When was the last time you reviewed your commercial real estate (CRE) lending portfolio?
The importance of risk management practices in the context of CRE and construction and development (C&D) concentrations was a point recently highlighted by the FDIC. Given current market conditions, including rising vacancy rates, reduced demand, and lower property values, CRE and C&D loan concentrations are clear vulnerabilities without robust planning. The following are excerpts from the FDIC’s six recommendations for ensuring your institution is prepared for any unexpected difficulties:
- Maintain Strong Capital Levels – Institutions with significant C&D and CRE exposures may require more capital because of uncertainty about market conditions causing an elevated risk of unexpected losses.
- Ensure that Credit Loss Allowances are Appropriate – Specifically, GAAP requires management to use relevant forward-looking information and expectations drawn from reasonable and supportable forecasts when estimating expected credit losses. While historical loss information generally provides a basis for assessing expected credit losses, management should consider whether further adjustments to historical loss information are needed to reflect current economic conditions.
- Manage C&D and CRE Loan Portfolios Closely – Institutions should maintain credit administration practices that consider the risks of material C&D and CRE concentrations. This includes management information systems that provide the board and management with relevant data on concentrations levels and related market conditions, including for concentration or market segments. Applying adverse scenarios while conducting stress tests or sensitivity analysis helps banks adjust risk management processes to prepare for credit risk problems before they impact earnings and capital. Additionally, appropriate risk management practices include maintaining a strong credit review and risk rating system that identifies deteriorating credit trends early. It is important for institutions to effectively manage interest reserves and loan accommodations, reflecting the borrower’s condition accurately in loan ratings and documented reviews.
- Maintain Updated Financial and Analytical Information – Prudent institutions with CRE and/or C&D concentrations maintain recent borrower financial statements, including property cash flow statements, rent rolls, guarantor personal statements, tax return data, and other income property performance information to better understand their borrowers’ ability to repay and overall financial condition and enable timely identification of adverse trends (also key inputs to stress testing). It is important for management to consider the continued relevance of appraisals and evaluations performed during prior economic or market and interest rate conditions, and update collateral valuation information as necessary.
- Bolster the Loan Workout Infrastructure – Well prepared institutions ensure they have sufficient staff and appropriate skill sets to properly manage an increase in problem loans and workouts. Likewise, institutions that have a ready network of legal, appraisal, real estate brokerage, and property management professionals to handle additional prospective workouts are better situated for more positive outcomes.
- Maintain Adequate Liquidity and Diverse Funding Sources – It is important for institutions to have a comprehensive management process for identifying, measuring, monitoring, and controlling liquidity and funding risks. Recent industry events have underscored risks related to relying on funding concentrations, such as high levels of uninsured deposits, and the importance of interest rate and liquidity risk management and contingency funding planning. Institutions that have identified appropriate levels of cash and cash equivalents, that have identified and are able to use a stable and diverse range of funding mechanisms, and that have identified and tested sources of contingent liquidity, are better positioned to profitably support CRE concentrations.
Of course, the FDIC’s publication contains more information than the above, but feel free to reach out to us on the hotline with any questions about it, or any questions you might have about the risk management in general. It’s not always easy to sift through a wealth of general guidance and determine how to best manage your particular situation. Compliance Alliance is here to help.