With commercial real estate markets deteriorating, Comptroller of the Currency John Dugan urged bankers Thursday to take proactive steps — or face harsh treatment from examiners.
Speaking in Florida, where nonperforming loans are multiplying as values plummet, Mr. Dugan said bankers should be beefing up reserves, vigorously stress-testing their portfolios, and updating property appraisals.
"I can't stress enough how important it is for you to make these realistic judgments yourselves, based on sound credit administration practices, instead of forcing our examiners to try and make these same judgments in the first instance," he said in remarks prepared for a meeting of the Florida Bankers Association in Miami. "For those of you in stressed markets, it will almost certainly require you to downgrade more of your assets, increase loan-loss provisions, and reassess the adequacy of bank capital."
Resurrecting an old feud between bank regulators and auditors, Mr. Dugan told the bankers not to worry about socking away money to cover bad loans.
"I firmly believe that, in this environment, increases in loan-loss reserves for many banks are both warranted and prudent," he said. "I would be extremely surprised if your auditors disagreed with this position," but "if we have to intervene in this situation, we will not hesitate to do so."
Fresh appraisals are crucial in a declining market, Mr. Dugan said.
His agency has already noticed "an increasing number of instances in which appraisals on file have become outdated with respect to current market conditions," he said. "That in turn can make it very hard to assess the true credit quality of loans on the books."
Mr. Dugan said some bankers are not heeding the guidance regulators issued in 2006 to improve risk management at institutions with high concentrations of CRE loans.
"Despite our previous guidance, a number of banks with CRE concentrations have not extended their stress-testing of income-producing properties beyond interest rates to other business variables that affect risk, such as vacancy rates, lease rates, and expense scenarios — not only at the time the loan is made but also periodically throughout the life of the credit relationship," he said.
"The potential for rapid deterioration in this business is simply too great not to conduct such testing on an ongoing basis."
The ratio of CRE loans to capital at community banks overall has almost doubled in the past six years, to 285%, and more than one-third of the country's community banks have concentrations exceeding 300% of their capital.
Mr. Dugan singled out a subset of these portfolios as particularly troubling: residential construction and development loans.
The share of national banks' construction and development loans that were not performing as of Sept. 30 more than doubled from a year earlier, to 2%, he said.
This problem is amplified in Florida, where the share of such loans greatly exceeds the national average. For nationally chartered community banks in the state, nonperforming construction and development loans have increased to 3.34% of all such loans, though this share had been 40 basis points below the national average a year earlier.
Mr. Dugan warned bankers against sitting back and watching as risky loans turn into damaged assets. Community bankers have been "a little too complacent," he said, about the losses that could result from the surge in CRE lending.
"The idea is to recognize problems early and manage through them, with good and continual communications between examiners and bankers, before the problems fester and get worse," Mr. Dugan said.
Noting the failure of a small bank in Kansas City, Mo., last week, he predicted that CRE loans will fell other banks this year.
"There will be more criticized assets, increases to loan-loss reserves, and more problem banks," Mr. Dugan said. "And, yes, there will be an increase in bank failures."
