How Current HVCRE Rules Cause More Risk To Banks

Mitigating Construction Loan Risk

Back in June of 2013, the FDIC, OCC, and Federal Reserve jointly approved rules intended to implement new international banking standards. Known as the Basel III Capital Accords, Basel III uses a risk weighting system to determine the capital ratios for higher risk assets. Starting in 2015, all US banks that lend on “high volatility commercial real estate” (HVCRE) are required to hold more capital against such loans. The regulations had some well-intentioned objectives, but the final rule and its application, falls short of its goals, and in the process, potentially damaging to community banks. In this article, we look at this issue and steps smart community banks will take to mitigate the risk.


Rationale for HVCRE Regulation


The housing bubble was a significant contribution to the great recession. However, residential real estate continues to receive favorable regulatory treatment. Residential mortgages generally have a 50% risk weight. Most commercial real estate loans have a 100% risk weight.  However, HVCRE loans carry a 150% risk weight.  The higher risk weight requires a bank to retain more capital for the exposure. This higher capital charge makes the loans less profitable or requires higher pricing to achieve equal profitability.  The obvious intent for the banking industry is to discourage this type of lending and/or attempt to mitigate the inherent risk through the use of higher required capital.


Surveys conducted by the Federal Reserve, the OCC, and the FDIC all showed that a lowering of underwriting standards for acquisition, construction, and development (ACD) loans created substantial risk in the banking system. During the Great Recession, ADC loans disproportionately experienced distress and contributed to many bank failures. 


ADC loans are considered to be among the riskiest loans by regulators (OCC, FDIC, Federal Reserve).  Regulators believe (and correctly) that ADC loans often suffer from some of the following risks: non-amortizing; non-income producing; speculative in nature; having long development periods; subject to additional security interests (mechanics liens); and, have a higher probability of containing cost overruns and loan administration errors.


Problems with HVCRE Rules


HVCRE exposure is defined as “a credit facility that, prior to conversion to permanent financing, finances or has had financed the acquisition, development, or construction (“ADC”) of real property.”  Further, to be defined as HVCRE, the facility also must fail to satisfy any of the following three requirements: 1) LTV below certain guidelines, 2) borrower contributes capital to the project (in specific form) of at least 15% of the real estate’s appraised “as-completed value,” and, 3) the borrower fails to contribute the required capital before the lender advanced funds under the credit facility.


Both the real estate and banking industries responded negatively when the HVCRE rules were introduced. There are a number of problems with the rules. First, the rules apply only to banks and not to nonbank lenders, thus creating a competitive disadvantage for banks. Second, because borrowers cannot remove capital from a project at any point during the life without triggering an HVCRE designation, borrowers have no incentive to contribute more than the 15% minimum capital required (generally making all ADC loans riskier).  Third, the purchase price, but not the value of the contributed land, may be used to satisfy the 15% minimum capital – a peculiar abstraction of economics.  Fourth, the minimum capital contribution uses the as-completed value of the project, rather than its cost.  Again, a peculiar result if a borrower contributes 15% of the cost, and the lender contributes the remaining amount, but the added value of the project then creates HVCRE classification.


The biggest problem with the HVCRE rules is that the regulators identified substantial underwriting issues with ADC loans, and instead of advocating a loan-by-loan solution that allows banks to measure individual loan probability of default and loss given default based on the economics of the loan, regulators applied a blunt instrument causing a suboptimal allocation of risk. Developers easily circumvent the regulation, while often increasing the risk of the transaction. Worst of all is that banks and the industry, often believe they have complied with the regulation thus mitigating the risk.


By forcing banks to use an expected loss methodology, banks and borrowers would have been channeled to solve the problem together by increasing equity, by increasing collateral, or through loan structure. This methodology would serve to mitigate the known risk thus solving the problem.


The issue with ADC loans is that, as an asset class, it has been historically and will continue to be risky.  The graph below shows default rates for various loan types for banks between $300mm and $3B in assets.  This data shows that ADC loans have three times the default rate as the average non-ADC loan.  Further, the mean loss given default on ADC loans is 31% higher (at 57.4%) versus other CRE loans (based on FDIC’s 2015 working paper series).  That means that the average ADC loan should require 400% capital weight and not the 150% of capital mandated by the HVCRE rules. 


Loan Default Rates


The HVCRE classification is easily avoided on the majority of loans at community banks which will cause ADC loans to continue to grow. Underwriting standards will continue to deteriorate through this credit cycle resulting in higher losses and more bank failures out the backend of the next recession. The graph below shows the higher concentration of ADC loans at community banks compared to larger banks. The reason for this difference in affinity for ADC credit is a lack of rigorous risk measure at many institutions. If banks making ADC loans were to measure the true capital charge for these loans, the vast majority of these loans would not be made at the prevailing loan spreads.


Development Loans




The HVCRE regulations were aimed at solving an identified weakness within the banking industry – the lack of financial modeling to assess true risk/reward profiles for ADC loans.  However, the regulation is simply not refined enough to help banks manage credit risk.  As a result, banks will use the regulation as a crutch and under price the risk instead of mitigating the risk. The banking industry needs to further embrace of quantification of credit risk, and adopt risk-adjusted return on capital modeling for all loan underwriting decision – especially ADC loans.