As reported in the American Banker on July 22, regulators are again warning community bankers about commercial real estate lending and reminding them of the need to manage the impending risks.
A slide presentation by the Federal Deposit Insurance Corp.'s New York regional office made the following assertions: While CRE trends are "positive," there are "some signs of emerging risk"; new multifamily units under construction "exceed absorption"; and "underwriting standards may continue to relax with increased competition."
Such findings are eerily familiar to those of us in the banking industry who first read the interagency guidance on CRE risk back in 2006, which warned of an impending CRE downturn. The guidance called on institutions to adopt prudent CRE risk management practices, such as improved management of the portfolio and information systems, as well as "portfolio stress testing and sensitivity analysis."
But the industry was slow to comply with the guidance. And, with the economy having improved since the crisis, banks appear to be taking those guidelines less seriously as the regulators have eased monitoring.
None of this is surprising. When the 2006 guidance was in the proposal phase, the industry's reaction was tepid if not outright hostile. In a letter dated March 9, 2006, filed as a comment on the proposed guidance, the then-chief lending officer of a community bank stated: "Banks like [ours]…have already taken the necessary steps to implement and put into practice these sound risk management practices to properly insulate their commercial real estate portfolios from an economic downturn." Further, the banker added, "The requirement that community banks, such as [ours], routinely 'stress test' their entire CRE portfolio is simply not practical".
We all know what happened after 2006. Initially, implementation of risk management practices supporting that guidance was slow going. But eventually, with the fallout from the crisis making examiners more aggressive, sensible risk management practices like CRE concentration management and stress testing became an expectation of all banks by 2009.
But memories are short. Five years later, with real estate prices normalizing and the regulators focused on other matters besides CRE, many community banks had already stopped actively managing their CRE concentrations and performing valuable practices like CRE stress testing.
Under the 2006 guidance, CRE-related assets were subject to greater prudential oversight if an institution's land and construction/development loans were equal to 100% of total capital, or total CRE loans were 300% of total capital. Managing those thresholds were the bare minimum. Beyond that, most smaller banking institutions' concerns with following the regulators' recommendations ended. With CRE one of the few profitable avenues for community banks today, banks have essentially gotten back to business as usual as long as they fall below those capital thresholds.
While some banks that have exceeded the thresholds see no problem with managing their concentrations, many other community bankers tell a different story today. They stopped with their formal CRE portfolio stress testing program in 2014 or 2015 because they were not always being asked by their regulators in their safety and soundness exam for the results of their stress testing program. Their thinking was: why spend the time and resources if the regulators didn't care?
Yet regulators appear to be cracking down once again. Now, many community banks are being asked by regulators about their CRE concentration management and stress testing practices, and again they have to relearn the process and restart their programs. Instead of making such useful credit risk management best practices part of their normal risk management process in 2006 and 2007, many bankers dropped practices like stress testing as soon as they felt they could avoid it. This response has required the agencies to remind those bankers about the need to use risk management practices like stress testing to manage CRE risk, again.
Today, more and more community banks are being told again by their examiners to focus on CRE risk, be aware of a potential downturn and re-implement their CRE portfolio stress testing programs. Hopefully, their memories aren't so short that they have forgotten how they did it the last time, and this time make it a permanent part of their risk management practices.
Peter Cherpack is a principal at Ardmore Banking Advisors and Ardmore Fintellix LLC.