Concentration risk is continuing to draw close scrutiny from financial regulators, who are focusing in particular on lenders’ commercial real estate (CRE) concentrations. Banks and other financial services organizations are responding to this regulatory interest by looking for ways to improve their CRE risk management and credit portfolio management capabilities.
As they do, many are finding that a holistic and integrated approach for concentration management is much more effective than a piecemeal effort that attempts to address specific concerns or issues individually. In addition, many banks are finding that other initiatives, such as more-effective loan review and stress-testing programs, can further support their CRE concentration risk management and regulatory compliance efforts.
Regulatory agencies’ concerns over concentration risk are nothing new, of course. As far back as the savings and loan crisis of the 1980s, the financial services industry has recognized that lending institutions with high CRE credit concentrations and weak risk management practices are exposed to a greater risk of loss. Depending on the markets they serve and the competition they face, lending institutions can develop CRE concentrations that expose them to significant risk during economic downturns, especially in certain geographic areas. If regulators determine a bank lacks adequate policies, credit portfolio management, or risk management practices, they may require it to develop more robust practices to measure, monitor, and manage concentration risk.
In addition to imposing specific requirements on individual institutions, federal regulatory agencies also have issued general guidance to help banks avoid developing dangerous CRE concentrations. In 2006, for example, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) issued joint guidance titled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.”
In 2015, the same three agencies returned to the topic, issuing another joint publication titled, “Statement on Prudent Risk Management for Commercial Real Estate Lending.” Noting that CRE asset and lending markets were experiencing substantial growth, the guidance specifically pointed out that “increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values.” As a result, the regulators noted, “many institutions’ CRE concentration levels have been rising.”
The nine years between those two joint statements saw a number of additional regulatory publications related to the issue of CRE concentrations, including a 2008 FDIC letter titled “Managing Commercial Real Estate Concentrations in a Challenging Environment” and a 2010 National Credit Union Administration (NCUA) supervisory letter on concentration risk. During this same time period, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) began a shift in CRE concentrations, as banks with less than $10 billion in assets were exempt from the more stringent stress-testing and capital requirements. (See Exhibit 1.)
These trends have led regulators to continue sharpening their focus on CRE concentrations. For example, the fall 2017 OCC "Semiannual Risk Perspective" notes: “The credit environment continues to be influenced by strong competition, tighter spreads, and slowing loan growth. These factors are driving incremental easing in underwriting practices and increasing concentrations in select loan portfolios – leading to heightened risk if the economy weakens or markets tighten quickly.”
For their part, banks seem to be taking note of this ongoing regulatory concern. In one recent Crowe webinar, more than three-quarters (76 percent) of the participants said their organizations had some level of concern over how to better mitigate the risks associated with growing CRE concentrations. (Exhibit 3.)