By now, the vast majority of banks with credit concentrations in excess of the 2006 Interagency Regulatory Guidance have discussed this with regulators during periodic reviews. To underscore the importance of this to the regulators, a reminder was sent by the Federal Reserve in December of 2015 about commercial real estate (CRE) concentrations. The guidance calls for further supervisory analysis if:
- loans for construction, land, and land development (CLD) represent 100 percent or more of the institution’s total risk-based capital, or
- total non-owner-occupied CRE loans (including CLD loans), as defined, represent 300 percent or more of the institution’s total risk-based capital, and further, that the institution’s non-owner occupied CRE loan portfolio has increased by 50 percent or more during the previous 36 months.
While the immediate consequence of exceeding these levels is for “further supervisory analysis,’’ what the regulators are really saying is that financial institutions “should have risk-management practices commensurate with the level and nature of their CRE concentration risk.” And it’s hard to argue with that considering that, of the banks that met or exceeded both concentration levels in 2007, 22.9 percent failed during the credit crisis and only .5 percent of the banks that were below both levels failed.
So the big question is: How to mitigate the risk? Just like the idea of having to fit into a bathing suit this summer can be motivation to exercise, the answer is to give your loan portfolio a workout.
And in this context, that workout should consist of stress testing designed to inform and complement your concentration limits. In other words, the limits you set for your bank should not exist in a vacuum or be made up from scratch, they need to be connected to your risk management approach and more specifically, your risk-based capital under stress. What’s necessary is to take your portfolio, simulate a credit crisis, and look at the impact on risk-based capital. How do your concentration limits impact the results?
For our larger customers, we find that a migration-based approach works best because the probability of default and loss given default calculations can come from their own portfolio and they can be used to project forward in a stress scenario (1 in 10 or 1 in 25-year event, for example). For our smaller banks or banks that do not have the historical data available, we use risk proxies and our own index data to help supplement the inevitable holes in data. Remember, the goal is to understand how the combination of concentrations and stress impacts your capital in a data-driven and defensible way.
Additionally, the data repository created from the collection of the regulatory flat files (the only standardized output from bank core systems) can be used for a variety of purposes. This data store can also be used to create tools for ongoing monitoring and management of concentrations that can include drill down capabilities for analysis of concentrations by industry, FFIEC Code, product/purpose/type codes, loan officer, industry and geography (including mapping), and many others. The results of loan review can even be tied in. The net result is a tool that provides significant insight into your portfolio and is a data-driven road map to your conversation with your regulators. It also demonstrates a bank’s commitment to developing and using objective analytics, which is precisely the goal of the regulators. They want banks to move past the days of reliance on “gut feel” and embrace a more regimented risk management process.
When the segmentation and data gathering is done well, you are well positioned to drive your portfolio through all sorts of different workouts. The data can be used for current allowance for loan and lease losses, stress testing, portfolio segmentation, merger scenarios and current expected credit loss (CECL) calculations, as well as providing rational, objective reasons why concentration limits should be altered.
And just like exercise, this work can be done with a personal trainer, or on your own. All you need is a well thought out plan and the discipline to work on it every day as part of an overall program designed for credit risk health.