A Multifaceted Approach to Managing CRE Concentration Risk
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.
Concentration risk: the focus intensifies
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.)
Looking forward, another upcoming regulator-driven event – the 2020 transition to the current expected credit loss (CECL) model for estimating credit losses – also is likely to have a significant effect on loan portfolio concentrations.
As a result of these and other events, CRE concentrations have been increasing at a more accelerated rate at the community bank level. As Exhibit 2 illustrates, by 2016, CRE concentrations in smaller organizations were beginning to approach levels last seen in mid-2007 (six months after the initial joint guidance on CRE concentrations was released).
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.)
It is worth noting that an almost identical number of participants (77 percent) reported they had received feedback within the past two years from regulators or auditors on the topic of concentrations. Each organization’s priorities are unique, but as the nature of their lending portfolios continues to shift over time, and as regulators continue to issue periodic guidance and cautionary statements, the number of banks expressing concern over the growth of their CRE concentrations is likely to continue growing over the coming years.
A four-step approach to CRE concentration risk
Experience indicates that the most effective methods for addressing concentration risk in general – and CRE concentration risk in particular – involve an integrated, holistic approach, rather than a piecemeal effort that focuses only on the most urgent or critical concerns. Such a holistic approach generally encompasses four principal steps:
- Validate CRE data. As a critical first step, lending organizations must examine their loan portfolio databases and verify that the information is classified correctly. Coding errors and other inaccuracies often can present a distorted picture of CRE concentrations. In many cases, the processes and procedures for creating, entering, validating, and quality checking the coding are not well planned or documented. Other roadblocks include limited loan knowledge and lack of training for those who do the actual coding. The validation process is particularly critical as more and more banks implement systemwide data warehouses.
- Analyze concentration risk. Once loan portfolio databases are validated, banks can carry out a risk analysis to expose both portfolio and loan sensitivity. Well-planned and carefully executed loan stratification can help management look at loan concentrations in a new light. In addition to conducting risk assessments for concentration levels within their loan portfolios, banks also are advised to incorporate stress testing at both the loan and portfolio levels.
- Mitigate CRE risk. After analyzing CRE concentrations, the next step is to mitigate risk by establishing policies and processes to monitor CRE loan performance closely and, where appropriate, to change the mix of the portfolio as the bank’s risk appetite changes. Bank and senior management oversight of credit portfolio management are critical, as is an effective management information system. The winter 2017 edition of FDIC Supervisory Insights reinforces this point, noting: “Performance metrics, including trends in charge-offs, delinquency ratios, nonaccrual loans, restructured loans, and adversely classified assets, are an integral part of a credit MIS program.” Banks also should gather external market data from as many sources as possible to support their decision-making.
- Report to management and the board. The final step in the process of managing concentration risk is reporting to senior management and the board on a regular basis. This periodic reporting should include an update on mitigation efforts for any concentrations that were identified. Banks with higher levels of CRE loan activity might consider investing in dashboard reporting systems. The loan review and internal appraisal departments also should present additional reporting.
Loan review can play an important role
In addition to more-active reporting, many best-in-class banking organizations are finding additional benefits can be gained by developing and implementing a more dynamic loan review function. A proactive loan review organization can give management and the board additional information they are not getting elsewhere.
For example, in addition to watching for conventional “red flags” and signs of risk, an assertive and proactive loan review function also will take advantage of technology and additional sampling to identify portfolio themes and trends. Today’s software already plays a major role in loan review, and with the advent of machine learning and other forms of artificial intelligence, this role will undoubtedly continue to grow.
Along with its responsibility for observing and reporting policy exceptions, trends, and recurring issues, the loan review function also should be able to point out if management reporting lacks granularity or sufficient detail, and identify other forms of risk associated with appraisal quality and underwriting practices.
Stress testing offers additional insights
Stress-testing processes – whether imposed by Dodd-Frank requirements or by banks’ own initiatives – can also provide management with useful insights into CRE concentration risk. Practices such as segmentation of customers and sensitivity analysis can provide additional understanding of the potential effects certain economic variables would have on the portfolio.
Tweaking a few key inputs can reveal how sensitive the bank’s models are to various economic scenarios. Beyond this most basic function, however, stress testing also can help facilitate discussions with executive management, board members, and regulators to develop a better understanding of the loan portfolio – in most cases using data that already is present in existing bank systems.
In addition to supporting risk management efforts, stress testing also can help identify better performing borrowers and segments, and thus reveal potential new growth opportunities.
Other best practices
Other effective CRE concentration risk management practices some banking organizations are now pursuing include establishing a CRE committee, creating a CRE dashboard to enable more timely and intuitive management decision-making, and adapting their reporting functions to incorporate the loan pipeline as well. In addition to revealing what existing concentrations are today, this approach can also help management envision what concentrations will look like in the future if potential opportunities are funded.
As CRE concentrations continue to attract regulatory scrutiny, risk management practices such as these are likely to become even more important to banking organizations. By pursuing a proactive, holistic, and integrated approach to concentration risk, and by taking advantage of new technology solutions that can provide clearer insights into their loan portfolios, management teams and boards can help their organizations manage risk more effectively while also identifying and pursuing promising growth opportunities.
