Concentration Risk Management Remains an Exam Focus: Stress Tests are Vital

Make no mistake about it: If your bank has concentrations that are at or above regulatory guidelines, examiners will expect to see a stress test that supports your concentration risk management plan.

Stress testing has never been mandated for community banks—but it is a tool examiners expect banks to use if they have concentration issues in their portfolio. And this isn’t going to change, no matter what Congress does to ease regulatory burden.

In the past year, many community banks have had regulators question their concentration risk management practices. Examiners have said the stress tests will be the primary focus, and in some cases the only focus, of the inquiry.

In several cases, regulators downgraded the bank’s CAMELS score for not having adequate stress testing in place. Regulators are most focused on the management’s command of the tests, and how they make real and critical decisions related to capital and strategic planning.

Banks with New Concentration Issues of Interest
Commercial real estate (CRE) concentration risk management is not a new issue, but regulators are especially targeting banks without a long history of managing CRE concentrations, and are growing their CRE book at excessive rates. 

A BankGenome™ analysis shows that 2,004 banks have grown their CRE portfolios by more than 50 percent in the last three years, a level that has regulators concerned. As of the first quarter of 2018, 293 banks were over the 100 percent construction threshold and 420 banks exceeded the 300 percent total CRE guidelines. Of banks exceeding the thresholds, 54 banks also had 50 percent or more growth within the last three years – a sure sign they will face increased scrutiny under current guidance.

Anticipate Exam Scrutiny
If you are one of these banks, the worst thing you can do is overlook your next safety and soundness exam. Regulators will come in guns blazing, and you should prepare yourself accordingly.

There will be findings and perhaps even formal Matters Requiring Attention (MRAs), no matter how prepared you are.

Make Minor Findings a Goal
However, the key is to manage those findings. You want only minor infractions, such as not having enough loans with Debt-Service Coverage Ratios (DSCRs) in your core, or having to deal with model risk and model validation. Those are easy to address, while allowing examiners to show their boss that they extracted blood from you. 

You do NOT want examiners to say management doesn’t understand or use the stress test. Those type of findings are far more serious and could lead to CAMELS rating downgrades or worse.

Regulators Expect Stress Tests
Examiners expect banks with CRE concentrations to conduct portfolio stress testing, so bank management and the board can determine the correct level of capital the bank needs. 

Banks with concentrations would be smart to follow the stress testing best practices outlined by the Federal Reserve Bank of Richmond’s Jennifer Burns. Those include:

• Running multiple scenarios to understand potential vulnerabilities
• Making sure assumptions for changes in borrower income and collateral values are severe enough
• Varying assumptions for what could happen in a downturn instead of just relying on what happened to a bank’s charge-off rates during the recession
• Using the stress test results for capital and strategic planning
• Changing the stress test scenarios to stay in sync with the bank’s current strategic plan

Burns’ article also notes that one new area of concern is owner-occupied CRE loans, which for years were considered extremely safe.

Report Finds Increased Scrutiny and Risk
The Government Accountability Office issued a report in March that warned of increased risk from CRE loan performance, though still lower than levels associated with the 2008 financial crisis. The GAO found that banks with higher CRE concentration were subject to greater supervisory scrutiny. Of 41 exams at banks with CRE concentrations, examiners documented 15 CRE-related risk management weaknesses, most often involving board and management oversight, management information systems and stress testing.

Prudential regulators acknowledge that proper concentration risk management is a supervisory concern for 2018.
The Office of the Comptroller of the Currency’s latest semi-annual risk perspective noted that “midsize and community banks continued to experience strong loan growth, particularly in CRE and other commercial lending, which grew almost 9 percent in 2017. Such growth heightens the need for strong credit risk management and effective management of concentration risk.”