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FDIC Federal Register Citations

[Federal Register: January 13, 2006 (Volume 71, Number 9)]
[Notices]              
[Page 2302-2307]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13ja06-162]                        

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 06-01]

BOARD OF THE GOVERNORS OF THE FEDERAL RESERVE SYSTEM

[Docket No. OP-1248]

FEDERAL DEPOSIT INSURANCE CORPORATION

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 2006-01]

 
Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices

AGENCIES: Office of the Comptroller of the Currency, Treasury (OCC);
Board of Governors of the Federal Reserve System (Board); Federal
Deposit Insurance Corporation (FDIC); and Office of Thrift Supervision,
Treasury (OTS).

[[Page 2303]]


ACTION: Proposed guidance with request for comment.

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SUMMARY: The OCC, Board, FDIC, and OTS (the Agencies), request comment
on this proposed guidance entitled, Concentrations in Commercial Real
Estate Lending, Sound Risk Management Practices (Guidance). The
Agencies have observed that some institutions have high and increasing
concentrations of commercial real estate loans on their balance sheets
and are concerned that these concentrations may make the institutions
more vulnerable to cyclical commercial real estate markets. This
proposed Guidance helps identify institutions with commercial real
estate loan concentrations that may be subject to greater supervisory
scrutiny. As provided in the proposed Guidance, such institutions
should have in place risk management practices and capital levels
appropriate to the risk associated with these concentrations.

DATES: Comments must be submitted on or before March 14, 2006.

ADDRESSES: The Agencies will jointly review all of the comments
submitted. Therefore, interested parties may send comments to any of
the Agencies and need not send comments (or copies) to all of the
Agencies. Please consider submitting your comments by e-mail or fax
since paper mail in the Washington area and at the Agencies is subject
to delay. Interested parties are invited to submit comments to:
    OCC: You should include ``OCC'' and Docket Number 06-01 in your
comment. You may submit your comment by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.
     OCC Web site: http://www.occ.treas.gov. Click on ``Contact

the OCC,'' scroll down and click on ``Comments on Proposed
Regulations.''
     E-Mail Address: regs.comments@occ.treas.gov.
     Fax: (202) 874-4448.
     Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 1-5, Washington, DC 20219.
     Hand Delivery/Courier: 250 E Street, SW., Attn: Public
Information Room, Mail Stop 1-5, Washington, DC 20219.
    Instructions: All submissions received must include the agency name
(OCC) and docket number for this notice. In general, the OCC will enter
all comments received into the docket without change, including any
business or personal information that you provide. You may review
comments and other related materials by any of the following methods:
     Viewing Comments in person: You may inspect and photocopy
comments at the OCC's Public Information Room, 250 E Street, SW.,
Washington, DC. You can make an appointment to inspect comments by
calling (202) 874-5043.
     Viewing Comments Electronically: You may request that we
send you an electronic copy of comments via e-mail or mail you a CD-ROM
containing electronic copies by contacting the OCC at
regs.comments@occ.treas.gov
.

     Docket Information: You may also request available
background documents and project summaries using the methods described
above.
    Board: You may submit comments, identified by Docket No. OP-1248,
by any of the following methods:
     Agency Web site: http://www.federalreserve.gov Follow the instructions for submitting comments at http://www.federalreserve.gov/.

.

     Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.
     E-mail: regs.comments@federalreserve.gov. Include the
docket number in the subject line of the message.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
    All public comments are available from the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as

submitted, unless modified for technical reasons. Accordingly, your
comments will not be edited to remove any identifying or contact
information. Public comments may also be viewed in electronic or paper
form in Room MP-500 of the Board's Martin Building (20th and C Streets,
NW.) between 9 a.m. and 5 p.m. on weekdays.
    FDIC: You may submit comments by any of the following methods:
     Agency Web site: http://www.fdic.gov/regulations/laws/federal/propose.html.
 Follow the instructions for submitting comments

on the Agency Web site.
     E-Mail: Comments@FDIC.gov.
     Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW.,
Washington, DC 20429.
     Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street) on business days between
7 a.m. and 5 p.m.
    Instructions: All submissions received must include the agency
name. All comments received will be posted without change to http://www.fdic.gov/regulations/laws/federal/propose.html
 including any

personal information provided.
     Public Inspection: Comments may be inspected and
photocopied in the FDIC Public Information Center, Room 100, 801 17th
Street, NW., Washington, DC, between 9 a.m. and 4:30 pm. on business
days.
    OTS: You may submit comments, identified by docket number 2006-01,
by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.
     E-mail address: regs.comments@ots.treas.gov. Please
include docket number 2006-01 in the subject line of the message and
include your name and telephone number in the message.
     Fax: (202) 906-6518.
     Mail: Regulation Comments, Chief Counsel's Office, Office
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552,
Attention: No. 2006-01.
     Hand Delivery/Courier: Guard's Desk, East Lobby Entrance,
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days. Address
envelope as follows: Attention: Regulation Comments, Chief Counsel's
Office, Attention: No. 2006-01.
    Instructions: All submissions received must include the agency name
and docket number for this proposed Guidance. All comments received
will be posted without change to the OTS Internet Site at http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1
, including any

personal information provided.
    Docket: For access to the docket to read background documents or
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1.
 In addition, you may inspect comments

at the OTS's Public Reading Room, 1700 G Street, NW., by appointment.
To make an appointment for access, call (202) 906-5922, send an e-mail
to public.info@ots.treas.gov, or send a facsimile transmission to (202)
906-7755. (Prior notice identifying the materials you will be
requesting will assist us in serving you.) We schedule appointments on
business days between 10 a.m. and 4 p.m. In most cases, appointments
will be available the next business day following the date we receive a
request.

FOR FURTHER INFORMATION CONTACT: OCC: Daniel Bailey, National Bank

[[Page 2304]]

Examiner, Credit Risk Division, (202) 874-5170, Office of the
Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.
    Board: Denise Dittrich, Supervisory Financial Analyst, (202) 452-
2783; or Virginia Gibbs, Senior Supervisory Financial Analyst, (202)
452-2521; or Sabeth I. Siddique, Assistant Director, (202) 452-3861,
Division of Banking Supervision and Regulation; or Mark Van Der Weide,
Senior Counsel, Legal Division, (202) 452-2263. For users of
Telecommunications Device for the Deaf (``TDD'') only, contact (202)
263-4869.
    FDIC: James Leitner, Senior Examination Specialist, Division of
Supervision and Consumer Protection, (202) 898-6790, or Benjamin W.
McDonough, Attorney, Legal Division, (202) 898-7411.
    OTS: William Magrini, Senior Project Manger, (202) 906-5744, or
Karen Osterloh, Counsel, (202) 906-6639.

SUPPLEMENTARY INFORMATION:

I. Background

    The Agencies have observed that some institutions have high and
increasing concentrations of commercial real estate loans on their
balance sheets and are concerned that these concentrations may make the
institutions more vulnerable to cyclical commercial real estate
markets. The Agencies have previously issued regulations and guidelines
that outline supervisory expectations for a safe and sound commercial
real estate lending program. This proposed statement is intended to
reinforce that guidance as it relates to institutions with
concentrations in commercial real estate loans.

II. Principal Elements of the Guidance

    For the purposes of the proposed Guidance, the Agencies are
focusing on concentrations in those types of commercial real estate
(CRE) loans that are particularly vulnerable to cyclical commercial
real estate markets. These include CRE exposures where the source of
repayment primarily depends upon rental income or the sale,
refinancing, or permanent financing of the property. Loans to REITs and
unsecured loans to developers that closely correlate to the inherent
risk in CRE markets would also be considered CRE loans for purposes of
the proposed Guidance.
    The proposed Guidance sets forth thresholds for assessing whether
an institution has a CRE concentration and should employ heightened
risk management practices. This Guidance is based upon the principles
contained in the Agencies' real estate lending standards regulations
and guidelines.
    The proposed Guidance also reminds institutions with CRE
concentrations that they should hold capital higher than regulatory
minimums and commensurate with the level of risk in their CRE lending
portfolios. In assessing the adequacy of an institution's capital, the
proposed Guidance states that the Agencies will take into account the
level of inherent risk in its CRE portfolio and the quality of its risk
management practices.

III. Request for Comment

    The Agencies are requesting public comment on all aspects of the
proposed Guidance. In particular, the Agencies request comment on the
scope of the definition of CRE and on the appropriateness of the
thresholds for determining elevated concentration risk.
    The text of the proposed Guidance entitled, Concentrations in
Commercial Real Estate Lending, Sound Risk Management Practices
follows:

Purpose

    The Office of the Comptroller of the Currency, the Board of
Governors of the Federal Reserve System, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision (the Agencies) are
jointly issuing this Guidance to address the increasing concentrations
of commercial real estate loans at many institutions. The Agencies are
concerned that concentrations in commercial real estate loans where
repayment is primarily dependent on rental income or from the proceeds
of the sale, refinancing or permanent financing of the property may
expose institutions to unanticipated earnings and capital volatility
due to adverse changes in the general commercial real estate market.
    This Guidance reinforces the Agencies' existing guidelines for real
estate lending and safety and soundness.\1\ This Guidance also provides
criteria for identifying institutions with commercial real estate loan
concentrations that may be subject to greater supervisory scrutiny. As
provided in the Guidance, such institutions should have in place risk
management practices and capital levels appropriate to the risk
associated with these concentrations.
---------------------------------------------------------------------------

    \1\ Refer to the Agencies' regulations on real estate lending
standards and the Interagency Guidelines for Real Estate Lending
Policies: 12 CFR part 34, subpart D and appendix A (OCC); 12 CFR
part 208, subpart E and appendix C (FRB); 12 CFR part 365 and
appendix A (FDIC); and 12 CFR 560.100-101 (OTS). Refer to the
Interagency Guidelines Establishing Standards for Safety and
Soundness: 12 CFR part 30, appendix A (OCC); 12 CFR part 208,
Appendix D-1 (FRB); 12 CFR part 364, appendix A (FDIC); and 12 CFR
part 570, appendix A (OTS).
---------------------------------------------------------------------------

    For purposes of this Guidance, commercial real estate (CRE) loans
are exposures secured by raw land, land development and construction
(including 1-4 family residential construction), multi-family property,
and non-farm nonresidential property where the primary or a significant
source of repayment is derived from rental income associated with the
property (that is, loans for which 50 percent or more of the source of
repayment comes from third party, non-affiliated, rental income) or the
proceeds of the sale, refinancing, or permanent financing of the
property. Loans to REITs and unsecured loans to developers that closely
correlate to the inherent risk in CRE markets would also be considered
CRE loans for purposes of this Guidance.

Background

    In the past, weak CRE loan underwriting and depressed CRE markets
have contributed to significant bank failures and instability in the
banking system. While underwriting standards are generally stronger
than those during previous CRE cycles, the Agencies have observed high
concentrations in CRE loans at some institutions. The Agencies are
concerned that these concentrations may make the institutions more
vulnerable to cyclical CRE markets. Accordingly, institutions with such
CRE concentrations should have both heightened risk management
practices and levels of capital that are higher than the regulatory
minimums and appropriate to the risk in their CRE lending portfolios.
    Recent examinations have indicated that the risk management
practices and capital levels of some institutions are not keeping pace
with their increasing CRE concentrations. In some cases, the Agencies
have observed that institutions have rapidly expanded their CRE lending
operations into new markets without establishing adequate control and
reporting processes, including the preparation of market analyses. The
Agencies are also concerned when institutions with high CRE
concentrations maintain capital levels near regulatory minimums.
Minimum levels of regulatory capital do not provide institutions with
an adequate cushion to absorb unexpected losses arising from loan
concentrations and are inconsistent with the Agencies' capital adequacy
guidelines. Institutions with a concentration in CRE loans should
ensure the maintenance of capital levels

[[Page 2305]]

that are commensurate with the risk of such concentrations.

Identification of Institutions With CRE Concentrations

    Institutions with CRE concentrations should have in place risk
management practices consistent with this Guidance to mitigate the
increased risks associated with such concentrations. To determine
whether it has a concentration in CRE lending that warrants the use of
heightened risk management practices, an institution, as a preliminary
step, should use regulatory reports to determine whether it exceeds or
is rapidly approaching the following thresholds:
    (1) Total reported loans for construction, land development, and
other land \2\ represent one hundred percent (100%) or more of the
institution's total capital; \3\ or
---------------------------------------------------------------------------

    \2\ For commercial banks as reported in the Call Report FFIEC
031 and 041 schedule RC-C item 1a. For Savings associations as
reported in the Thrift Financial Report, schedule SC lines SC230,
SC235, SC240, and SC265.
    \3\ For purposes of this Guidance, the term ``total capital''
means the total risk-based capital as reported for commercial banks
in the Call Report (FFIEC 031 and 041 schedule RC-R--Regulatory
Capital, line 21). For savings associations as reported in the
Thrift Financial Report, CCR, Line CCR39.
---------------------------------------------------------------------------

    (2) Total reported loans secured by multifamily and nonfarm
nonresidential properties and loans for construction, land development,
and other land \4\ represent three hundred percent (300%) or more of
the institution's total capital.
---------------------------------------------------------------------------

    \4\ For commercial banks as reported in the Call Report FFIEC
031 and 041 schedule RC-C items 1a, 1d, and 1e. For savings
associations as reported in the Thrift Financial Report Schedule SC
lines SC230, SC235, SC240, SC256, SC260, and SC 265.
---------------------------------------------------------------------------

    Institutions exceeding threshold (1) would be deemed to have a
concentration in CRE construction and development loans and should have
heightened risk management practices appropriate to the degree of CRE
concentration risk of these loans in their portfolios and consistent
with the Guidance set forth below. If an institution exceeds threshold
(2), the institution should further analyze its loans and quantify the
dollar amount of those that meet the definition of a CRE loan contained
in this Guidance. If the institution has a level of CRE loans meeting
the CRE definition of 300 percent or more of total capital, it should
have heightened risk management practices that are consistent with the
Guidance set forth below. The Agencies have excluded loans secured by
owner-occupied properties from the CRE definition because their risk
profiles are less influenced by the condition of the general CRE
market.
    This Guidance may be applied on a case-by-case basis to any
institution that has had a sharp increase in CRE lending over a short
period of time or has a significant concentration in CRE loans secured
by a particular property type.

Risk Management Principles

    The Agencies have previously issued regulations and guidance that
outline supervisory expectations for a safe and sound real estate
lending program. This statement is intended to reinforce that guidance
as it relates to institutions with concentrations in CRE loans. The
risk management and capital adequacy principles contained in this
guidance are broadly prudent for all institutions involved in CRE
lending.
    Board and Management Oversight. The board of directors has ultimate
responsibility for the level of risk taken by its institution.
Directors, or a committee thereof, should explicitly approve the
overall CRE lending strategy and policies of the institution. They
should receive reports on changes in CRE market conditions and the
institution's CRE lending activity that identify the size,
significance, and risks related to CRE concentrations. Directors should
use this information to provide clear guidance to management regarding
the level of CRE exposures acceptable to the institution. The board
also has the responsibility to ensure that senior management implements
the procedures and controls necessary to comply with adopted policies.
The board should periodically review and approve CRE aggregate risk
exposure limits and appropriate sublimits (for example, by property
type and geographic area) to conform to any changes in the
institution's strategies and to respond to changes in market
conditions. Directors should also ensure that management compensation
policies are compatible with the institution's strategy and do not
create incentives to assume unintended risks.
    Management is responsible for implementing the CRE strategy in a
manner that is consistent with the institution's stated risk tolerance.
Management should develop and implement policies, procedures, and
limits that provide for adequate identification, measurement,
monitoring, and control of the CRE risks. The Agencies' real estate
lending regulations require that each institution adopt and maintain a
written policy that establishes appropriate limits and standards for
all extensions of credit that are secured by liens on or interests in
real estate, including CRE loans. The Interagency Guidelines for Real
Estate Lending Policies state that loans exceeding the interagency
loan-to-value (LTV) guidelines should be recorded in the bank's records
and the aggregate amount of loans exceeding the LTV guidelines reported
to the board at least quarterly. Examiners will continue to review
these reports to determine whether the institution's exceptions are
adequately documented and are appropriate in view of all relevant
credit considerations. Further, the Agencies' appraisal regulations and
related guidance require that each institution have an effective real
estate appraisal and evaluation program that adequately supports its
CRE lending activity.\5\
---------------------------------------------------------------------------

    \5\ Refer to the Agencies' appraisal regulations: 12 CFR part
34, subpart C (OCC); 12 CFR part 208, subpart E and 12 CFR part 225,
subpart G (FRB); 12 CFR part 323 (FDIC); and 12 CFR part 564 (OTS).
---------------------------------------------------------------------------

    Strategic Planning. An institution's strategic plan should address
the rationale for its CRE concentration levels relative to the
institution's overall growth objectives and financial targets and
capital levels. In developing its strategy as well as in continuous
monitoring of CRE exposure, an institution should perform an analysis
of the potential effect of a downturn in real estate markets on both
earnings and capital. The strategy should also include a contingency
plan for responding to adverse market conditions. The contingency plan
should address possible actions for mitigating CRE concentration risk
and ensuring the adequacy of capital and reserves. If management
believes the institution could reduce its CRE exposure by selling
exposures, it should assess the marketability of the portfolio. This
should include an evaluation of the institution's capabilities in
accessing the secondary market and a comparison of its underwriting
standards with those that exist in the secondary market.
    Underwriting. An institution's lending policies should define the
level of risk that is acceptable to its board of directors. Therefore,
lending policies should provide clear and measurable underwriting
standards and be consistent with the Agencies' real estate lending
regulations and guidelines. Policy guidelines should be based on a
careful review of internal and external factors that affect the
institution, such as its market position, historical experience,
present and prospective trade area, probable future loan and funding
trends, staff capabilities, and technology.
    Consistent with the Agencies' real estate lending standards,
underwriting standards should include standards for:

[[Page 2306]]

     Maximum loan amount by type of property,
     Loan terms,
     Pricing structures,
     LTV limits by property type,
     Requirements for feasibility studies and sensitivity
analysis or stress-testing,
     Minimum requirements for initial investment and
maintenance of hard equity by the borrower, and
     Minimum standards for borrower net worth, property cash
flow, and debt service coverage for the property.
    Credit analysis should reflect both the borrower's overall
creditworthiness and project-specific considerations.\6\ Management
should also compare the institution's underwriting standards for
individual property types with those that exist in the secondary
market. When an institution's standards are substantially more lenient,
management should justify the reasons why the institution's risk
criteria deviate from those of the secondary market and should document
their long-term plans for these credits. Additionally, for development
and construction loans, the institution should have sound policies and
procedures governing loan disbursements to ensure that disbursements do
not exceed actual development and construction costs. Prudent controls
should include an inspection process, documentation on construction
progress, tracking presales and preleasing, and exception reporting.
---------------------------------------------------------------------------

    \6\ Refer to the Interagency Guidelines for Real Estate Lending
Policies: 12 CFR part 34, appendix A (OCC); 12 CFR part 208,
appendix C (FRB); 12 CFR part 365, appendix A (FDIC); and 12 CFR
560.100-101 (OTS).
---------------------------------------------------------------------------

    An institution's lending policies should permit exceptions to
underwriting standards only on a limited basis. When an institution
does permit an exception, it should document how the transaction does
not conform to the institution's policy or underwriting standards,
obtain appropriate management approvals, and provide reports to the
board of directors detailing the number, nature, justifications, and
trends for exceptions in a timely manner. Exceptions to both the
institution's internal lending standards and the Agencies' supervisory
LTV limits should be monitored and reported on a regular basis.
Further, institutions should analyze trends in exceptions to ensure
that risk remains within the institution's established risk tolerance
limits.
    Risk Assessment and Monitoring of CRE Loans. Institutions should
establish and maintain thoroughly articulated policies that specify
requirements and criteria for risk rating CRE exposures, ongoing
account monitoring, identifying loan impairment, and recognizing
losses. Risk ratings should be risk sensitive, objective, and tailored
to the CRE exposure types underwritten by the institution. A strong
risk rating system is important for maintaining the integrity of an
institution's risk management system and in providing an early warning
of emerging weaknesses. An institution's internal rating systems should
consider an assessment of a borrower's creditworthiness and of an
exposure's estimated loss severity to ensure that both the risk of the
obligor and the transaction itself are clearly evaluated. When
assigning risk ratings to CRE loans, an institution should consider the
property's sensitivity to changes in macro and project-specific factors
including variations in vacancy and rental rates, interest rates, and
inflation rates.
    Policies should address the ongoing monitoring of individual loans,
including the frequency of account reviews, updating of borrower credit
information, and status of leasing. Policies should require periodic
comparisons of actual property performance information with projections
at the time of original underwriting and the appraisal assumptions (for
example, lease-up assumptions) to determine if any credit deterioration
or value impairment has occurred. In addition, policies should specify
the frequency with which transaction risk ratings should be reviewed to
ensure they appropriately reflect the transaction's level of credit
risk.
    Portfolio Risk Management. Even when individual CRE loans are
underwritten conservatively, large aggregate exposures to related
sectors can expose an institution to an unacceptable level of risk.
Therefore, an institution should measure and control CRE credit risk on
a portfolio basis by identifying and managing concentrations,
performing market analysis, and stress testing. A strong management
information system is key to the successful implementation of a
portfolio management system.
    Management Information System (MIS). To accurately assess and
manage portfolio concentration risk, the MIS should provide meaningful
information on CRE portfolio characteristics that are relevant to the
institution's lending strategy, underwriting standards, and risk
tolerances. Institutions are encouraged, on either an automated or
manual basis, to stratify the portfolio by property type, geographic
area, tenant concentrations, tenant industries, developer
concentrations, and risk rating. Institutions should be able to
aggregate total exposure to a borrower including their credit exposure
related to derivatives, such as interest rate swaps. MIS should
maintain the appraised value at origination and subsequent valuations.
Other useful stratifications include loan structure (for example, fixed
rate or adjustable), loan type (for example, construction, mini perm,
or permanent), loan-to-value limits, debt service coverage, policy
exceptions on newly underwritten credit facilities, and related loans
(for example, loans to tenants). Management reporting should be timely
and in a format that clearly shows changes in the portfolio's risk
profile, including risk-rating migrations. In addition, the MIS should
provide management with the ability to conduct stress test analysis of
the CRE portfolio for varying scenarios. There should also be a well-
defined, formal process through which management reviews and evaluates
concentration and risk management reports, as well as special ad hoc
analyses in response to market events.
    Identifying and Managing Concentrations. Active oversight and
monitoring by management is an important component of the management of
CRE concentration risk. Management should continually evaluate the
degree of potential correlation between related sectors and establish
internal lending guidelines and limits that control the institution's
overall risk exposure. An institution should combine and view as
concentrations any groups or classes of CRE loans sharing significant
common characteristics and similar sensitivity to adverse economic,
financial, or business developments. Using established limits relevant
to its lending strategy and portfolio characteristics, an institution
should monitor and control its CRE concentrations.
    Management should have strategies for managing concentration
levels. The use of secondary market sales to institutional investors or
securitizations is one example of a strategy for actively managing
concentration levels without curtailing new originations. In addition,
executing market sales provides corroboration that the institution's
underwriting and pricing are consistent with market standards.
Moreover, as firm take-out commitments have become rare, many
institutions require that commercial construction loans be written to
secondary market standards. Institutions with high levels of
construction and development loans should closely monitor market
conditions particularly when relying on permanent loan take-outs as a
way of managing concentration levels.

[[Page 2307]]

    In managing CRE concentration levels, institutions are also
encouraged to consider other credit exposures correlated to the CRE
market such as commercial mortgage-backed securities.
    Market Analysis. Institutions should perform ongoing evaluations of
the market conditions for the various property types and geographic
areas or markets represented in their portfolio. Market analysis is
particularly important as an institution expands its geographic scope
of operations into new markets. In making decisions about new markets
and new originations, market analysis should be an important evaluation
criterion for individual credits as well as for the portfolio.
Institutions should utilize multiple sources for obtaining market
information such as published research data, monitoring new building
permits, and maintaining contacts with local contractors, builders,
real estate agents, and community development groups.
    Management should ensure that the institution's CRE lending
strategy and portfolio risk assessments integrate the findings of its
market analysis and evaluation. Moreover, market information should
provide management with sufficient information to determine whether
revisions to its CRE lending strategy and policies are necessary to
respond to identified market trends, and to form the basis for its
stress testing.
    Portfolio Stress Testing. Institutions should consider performing
portfolio level stress tests of their CRE exposures to quantify the
impact of changing economic scenarios on asset quality, earnings, and
capital. The Agencies recognize that portfolio level stress testing is
an evolving process and encourage institutions to consider its use as a
risk management tool and to review periodically the adequacy of stress
testing practices relative to their CRE exposures. The sophistication
of stress testing practices should be consistent with the size and
complexity of the institution's CRE loan portfolio.
    Portfolio stress testing does not necessarily require the use of a
sophisticated portfolio model. Depending on the risk characteristics of
the CRE portfolio, it may be appropriate for a stress test to be as
simple as an aggregation of the results of individual loan stress
tests, testing the impact of ratings migration, or applying stressed
historical loss rates to the portfolio. Stress tests should focus on
the more vulnerable segments of an institution's CRE portfolio, given
the prevailing market environment and the institution's business
strategy.
    Allowance for Loan Losses. Institutions also should consider CRE
concentrations in their assessment of the adequacy of the allowance for
loan and lease losses. The Interagency Policy Statement on Allowance
for Loan and Lease Losses Methodologies and Documentation for Banks and
Savings Institutions provides guidance on criteria that institutions
should consider when evaluating groups of loans with common risk
characteristics.

Capital Adequacy

    The Agencies' capital adequacy guidelines note that institutions
should hold capital commensurate with the level and nature of the risks
to which they are exposed and that institutions with high or inordinate
levels of risk are expected to operate well above minimum regulatory
capital requirements. Minimum levels of regulatory capital \7\ do not
provide institutions with sufficient buffer to absorb unexpected losses
arising from loan concentrations.\8\ Failure to maintain an appropriate
cushion for concentrations is inconsistent with the Agencies' capital
adequacy guidelines. Moreover, an institution with a CRE concentration
should recognize the need for additional capital support for CRE
concentrations in its strategic, financial, and capital planning,
including an assessment of the potential for future losses on CRE
exposures.
---------------------------------------------------------------------------

    \7\ Most CRE exposures are risk-weighted at 100 percent. By
statute, however, certain loans made for the construction of single-
family housing and certain multifamily housing loans are risk-
weighted at 50 percent. See 12 U.S.C. 1831n note (Risk-Weighting of
Housing Loans for Purposes of Capital Requirements). The Agencies
have codified these statutory risk-weighting requirements in their
regulations at 12 CFR Part 3, Appendix A, Section 3 (OCC); 12 CFR
Part 208, Appendix A, Section III. C. (FRB); 12 CFR Part 325,
Appendix A, Section II.C. (FDIC); and 12 CFR 567.6(a)(1)(iii) (50%
risk-weights for ``qualifying multifamily mortgage loan'' and
``qualifying residential construction loan'' as defined in 12 CFR
567.1) (OTS).
    \8\ Depending upon the level and nature of the CRE
concentration, an institution may need to maintain capital at levels
exceeding the ``well capitalized'' standard to ensure the overall
sound financial condition of the institution.
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    In performing its internal capital analysis, an institution should
make use of the results of any stress testing and other quantitative
and qualitative analysis. The internal capital analysis should also
reflect the possibility that any historical correlations used might not
remain stable under stress conditions. For larger, more complex
institutions that employ formal quantitative economic capital systems,
the analysis of concentrations should provide for an adequate
``cushion'' above model outputs to compensate for potential
uncertainties in risk measurement.
    In assessing the adequacy of an institution's capital, the Agencies
will take into account analysis provided by the institution as well as
an evaluation of the level of inherent risk in the CRE portfolio and
the quality of risk management based on the sound practices set forth
in this Guidance.

Supervisory Evaluation and Action

    The CRE sound practices set forth in this Guidance are effective
methods for addressing the increased risks associated with CRE
concentrations, and illustrate the types of practices that the Agencies
consider important elements of sound risk management and adequate
capital. An institution that is unable to adequately assess and meet
its capital needs may be required to develop a plan for reducing its
concentrations or for achieving higher capital ratios.
    This concludes the text of the proposed Guidance entitled,
Concentrations in Commercial Real Estate Lending, Sound Risk Management
Practices.

    Dated: January 6, 2006.
John C. Dugan,
Comptroller of the Currency.

    By order of the Board of Governors of the Federal Reserve
System, January 10, 2006.
Jennifer J. Johnson,
Secretary of the Board.

    Dated at Washington, DC, this 9th day of January, 2006.

    By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.

    Dated: January 9, 2006.

    By the Office of Thrift Supervision.
John M. Reich,
Director.
[FR Doc. 06-340 Filed 1-12-06; 8:45 am]
BILLING CODE 4810-33-U; 6210-01-U; 6714-01-U; 6720-01-U


  
 


Last Updated 12/29/2005 Regs@fdic.gov