Community bankers are looking longingly at construction loans' relatively generous returns. What they're not seeing are the higher risk-weightings that may soon go along with such assets.

The Basel Committee on Banking Supervision is currently entertaining tougher capital rules for certain types of construction and commercial real estate loans. If the rules go through, they could ice small banks' plans for returning to profit growth, says Jonathan Hightower, a banking lawyer at Bryan Cave.

Banks "not only have to be more conservative now, but [they have] also got to be more conservative in the future," Hightower says.

Once the bread-and-butter of many small banks, construction lending dried up during the recession and financial crisis.

Mirroring the home building collapse, construction and development loans fell by $375 billion from mid-2008 through the third quarter of last year, to $250 billion, according to the most recent Federal Deposit Insurance Corp. data. At Sept. 30, construction and development loans accounted for about 7% of total loans at banks with assets of $10 billion or less. At bigger banks, such loans made up only 2% of loan books.

A recent spike in new housing starts, along with other signs of a modest economic rebound, has led to some optimism, however. Community bankers have been hoping that they might again be able to make loans for residential subdivisions, strip malls and other construction projects. Single-family housing starts rose 3.2% in May compared with a month earlier, as consumers took advantage of lower housing costs and record-low interest rates.

At the $720 million-asset SBC in Countryside, Ill., 41.7% of the loan book was in construction loans at March 31, the highest percentage of any banking company (although down from 75% of its portfolio five years ago). SBC isn't the only small bank to have placed a hefty emphasis on construction loans. Although most have reduced exposures to the asset category, C&D loans are still a huge portion of their business.

The Basel rules, if approved, would force many banks to become more cautious about construction loans, though it won't be an impossible task, says Damon DelMonte, an analyst at KBW's Keefe, Bruyette & Woods.

"This will act as a check and balance to make sure banks don't overextend in one asset class," DelMonte says. "Banks will be forced to be more prudent when making construction loans, but it won't prevent them from lending in this class."

Basel rules would require certain types of high-risk commercial real estate loans to carry a 150% risk weighting. That rule would cap the amount of leverage banks can use in making loans, leading lenders to look for deals where a developer would put in a significant amount of cash equity, Hightower says. Banks would be less likely to let developers rely just on the equity from appraisals.

"A lot of what we saw in the run-up to the downturn was developers using a piece of real estate as their equity," Hightower says.

Better-capitalized banks will be more likely to consider construction loans, DelMonte says. Though it varies by each bank, institutions with double-digit tangible common equity ratios would be best suited to devote more resources to such loans, he says.

Umpqua Holdings in Portland, Ore., is eager to make more construction loans after opening a loan office in Walnut Creek, Calif., in May. The $11.5 billion-asset company has said that it is looking at such loans because other banks are focused on commercial lending.

"Most of the construction loans we're doing today will probably be paid off before the rules go into effect," says Cort O'Haver, Umpqua's head of commercial banking. "It could put a chill on lending down the road, I'm not denying that. We'll have to evaluate it."

The United States has lagged other countries in its implementation of Basel 2.5, though U.S. regulators have voted to finalize its market-risk rule, and have released a proposal for a minimum capital requirement. Though the Basel rules on capital would not take effect until 2015, banks should take the possible rules into account now as they form long-term plans, Hightower says.

FNB United in Asheboro, N.C., should be ready. The $2.4 billion-asset company has reduced exposure to construction loans, cutting such loans as a percentage of its total book to 6% at March 31 from 19% a year earlier.

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