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Home > Regulation & Examinations > Laws & Regulations > FDIC Federal Register Citations




FDIC Federal Register Citations

[Federal Register: December 12, 2006 (Volume 71, Number 238)]

[Notices]

[Page 74580-74588]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr12de06-144]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 06-14]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1248]

FEDERAL DEPOSIT INSURANCE CORPORATION

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); and Federal

Deposit Insurance Corporation (FDIC).

ACTION: Final guidance.

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SUMMARY: The OCC, Board, and FDIC (the Agencies) are issuing final

joint Guidance on Concentrations in Commercial Real Estate Lending,

Sound Risk Management Practices (Guidance). This Guidance has been

developed to reinforce sound risk management practices for institutions

with high and increasing concentrations of commercial real estate loans

on their balance sheets. This Guidance applies to national banks and

state chartered banks (institutions). Further, the Board believes that

the Guidance is broadly applicable to bank holding companies.

DATES: Effective Date: The final Guidance is effective December 12,

2006.

FOR FURTHER INFORMATION CONTACT:

OCC: Dena G. Patel, Credit Risk Specialist, (202) 874-5170; or

Vance Price, National Bank Examiner, (202) 874-5170.

Board: Denise Dittrich, Supervisory Financial Analyst, (202) 452-

2783; 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: Patricia A. Colohan, Senior Examination Specialist, (202)

898-7283; or Serena L. Owens, Chief, Planning and Program Development,

(202) 898-8996, Division of Supervision and Consumer Protection; or

Benjamin W. McDonough, Attorney, Legal Division, (202) 898-7411.

SUPPLEMENTARY INFORMATION:

I. Background

The Agencies have observed that commercial real estate (CRE)

concentrations have been rising over the past several years and have

reached levels that could create safety and soundness concerns in the

event of a significant economic downturn. To some extent, the level of

CRE lending reflects changes in the demand for credit within certain

geographic areas and the movement by many financial institutions to

specialize in a lending sector that is perceived to offer enhanced

earnings. In particular, small to mid-size institutions have shown the

most significant increase in CRE concentrations over the last decade.

CRE concentration levels \1\ at commercial and savings banks with

assets between $100 million and $1 billion have doubled from

approximately 156 percent of total risk-based capital in 1993 to 318

percent in third quarter 2006. This same trend has been observed at

commercial and savings banks with assets of $1 billion to $10 billion

with concentration levels rising from approximately 127 percent in 1993

to approximately 300 percent in third quarter 2006.

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\1\ CRE concentration levels for loans secured by real estate

for (a) construction, land development, and other land loans; (b)

multifamily residential properties; and (c) nonfarm nonresidential

properties.

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While current CRE market fundamentals remain generally strong, and

supply and demand are generally in balance, past history has

demonstrated that commercial real estate markets can experience fairly

rapid changes. For institutions with significant concentrations, the

ability to withstand difficult market conditions will depend heavily on

the adequacy of their risk management practices and capital levels. In

recent examinations, the Agencies' examiners have observed that some

institutions have relaxed their underwriting standards as a result of

strong competition for business. Further, examiners also have

identified a number of institutions with high CRE concentrations that

lack appropriate policies and procedures to manage the associated risk

arising from a CRE concentration. For these reasons, the Agencies are

concerned with institutions' CRE concentrations and the risks arising

from such concentrations.

To address these concerns, the Agencies published for comment

proposed Interagency Guidance on Concentrations in Commercial Real

Estate Lending, Sound Risk Management Practices, 71 FR 2302 (January

13,2006). The proposal set forth thresholds to identify institutions

with CRE loan concentrations that would be subject to greater

supervisory scrutiny. As provided in the proposal, an institution

exceeding these thresholds would be deemed to have a CRE concentration

and expected to have appropriate risk management practices as described

in the proposed guidance.

After reviewing the public comment letters \2\ on the proposal, the

Agencies are now issuing final Guidance to remind institutions that

there are substantial risks posed by CRE concentrations and that these

risks should be recognized and appropriately addressed. The final

Guidance describes sound risk management practices that are important

for an institution that has strategically decided to concentrate in CRE

lending. These risk management practices build upon existing real

estate lending regulations and guidelines. The Agencies also have

clarified that they are not establishing a limit on the amount of

commercial real estate lending that an institution may conduct.

[[Page 74581]]

In addition, the final Guidance includes supervisory criteria to help

the Agencies' supervisory staff identify institutions that may have

significant CRE concentration risk.

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\2\ The Agencies did receive a number of comment letters

requesting a 30-day extension of the comment period, which the

Agencies granted. See 71 FR 13215 (March 14, 2006).

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II. Proposed Guidance

The proposed guidance described the Agencies' expectations for

heightened risk management practices for an institution with a

concentration in CRE loans. Further, the proposal set forth two

thresholds to identify institutions with CRE loan concentrations that

would be subject to greater supervisory scrutiny. The proposal provided

that such institutions should have in place the heightened risk

management practices and capital levels set forth in the proposal.

The first proposed threshold stated that if loans for construction,

land development, and other land were 100 percent or more of total

capital, the institution would be considered to have a CRE

concentration and should have heightened risk management practices.

Secondly, if loans for construction, land development, and other land

and loans secured by multifamily and nonfarm nonresidential property

(excluding loans secured by owner-occupied properties) were 300 percent

or more of total capital, the institution would also be considered to

have a CRE concentration and should employ heightened risk management

practices.

The proposal described the key risk management elements for an

institution's CRE lending activity with an emphasis on those components

of the risk management process that are particularly applicable to an

institution with a CRE concentration, including: board and management

oversight, strategic planning, underwriting, risk assessment and

monitoring of CRE loans, portfolio risk management, management

information systems, market analysis, and stress testing. The proposal

also reminded institutions with CRE concentrations that they should

hold capital exceeding regulatory minimums and commensurate with the

level of risk in their CRE lending portfolios.

III. Overview of Public Comments

Collectively, the Agencies received over 4,400 comment letters on

the proposed guidance. The OCC received approximately 1,700 comment

letters, the Board had approximately 1,700 letters, and the FDIC had

approximately 1,000 letters. The majority of comment letters were from

regulated financial institutions and their trade groups.

Among the trade or other groups submitting comments were seven

nationwide banking trade associations, 26 state banking trade

associations, the Conference of State Bank Supervisors, three state

financial institution regulatory agencies, the Appraisal Institute, the

National Association of Home Builders, National Association of REITs,

and Real Estate Roundtable. Additionally, during the comment period,

the Agencies met with several industry groups.

The vast majority of commenters expressed strong opposition to the

proposed guidance and believe that the Agencies should address the

issue of CRE concentration risk on a case-by-case basis as part of the

examination process. Many commenters contended that existing

regulations and guidance are sufficient to address the Agencies'

concerns regarding CRE concentration risk and the adequacy of an

institution's risk management practices and capital.

Several commenters asserted that today's lending environment is

significantly different than that of the late 1980s and early 1990s

when regulated financial institutions suffered losses from their real

estate lending activities due to weak underwriting standards and risk

management practices. These commenters contended that regulated

financial institutions learned their lessons from past economic cycles

and that underwriting practices are now stronger.

Many community-based institutions, particularly Florida-based and

Massachusetts-based institutions, opposed the proposed guidance and

contended that the proposal would discourage community-based

institutions from CRE lending and serving the needs of their

communities. If community-based institutions were forced to reduce

their CRE lending activity, these commenters asserted that there was

the potential for a downturn in the economy, creating systemic problems

beyond the risks in CRE loans.

While smaller institutions acknowledged that many community banks

do concentrate in commercial real estate loans, they contended that

there are few other lending opportunities in which community-based

institutions can successfully compete against larger financial

institutions. Community-based institutions commented that secured real

estate lending has been their ``bread and butter'' business and, if

required to reduce their commercial real estate lending activity, they

would have to look to other types of lending, which have been

historically more risky. Moreover, these commenters noted that

community-based institutions are actively involved in their local

communities and markets, which affords them a significant advantage

when competing for CRE loan business. Community-based institutions also

noted that their lending opportunities have dwindled as a result of

competition from other types of financial institutions, such as finance

companies, Farm Credit banks, and credit unions.

IV. Overview of Final Guidance

After carefully reviewing the comments on the proposed guidance,

the Agencies have made significant changes to the proposal to clarify

the purpose and scope of the Guidance. The Agencies continue to believe

that it is important for institutions with CRE credit concentrations to

assess the risk posed by the concentration and to maintain sound risk

management practices and an adequate level of capital to address the

risk. Therefore, while the final Guidance continues to emphasize these

principles, the Agencies have revised the proposal to clarify that

financial institutions play a vital role in providing credit for

commercial real estate activity and to make clear that the Guidance

does not establish a limit on an institution's CRE lending activity.

A discussion of the changes in the final Guidance from the

proposal, major comments on the proposal, and the Agencies' responses

follows.

A. Purpose

The final Guidance reminds institutions that sound risk management

practices and appropriate capital levels are important when an

institution has a CRE concentration. Like the proposal, the final

Guidance reinforces and builds upon the Agencies' existing regulations

and guidelines for real estate lending and loan portfolio management.

Commenters expressed concern that the proposal placed additional

burden on institutions that already have sound practices in place to

manage their CRE lending activity. Further, commenters contended that

the Agencies have sufficient existing authority to address their

concerns with an institution's CRE lending activity and that the

Agencies' examination process affords the Agencies with ample

opportunity to address weaknesses in an institution's lending

practices.

The Agencies are issuing the final Guidance to remind institutions

of the substantial potential risks posed by credit concentrations,

especially in sectors such as CRE, which history has shown to have

cycles that can, at much lower concentration levels, inflict large

losses upon institutions. While most institutions are practicing sound

credit

[[Page 74582]]

risk management on a transaction basis, the Agencies believe this

Guidance is necessary to emphasize the importance of portfolio risk

management practices to address CRE concentration risk.

B. Scope

The final Guidance, like the proposal, focuses on CRE loans that

have risk profiles sensitive to the condition of the general CRE

market. This includes loans for land development and construction

(including 1- to 4-family residential and commercial properties), other

land loans, and loans secured by multifamily and nonfarm nonresidential

properties (where the primary source of repayment is cash flows from

the real estate collateral). Loans to REITs and unsecured loans to

developers also are considered CRE loans for purposes of this Guidance

if their performance is closely linked to the performance of the

general CRE market.

Commenters noted that the identification of CRE loans in the

current Consolidated Reports of Condition and Income (Call Report) did

not correspond to the proposed guidance's CRE definition and did not

constitute an accurate measurement of the volume of an institution's

CRE loans that would be vulnerable to cyclical CRE markets. Commenters

did acknowledge that the revisions to the Call Reports, effective in

2007, would address this inconsistency.

In response to these comments, the Agencies have clarified that the

focus of the Guidance is on those CRE loans where the cash flow from

the real estate collateral is the primary source of repayment rather

than on loans to a borrower where real estate is a secondary source of

repayment or is taken as collateral through an abundance of caution.

This is consistent with the 2007 revisions to the Call Report.

Many commenters found the proposal's definition of CRE loans overly

broad and failed to recognize unique risks posed by loans with

different risk characteristics. Further, commenters asked for

clarification as to the types of properties included in the scope of

the Guidance, such as loans secured by motels, hotels, mini-storage

warehouse facilities, and apartment complexes where the primary source

of repayment is rental or lease income. A number of commenters

contended that loans on certain types of CRE properties should not be

considered CRE loans, including: Presold 1- to 4-family residential

construction loans, multifamily loans, and loans to REITs.

Commenters recommended that the proposal should not cover

residential construction loans where a house has been sold to a

qualified borrower prior to the start of the construction. These

commenters argued that presold 1- to 4-family residential construction

loans carry far less risk than speculative home construction loans

because the future homeowners are known and contractually obligated to

purchase the home, and have passed a credit review prior to the

commencement of construction. Commenters noted that their rationale for

excluding presold 1- to 4-family residential construction is consistent

with the proposal's exclusion of CRE loans on owner-occupied

properties.

Further, commenters recommended that multifamily construction loans

with firm takeouts or loans on completed multifamily properties with

established rent rolls be excluded from the scope of the guidance.

Commenters contended that multifamily residential loans have much less

risk than CRE loans that have no firm takeout or established cash flow

history.\3\ One commenter noted that over the last 20 years,

institutions have incurred minimal losses on multifamily loans and

attributed this performance to strong underwriting and stability in

rental properties.

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\3\ Another commenter, representing REITs, sought clarification

as to whether the proposed guidance would apply to both secured and

unsecured loans to REITs. This commenter asserted that unsecured

loans to REITs should not be considered a CRE loan for purposes of

the proposed guidance as the commenter believes that the risk of an

unsecured loan to a REIT is mitigated by well-diversified cash flow

comprising the sources of repayment. The final Guidance, like the

proposal, applies to both secured and unsecured loans to REITs where

repayment capacity is sensitive to conditions of the general CRE

market. The Agencies note that the structure of such loans would be

considered a mitigating factor when an institution analyzes the risk

posed by such a concentration.

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The Agencies note that because the Guidance does not impose lending

limits, its scope is purposely broad so that it includes those CRE

loans, including multifamily loans, with risk profiles sensitive to the

condition of the general CRE markets, such as market demand, changes in

capitalization rates, vacancy rates, and rents. However, the Agencies

believe that institutions are in the best position to segment their CRE

portfolios and group credit exposures by common risk characteristics or

sensitivities to economic, financial, or business developments. As

explained in the final Guidance, institutions should be able to

identify potential concentrations in their CRE portfolios by common

risk characteristics, which will differ by property type. The final

Guidance notes that factors, such as portfolio diversification,

geographic dispersion, levels of underwriting standards, level of

presold buildings, and portfolio liquidity, would be considered in

evaluating whether an institution has mitigated the risk posed by a

concentration. Further, the Agencies acknowledge in the final guidance

that consideration should be given to the lower risk profiles and

historically superior performance of certain types of CRE such as well-

structured multifamily housing loans, when compared to others, such as

speculative office construction.

C. CRE Concentration Assessment

The final Guidance contains a new section referred to as ``CRE

Concentration Assessment'' that provides that institutions should

perform their own assessment of concentration risk in their CRE loan

portfolios. While the final Guidance does not establish a CRE

concentration limit, the Agencies have retained high-level indicators

to assist examiners in identifying institutions potentially exposed to

CRE concentration risk. These are described in section IV.E of this

preamble.

Many commenters noted that the proposal did not recognize the

different segments in an institution's CRE portfolio and treated all

CRE loans as having equal risk. A commenter noted that a concentration

test cannot reflect the distinct risk profile within an institution's

loan portfolio and that the risk profile is a function of many factors,

including the institution's risk tolerance, portfolio diversification,

the prevalence of guarantees and secondary collateral, and the

condition of the regional economy.

In response to such comments, the Agencies have added a section on

CRE Concentration Assessments to the final Guidance. The Agencies

recognize that risk characteristics vary by different property types of

CRE loans and that institutions are in the best position to identify

potential concentrations by stratifying their CRE portfolios into

segments with common risk characteristics. The Agencies believe an

institution's board of directors and management should identify and

monitor credit concentrations and establish internal concentration

limits. The final Guidance clarifies that an institution actively

involved in CRE lending should be able to identify concentrations in

its CRE portfolio and to monitor concentration risk on an ongoing

basis.

Commenters raised concern that the proposed thresholds would be

perceived by examiners as de facto limits on an institution's CRE

lending activity. The Agencies believe that the

[[Page 74583]]

final Guidance addresses the concerns of commenters by placing the

emphasis on the institution's own assessment of its CRE concentration

risk rather than on the proposed concentration thresholds. In the final

Guidance, the Agencies have responded to these concerns by specifically

stating that the Guidance does not establish any specific limits on

institutions' CRE lending activity. Moreover, in implementing the

Guidance, the Agencies will take the necessary steps to communicate the

purpose of the Guidance to their supervisory staffs to prevent any

unintended consequences.

The final Guidance does incorporate the proposed concentration

thresholds as part of the Agencies' supervisory oversight criteria for

examiners to use as a starting point for identifying institutions that

are potentially exposed to significant CRE concentration risk. The

Agencies believe that these numerical supervisory screens will serve to

promote consistent application of this Guidance across the Agencies as

well as within an agency. The supervisory oversight and evaluation of

an institution's CRE concentration risk are discussed in more detail in

section IV.E. of the preamble.

D. Risk Management

The final Guidance, like the proposal, builds upon the Agencies'

existing regulations and guidance for real estate lending and loan

portfolio management, emphasizing those risk management practices that

will enable an institution to pursue CRE lending in a safe and sound

manner.

Many commenters acknowledged that the risk management principles

described in the proposal should be viewed as prudent industry

standards for an institution engaged in CRE lending. However, some

commenters alleged that the proposed guidance would create additional

regulatory burden at a time when institutions are already faced with

other compliance responsibilities. Further, commenters noted that the

Agencies needed to consider an institution's size and complexity in

assessing the adequacy of risk management practices. This particular

concern was raised with regard to the expectations for management

information systems and portfolio stress testing that commenters found

to be burdensome for smaller institutions.

In response to these comments, the Agencies have revised the final

Guidance's risk management section to make the discussion more

principle-based and to focus on those aspects of existing regulations

and guidelines that deserve greater attention when an institution has a

CRE concentration or is pursuing a CRE lending strategy leading to a

concentration. As a result, the risk management section in the final

Guidance sets forth the key elements of an institution's risk

management framework for managing concentration risk. Further, the

final Guidance recognizes the sophistication of an institution's risk

management processes will depend upon the size of the CRE portfolio and

the level and nature of its CRE concentration risk.

The final Guidance describes the key elements that an institution

should address in board and management oversight, portfolio management,

management information systems, market analysis, credit underwriting

standards, portfolio stress testing and sensitivity analysis, and

credit risk review function. In general, an institution with a CRE

concentration should manage not only the risk of the individual loans

but also the portfolio risk. Recognizing that an institution's board of

directors has ultimate responsibility for the level of risk assumed by

the institution, the Agencies believe that appropriate board oversight

should address the rationale for an institution's CRE lending levels in

relation to its growth objectives, financial targets, and capital plan.

The Agencies believe that the final Guidance's discussion of

management information systems (MIS), market analysis, and portfolio

stress testing addresses the concerns of smaller institutions regarding

regulatory burden. The Agencies recognize that the level of

sophistication of an institution's MIS, market analysis and stress

testing will depend upon the size and complexity of the institution.

Therefore, the focus of the final Guidance is on the ability of the

institution to provide its management and board of directors with the

necessary information to assess its CRE lending strategy and policies

in light of changes in CRE market conditions. Regardless of its size,

an institution should be able to identify and monitor CRE

concentrations and the potential effect that changes in market

conditions may have on the institution.

Some commenters requested clarification on the Agencies'

expectations for stress testing. These commenters expressed concern

that, as a result of the proposal, management's time would be diverted

to creating reports and statistics with not much value. These

commenters represented that an institution's focus should be on a loan

review program, portfolio monitoring procedures, and loan loss

reserves.

The Agencies agree with these comments and have revised the

discussion on market analysis and stress testing. The final Guidance

acknowledges that an institution's market analysis will vary by its

market share and exposure levels as well as the availability of market

data. Further, the final Guidance notes that portfolio stress testing

does not require the use of sophisticated portfolio models. Depending

on the institution, stress testing may be as simple as analyzing the

potential effect of stressed loss rates on the institution's CRE

portfolio, capital, and earnings. The important objective is that an

institution should have the information necessary to assess the

potential effect of market changes on its CRE portfolio and lending

strategy.

Commenters questioned the proposed guidance's suggestion that

institutions should compare their underwriting standards to those of

the secondary commercial mortgage market. Commenters noted that there

is not a ready secondary market for CRE loans made by smaller

institutions as the loans are smaller in dollar size and have

characteristics that make them unsuitable for securitization.

The Agencies recognize that smaller institutions do not have ready

access to the secondary market and had not intended that the proposal

be viewed in this way. Therefore, in the final Guidance, the Agencies

have clarified the situations when an institution should conduct

secondary market comparisons. If an institution's portfolio management

strategy includes selling or securitizing CRE loans as a contingency

plan for managing concentration levels, an institution should evaluate

its ability to do so and compare its underwriting standards to those of

the secondary market.

E. Supervisory Oversight

In the final Guidance, the Agencies have retained the concept of

concentration thresholds as a supervisory tool for examiners to screen

institutions for potential CRE concentration risk. The intent of these

indicators is to encourage a dialogue between the Agency supervisory

staff and an institution's management about the level and nature of CRE

concentration risk. While the final Guidance is effective immediately

upon publication in the Federal Register, the Agencies will provide

institutions with CRE concentrations a reasonable timeframe over which

to demonstrate that their risk management practices are appropriate for

the level and nature of the concentration risk.

[[Page 74584]]

Commenters encouraged the Agencies to evaluate institutions' CRE

concentrations on a bank-by-bank basis and not to take a ``one-size-

fits-all'' approach to evaluating concentrations. Commenters asserted

that an assessment of concentration risk based on the Agencies'

proposed thresholds did not consider the differing risk characteristics

of the subcategories of CRE loans. Further, commenters noted that the

proposed thresholds did not consider whether or not an institution had

an established history of managing a high CRE concentration.

In the final Guidance, the Agencies addressed the commenters'

concerns by stating that numeric indicators do not constitute limits;

rather they will be used as a supervisory monitoring tool. These

indicators will assist examiners in identifying institutions with CRE

concentrations. These indicators will function similarly to other

analytical screens that the Agencies use to evaluate an institution. By

including these indicators in the final Guidance, institutions will

have an understanding of the Agencies' supervisory monitoring criteria.

The Agencies also have tried to strike a balanced tone in the final

Guidance to promote an appropriate and consistent application of these

indicators by their supervisory staffs.

As explained in the final Guidance, an institution that has

experienced rapid growth in CRE lending, has notable exposure to a

specific type of CRE, or is approaching or exceeds the following

supervisory criteria may be identified for further supervisory analysis

of the level and nature of its CRE concentration risk. The supervisory

criteria are:

(1) Total reported loans for construction, land development, and

other land \4\ represent 100 percent or more of the institution's total

capital; \5\ or

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\4\ For commercial banks, this total is reported in the Call

Report FFIEC 031 and 041 schedule RC-C item 1a.

\5\ 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.

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(2) Total commercial real estate loans as defined in the Guidance

\6\ represent 300 percent or more of the institution's total capital

and the outstanding balance of the institution's CRE loan portfolio has

increased 50 percent or more during the prior 36 months.

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\6\ For commercial banks, this total is reported in the Call

Report FFIEC 031 and 041 schedule RC-C items 1a, 1d, 1e, and

Memorandum Item 3.

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While the criteria will serve as a screen for identifying

institutions with potential CRE concentration risk, the final Guidance

notes that institutions should not view the criteria as a ``safe

harbor'' if other risk indicators are present, regardless of the

measurements under criteria (1) and (2). Further, the final Guidance

notes that institutions experiencing recent, significant growth in CRE

lending will receive closer supervisory review than other institutions

that have demonstrated a successful track record of managing the risks

in CRE concentrations.

In response to comments that the proposal concentration thresholds

did not consider an institution's track record for managing CRE

concentrations, the Agencies have included an additional condition to

the 300 percent screen. The Agencies also will consider whether the

institution's CRE portfolio increased by 50 percent or more during the

prior 36 months. This additional screen acknowledges that the Agencies

will be focusing on those institutions that have recently experienced a

significant growth in their CRE portfolio and may not have been subject

to prior supervisory review.

While most commenters opposed the adoption of any concentration

thresholds, several commenters did comment on the appropriateness of

the proposed CRE concentration thresholds. These commenters asserted

that the proposed 300 percent threshold was too low and suggested that

a benchmark from 400 to 600 percent of capital would be more

appropriate.

As previously discussed, the Agencies have retained the 300 percent

screen with an additional screen (that is, an institution's CRE

portfolio increased by 50 percent or more during the prior 36 months).

In developing the supervisory criteria, the Agencies relied on

historical trends in concentration levels over real estate cycles, the

relationship of CRE concentration levels to bank failures, and

supervisory experience. Further, the final Guidance clarifies that the

Agencies' supervisory staffs will consider other factors, and not just

these indicators, in evaluating the risk posed by an institution's CRE

concentration.

F. Assessment of Capital Adequacy

In the final Guidance, the section on the ``Assessment of Capital

Adequacy'' was significantly revised to address the commenters'

concerns that the proposal was too restrictive and did not take into

account the institution's lending and risk management practices. The

proposal stated that institutions should hold capital commensurate with

the level and nature of their CRE concentration risks and that an

institution with high or inordinate levels of risk would be expected to

operate well above minimum regulatory capital requirements. In the

final Guidance, the discussion on the adequacy of an institution's

capital has been incorporated into the Supervisory Oversight section to

clarify that the assessment of an institution's capital will be

performed in connection with the supervisory assessment of an

institution's risk management.

Commenters asserted that many institutions already hold capital at

levels above minimum standards and should not be required to raise

additional capital simply because their CRE concentrations exceeded a

threshold. There also was concern that the proposal would give

examiners the ability to arbitrarily assess additional capital

requirements solely due to a high concentration.

The Agencies agree with commenters that the majority of

institutions with CRE concentrations presently have capital exceeding

regulatory minimums and would generally not be expected to increase

their capital levels. However, since an institution's capital serves as

a buffer against unexpected losses from its CRE concentration, an

institution with a CRE concentration and inadequate capital should

develop a plan for reducing its concentration or maintaining capital

appropriate for the level and nature of the concentration risk. To the

extent an institution with a CRE concentration has effective risk

management practices or is addressing the need for such practices, the

Agencies' concerns regarding capital adequacy are reduced. However, an

institution with a CRE concentration and with no prospects of enhancing

its risk management practices should address the need for additional

capital. Therefore, the final Guidance reminds institutions that they

should hold capital commensurate with the level and nature of the risks

to which they are exposed.

Commenters noted that the allowance for loan and lease losses

(ALLL) is another means of protection for an institution and,

therefore, should be considered in determining whether capital is

adequate for the level and nature of concentration risk. The Agencies

agree with this comment and have addressed ALLL within the context of

the capital adequacy section.

V. Text of the Final Joint Guidance

The text of the final joint Guidance on Concentrations in

Commercial Real Estate Lending, Sound Risk Management Practices

follows:

[[Page 74585]]

Concentrations in Commercial Real Estate Lending, Sound Risk Management

Practices

Purpose

The Office of the Comptroller of the Currency, the Board of

Governors of the Federal Reserve System, and the Federal Deposit

Insurance Corporation (collectively, the Agencies), are jointly issuing

this Guidance to address institutions' increased concentrations of

commercial real estate (CRE) loans. Concentrations of credit exposures

add a dimension of risk that compounds the risk inherent in individual

loans.

The Guidance reminds institutions that strong risk management

practices and appropriate levels of capital are important elements of a

sound CRE lending program, particularly when an institution has a

concentration in CRE loans. The Guidance reinforces and enhances the

Agencies' existing regulations and guidelines for real estate lending

\1\ and loan portfolio management in light of material changes in

institutions' lending activities. The Guidance does not establish

specific CRE lending limits; rather, it promotes sound risk management

practices and appropriate levels of capital that will enable

institutions to continue to pursue CRE lending in a safe and sound

manner.

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\1\ Refer to the Agencies' regualtions 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); and 12 CFR part 365 and

appendix A (FDIC). 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); and 12 CFR part 364,

appendix A (FDIC).

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Background

The Agencies recognize that regulated financial institutions play a

vital role in providing credit for business and real estate

development. However, concentrations in CRE lending coupled with weak

loan underwriting and depressed CRE markets have contributed to

significant credit losses in the past. While underwriting standards are

generally stronger than during previous CRE cycles, the Agencies have

observed an increasing trend in the number of institutions with

concentrations in CRE loans. These concentrations may make such

institutions more vulnerable to cyclical CRE markets. Moreover, the

Agencies have observed that some institutions' risk management

practices are not evolving with their increasing CRE concentrations.

Therefore, institutions with concentrations in CRE loans are reminded

that their risk management practices and capital levels should be

commensurate with the level and nature of their CRE concentration risk.

Scope

In developing this guidance, the Agencies recognized that different

types of CRE lending present different levels of risk, and that

consideration should be given to the lower risk profiles and

historically superior performance of certain types of CRE, such as

well-structured multifamily housing finance, when compared to others,

such as speculative office space construction. As discussed under ``CRE

Concentration Assessments,'' institutions are encouraged to segment

their CRE portfolios to acknowledge these distinctions for risk

management purposes.

This Guidance focuses on those CRE loans for which the cash flow

from the real estate is the primary source of repayment rather than

loans to a borrower for which real estate collateral is taken as a

secondary source of repayment or through an abundance of caution. Thus,

for the purposes of this Guidance, CRE loans include those loans with

risk profiles sensitive to the condition of the general CRE market (for

example, market demand, changes in capitalization rates, vacancy rates,

or rents). CRE loans are land development and construction loans

(including 1 - to 4-family residential and commercial construction

loans) and other land loans.

CRE loans also include loans secured by multifamily property, and

nonfarm nonresidential property where the primary 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, nonaffiliated, rental income) or the proceeds of the

sale, refinancing, or permanent financing of the property. Loans to

real estate investment trusts (REITs) and unsecured loans to developers

also should be considered CRE loans for purposes of this Guidance if

their performance is closely linked to performance of the CRE markets.

Excluded from the scope of this Guidance are loans secured by nonfarm

nonresidential properties where the primary source of repayment is the

cash flow from the ongoing operations and activities conducted by the

party, or affiliate of the party, who owns the property.

Although the Guidance does not define a CRE concentration, the

``Supervisory Oversight'' section describes the criteria that the

Agencies will use as high-level indicators to identify institutions

potentially exposed to CRE concentration risk.

CRE Concentration Assessments

Institutions actively involved in CRE lending should perform

ongoing risk assessments to identify CRE concentrations. The risk

assessment should identify potential concentrations by stratifying the

CRE portfolio into segments that have common risk characteristics or

sensitivities to economic, financial or business developments. An

institution's CRE portfolio stratification should be reasonable and

supportable. The CRE portfolio should not be divided into multiple

segments simply to avoid the appearance of concentration risk.

The Agencies recognize that risk characteristics vary among CRE

loans secured by different property types. A manageable level of CRE

concentration risk will vary by institution depending on the portfolio

risk characteristics, the quality of risk management processes, and

capital levels. Therefore, the Guidance does not establish a CRE

concentration limit that applies to all institutions. Rather, the

Guidance encourages institutions to identify and monitor credit

concentrations, establish internal concentration limits, and report all

concentrations to management and the board of directors on a periodic

basis. Depending on the results of the risk assessment, the institution

may need to enhance its risk management systems.

Risk Management

The sophistication of an institution's CRE risk management

processes should be appropriate to the size of the portfolio, as well

as the level and nature of concentrations and the associated risk to

the institution. Institutions should address the following key elements

in establishing a risk management framework that effectively

identifies, monitors, and controls CRE concentration risk:

Board and management oversight.

Portfolio management.

Management information systems.

Market analysis.

Credit underwriting standards.

Portfolio stress testing and sensitivity analysis.

Credit risk review function.

Board and Management Oversight. An institution's board of directors

has ultimate responsibility for the level of risk assumed by the

institution. If the institution has significant CRE concentration risk,

its strategic plan should address the rationale for its CRE levels in

relation to its overall growth objectives, financial targets, and

capital

[[Page 74586]]

plan. In addition, 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. Therefore, the board of directors or a designated

committee thereof should:

Establish policy guidelines and approve an overall CRE

lending strategy regarding the level and nature of CRE exposures

acceptable to the institution, including any specific commitments to

particular borrowers or property types, such as multifamily housing.

Ensure that management implements procedures and controls

to effectively adhere to and monitor compliance with the institution's

lending policies and strategies.

Review information that identifies and quantifies the

nature and level of risk presented by CRE concentrations, including

reports that describe changes in CRE market conditions in which the

institution lends.

Periodically review and approve CRE risk exposure limits

and appropriate sublimits (for example, by nature of concentration) to

conform to any changes in the institution's strategies and to respond

to changes in market conditions.

Portfolio Management. Institutions with CRE concentrations should

manage not only the risk of individual loans but also portfolio risk.

Even when individual CRE loans are prudently underwritten,

concentrations of loans that are similarly affected by cyclical changes

in the CRE market can expose an institution to an unacceptable level of

risk if not properly managed. Management regularly should evaluate the

degree of correlation between related real estate sectors and establish

internal lending guidelines and concentration limits that control the

institution's overall risk exposure.

Management should develop appropriate strategies for managing CRE

concentration levels, including a contingency plan to reduce or

mitigate concentrations in the event of adverse CRE market conditions.

Loan participations, whole loan sales, and securitizations are a few

examples of strategies for actively managing concentration levels

without curtailing new originations. If the contingency plan includes

selling or securitizing CRE loans, management should assess

periodically the marketability of the portfolio. This should include an

evaluation of the institution's ability to access the secondary market

and a comparison of its underwriting standards with those that exist in

the secondary market.

Management Information Systems. A strong management information

system (MIS) is key to effective portfolio management. The

sophistication of MIS will necessarily vary with the size and

complexity of the CRE portfolio and level and nature of concentration

risk. MIS should provide management with sufficient information to

identify, measure, monitor, and manage CRE concentration risk. This

includes meaningful information on CRE portfolio characteristics that

is relevant to the institution's lending strategy, underwriting

standards, and risk tolerances. An institution should assess

periodically the adequacy of MIS in light of growth in CRE loans and

changes in the CRE portfolio's size, risk profile, and complexity.

Institutions are encouraged to stratify the CRE portfolio by

property type, geographic market, tenant concentrations, tenant

industries, developer concentrations, and risk rating. Other useful

stratifications may include loan structure (for example, fixed rate or

adjustable), loan purpose (for example, construction, short-term, or

permanent), loan-to-value limits, debt service coverage, policy

exceptions on newly underwritten credit facilities, and affiliated

loans (for example, loans to tenants). An institution should also be

able to identify and aggregate exposures to a borrower, including its

credit exposure relating to derivatives.

Management reporting should be timely and in a format that clearly

indicates changes in the portfolio's risk profile, including risk-

rating migrations. In addition, management reporting should include a

well-defined process through which management reviews and evaluates

concentration and risk management reports, as well as special ad hoc

analyses in response to potential market events that could affect the

CRE loan portfolio.

Market Analysis. Market analysis should provide the institution's

management and board of directors with information to assess whether

its CRE lending strategy and policies continue to be appropriate in

light of changes in CRE market conditions. An institution should

perform periodic market analyses for the various property types and

geographic markets represented in its portfolio.

Market analysis is particularly important as an institution

considers decisions about entering new markets, pursuing new lending

activities, or expanding in existing markets. Market information also

may be useful for developing sensitivity analysis or stress tests to

assess portfolio risk.

Sources of market information may include published research data,

real estate appraisers and agents, information maintained by the

property taxing authority, local contractors, builders, investors, and

community development groups. The sophistication of an institution's

analysis will vary by its market share and exposure, as well as the

availability of market data. While an institution operating in

nonmetropolitan markets may have access to fewer sources of detailed

market data than an institution operating in large, metropolitan

markets, an institution should be able to demonstrate that it has an

understanding of the economic and business factors influencing its

lending markets.

Credit Underwriting Standards. An institution's lending policies

should reflect the level of risk that is acceptable to its board of

directors and should provide clear and measurable underwriting

standards that enable the institution's lending staff to evaluate all

relevant credit factors. When an institution has a CRE concentration,

the establishment of sound lending policies becomes even more critical.

In establishing its policies, an institution should consider both

internal and external factors, such as its market position, historical

experience, present and prospective trade area, probable future loan

and funding trends, staff capabilities, and technology resources.

Consistent with the Agencies' real estate lending guidelines, CRE

lending policies should address the following underwriting standards:

Maximum loan amount by type of property.

Loan terms.

Pricing structures.

Collateral valuation.\2\

Loan-to-Value (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.

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\2\ Refer to the Agencies' appraisal regualtins: 12 CFR part 34,

subpart C (OCC); 12 CFR part 208 subpart E and 12 CFR part 225,

subpart G (FRB); and 12 CFR part 323 (FDIC).

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Minimum standards for borrower net worth, property cash

flow, and debt service coverage for the property.

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

[[Page 74587]]

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 or designated

committee detailing the number, nature, justifications, and trends for

exceptions. Exceptions to both the institution's internal lending

standards and the Agencies' supervisory LTV limits \3\ 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.

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\3\ The Interagency Guidelines for Real Estate Lending state

that loans exceeding the supervisory LTV guidelines should be

recorded in the institution's records and reported to the board at

least quarterly.

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Credit analysis should reflect both the borrower's overall

creditworthiness and project-specific considerations as appropriate. In

addition, for development and construction loans, the institution

should have policies and procedures governing loan disbursements to

ensure that the institution's minimum borrower equity requirements are

maintained throughout the development and construction periods. Prudent

controls should include an inspection process, documentation on

construction progress, tracking pre-sold units, pre-leasing activity,

and exception monitoring and reporting.

Portfolio Stress Testing and Sensitivity Analysis. An institution

with CRE concentrations should perform portfolio-level stress tests or

sensitivity analysis to quantify the impact of changing economic

conditions on asset quality, earnings, and capital. Further, an

institution should consider the sensitivity of portfolio segments with

common risk characteristics to potential market conditions. The

sophistication of stress testing practices and sensitivity analysis

should be consistent with the size, complexity, and risk

characteristics of its CRE loan portfolio. For example, well-margined

and seasoned performing loans on multifamily housing normally would

require significantly less robust stress testing than most acquisition,

development, and construction loans.

Portfolio stress testing and sensitivity analysis may not

necessarily require the use of a sophisticated portfolio model.

Depending on the risk characteristics of the CRE portfolio, stress

testing may be as simple as analyzing the potential effect of stressed

loss rates on the CRE portfolio, capital, and earnings. The analysis

should focus on the more vulnerable segments of an institution's CRE

portfolio, taking into consideration the prevailing market environment

and the institution's business strategy.

Credit Risk Review Function. A strong credit risk review function

is critical for an institution's self-assessment of emerging risks. An

effective, accurate, and timely risk-rating system provides a

foundation for the institution's credit risk review function to assess

credit quality and, ultimately, to identify problem loans. Risk ratings

should be risk sensitive, objective, and appropriate for the types of

CRE loans underwritten by the institution. Further, risk ratings should

be reviewed regularly for appropriateness.

Supervisory Oversight

As part of their ongoing supervisory monitoring processes, the

Agencies will use certain criteria to identify institutions that are

potentially exposed to significant CRE concentration risk. An

institution that has experienced rapid growth in CRE lending, has

notable exposure to a specific type of CRE, or is approaching or

exceeds the following supervisory criteria may be identified for

further supervisory analysis of the level and nature of its CRE

concentration risk:

(1) Total reported loans for construction, land development, and

other land \4\ represent 100 percent or more of the institution's total

capital;\5\ or

(2) Total commercial real estate loans as defined in this Guidance

\6\ represent 300 percent or more of the institution's total capital,

and the outstanding balance of the institution's commercial real estate

loan portfolio has increased by 50 percent or more during the prior 36

months.

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\4\ For commercial banks as reported in the Call Report FFIEC

031 and 041, schdule RC-C, item la.

\5\ For purposes of this Guidance, the term ``total capital''

means the total risk-based capital as reported fro commercial banks

in the Call Report FFIEC 031 and 041 schedule RC-R--Regulatory

Capital, line 21.

\6\ For commercial banks as reported in the Call Report FFIEC

031 and 041 schedule RC-C, items 1a, 1d, 1e, and Memorandum Item

3.

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The Agencies will use the criteria as a preliminary step to

identify institutions that may have CRE concentration risk. Because

regulatory reports capture a broad range of CRE loans with varying risk

characteristics, the supervisory monitoring criteria do not constitute

limits on an institution's lending activity but rather serve as high-

level indicators to identify institutions potentially exposed to CRE

concentration risk. Nor do the criteria constitute a ``safe harbor''

for institutions if other risk indicators are present, regardless of

their measurements under (1) and (2).

Evaluation of CRE Concentrations. The effectiveness of an

institution's risk management practices will be a key component of the

supervisory evaluation of the institution's CRE concentrations.

Examiners will engage in a dialogue with the institution's management

to assess CRE exposure levels and risk management practices.

Institutions that have experienced recent, significant growth in CRE

lending will receive closer supervisory review than those that have

demonstrated a successful track record of managing the risks in CRE

concentrations.

In evaluating CRE concentrations, the Agencies will consider the

institution's own analysis of its CRE portfolio, including

consideration of factors such as:

Portfolio diversification across property types.

Geographic dispersion of CRE loans.

Underwriting standards.

Level of pre-sold units or other types of take-out

commitments on construction loans.

Portfolio liquidity (ability to sell or securitize

exposures on the secondary market).

While consideration of these factors should not change the method

of identifying a credit concentration, these factors may mitigate the

risk posed by the concentration.

Assessment of Capital Adequacy. The Agencies' existing capital

adequacy guidelines note that an institution should hold capital

commensurate with the level and nature of the risks to which it is

exposed. Accordingly, institutions with CRE concentrations are reminded

that their capital levels should be commensurate with the risk profile

of their CRE portfolios. In assessing the adequacy of an institution's

capital, the Agencies will consider the level and nature of inherent

risk in the CRE portfolio as well as management expertise, historical

performance, underwriting standards, risk management practices, market

conditions, and any loan loss reserves allocated for CRE concentration

risk. An institution with inadequate capital to serve as a buffer

against unexpected losses from a CRE concentration should develop a

plan for reducing its CRE concentrations or for maintaining capital

appropriate to the level and nature of its CRE concentration risk.


[[Page 74588]]

Dated: December 5, 2006.

John C. Dugan,

Comptroller of the Currency.

By order of the Board of Governors of the Federal Reserve

System, December 6, 2006.

Jennifer J. Johnson,

Secretary of the Board.

Dated at Washington, DC, this 6th day of December 2006.

By order of the Federal Deposit Insurance Corporation.

Robert E. Feldman,

Executive Secretary.

[FR Doc. 06-9630 Filed 12-11-06; 8:45 am]


BILLING CODE 4810-33-P



Last Updated 12/12/2006 Regs@fdic.gov