Some metrics hint CRE lenders may not be as prepared for potential downturns as they should be.
The Summer 2022 issue of the FDIC’s Supervisory Insights ran an article called “Commercial Real Estate: An Update on Bank Lending Amid the Evolving Pandemic Backdrop.” While an examination of financial performance of banks lending to CRE, it also mentions “observations about CRE lending risk management practices” and “the FDIC’s forward-looking supervisory focus for banks with significant exposure in this sector.”
“The majority of banks with CRE loan concentrations are satisfactorily rated,” the article said. “Nevertheless, CRE loan concentrations add dimensions of risk that necessitate continued attention from banks and their regulators, especially as the pandemic lingers and uncertainties remain.”
There is a lot of money in bank CRE lending, recently peaking at $2.7 trillion, or “well above the $1.9 trillion held in 2008.” Community banks held almost $800 billion of this. And at the end of 2021, a quarter of banks had CRE loan concentration of more than triple their tier-1 capital and reserves for loan losses. There are various other criteria used in examining risk management of CRE lending.
But, as the article explains, none of these metrics are “safe harbors nor regulatory limits. Rather, regulators may identify a bank that is approaching or meets the criteria, or that has notable exposure to a specific type of CRE, for further supervisory analysis.”
While ADC (Acquisition, Development, and Construction) and CRE lenders are generally showing higher returns on average assets than other banks, they also “still operate with a generally higher-risk profile, including lower capital and loan loss reserve levels.”
The CRE lenders rely more on wholesale funding than ADC lenders or other banks. Both the CRE and ADC lenders held lower capital than other banks. “As part of assessing the adequacy of a bank’s capital, regulators 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.”
The CRE and ADC banks loan loss reserves to total loans that were eight to 12 basis points below other banks. However, historically, CRE portfolios, and particularly the ADC segment, “have the propensity to produce significant losses during periods of economic stress, especially when not properly managed.”
So far, delinquencies are at historically low levels and losses have been nominal. But that’s at least in part due to stimulus and pandemic relief programs as well as the low cost of capital. Workouts of loans during the pandemic may have suppressed delinquencies and limited losses.
This all seems to be creating concern among regulators. “As a continuance of the FDIC’s longstanding risk-focused and forward-looking supervision principle, FDIC examiners prioritize resources toward areas presenting the highest risk at an individual bank, which often includes significant CRE lending concentrations,” the article noted. And it seems that the FDIC will prioritize the effectiveness of governance and risk management in CRE lending going forward.