its debt. The lender could then aggregate the results across the portfolio to identify what percentage of the portfolio would be vulnerable to a 10 percent decrease in rental rates” (Comptroller’s Handbook on Concentrations of Credit, Dec 2011). For additional examples, the FDIC has outlined additional ways of applying transactional sensitivity analysis to a pool of loans (along with other stress tests commonly used in banks).
With the appropriate backward- and forward-looking monitoring in place, the next step is to establish the appropriate thresholds and triggers that can lead the monitoring to action. Here, too, the regulatory community has sided with prudence: while highlighting that the definition of a “concentration” is any correlated pool of exposures that exceeds 25 percent of the capital (Tier 1 + ALLL), they concede that “not all concentrations measured at this level… represent the same level of risk or require the same level of supervision” (Comptroller’s Handbook on Concentrations of Credit, Dec 2011). To help differentiate these pools, you can use the same combination of capital, growth and asset quality metrics that informs your monitoring regime in your bank’s concentration policies and escalation triggers. It is helpful to monitor performance against multiple threshold levels such as: regulatory guidelines, board-level targets for critical concentrations, and management-level targets. The OCC specifically stipulates that when “banks set higher concentration limits for broadly defined pools—especially where those limits are more than 100 percent of capital—the OCC expects appropriate sub-limits for material groups of segmented exposures” (
To help differentiate these pools, you can use the same combination of capital, growth and asset quality metrics that informs your monitoring regime in your bank’s concentration policies and escalation triggers. It is helpful to monitor performance against multiple threshold levels such as: regulatory guidelines, board-level targets for critical concentrations, and management-level targets. The OCC specifically stipulates that when “banks set higher concentration limits for broadly defined pools—especially where those limits are more than 100 percent of capital—the OCC expects appropriate sub-limits for material groups of segmented exposures” (Comptroller’s Handbook on Concentrations of Credit, Dec 2011).
As CRM points out, a too-common pitfall is for banks to raise limits at the first sign of concentration strain. Remember that a wide array of mitigation strategies exist for managing elevated concentration risk—especially when caught early and caught (and documented) internally. These include:
- Modify underwriting strategies and loan structures
- Modify growth targets (and renewal strategies)
- Increase credit supervision
- Alter exposure limits or credit risk benchmarks
- Obtain insurance or guarantees
- Sell off loans or loan participations
- Hold additional capital
- Buy credit derivative protection
Conclusion: The Difference Between “Guidelines” and “Limits”
With the risk management infrastructure outlined above, banks can engage in lending activities in a safe and sound manner even with concentrations in excess of the regulatory guidelines. Indeed, the guidance repeatedly stresses that “numeric indicators do not constitute limits” and “The Guidance does not establish specific CRE lending limits; rather, it promotes sound risk management practices and appropriate levels of capital that will enable institutions to continue to pursue CRE lending in a safe and sound manner” (CRE Guidance, Dec 2006).
Diversification is always important but often banks are strategically constrained. In these cases, concentration management is a critical skill all banks need to develop. Viewing risk through this lens is critical because of its comprehensive and holistic treatment of credit underwriting standards, baseline/stressed performance monitoring and reserve/capital considerations at the line-of-business level. Taking this analysis and using it to set reserve levels, budgets, strategic planning and to tactically manage borrower and channel relationships will move your bank’s concentration risk management practices to the vanguard of the industry.
Submitted by Chris Nichols on August 01, 2016