Which Red Flags are Bank Watchdogs Raising?

By Steven Bandolik and Chris Spoth

Steve Bandolik, Director, Deloitte Services LP

In recent months, we’ve explored the key commercial real estate trends to watch in 2016 (see, for example, our columns in CPE’s November and December digital issues). To those topics we add another urgent issue: the regulatory environment.

In this month’s column, we discuss the red flags that bank watchdogs are raising. The combination of increased exposure to real estate and relaxed underwriting is once again drawing attention to lending practices. For banks playing in this space, that heightened scrutiny may well prove to be a pain point this year:

What goes around …

This past December, federal banking agencies decided to reinforce a decade-old guidance on risk management in CRE lending. They announced intentions to pay special attention to potential risks in the year ahead, especially where CRE concentrations are high.

This prompts two observations:

• Banks are increasing their exposures to CRE lending, reflecting an increased appetite for risk in the sector, and
• In response, regulators are flashing yellow on risk concentration and warning banks to maintain underwriting discipline and exercise prudent risk management, which they say has eased significantly in recent years.

Precautionary moves

Chris Spoth, Executive Director, Deloitte Center for Regulatory Services

For banks with high concentrations of commercial real estate in their portfolios, this reminder from regulators is precautionary; they’ve seen this play out in prior bubbles, and this time they are pointing to growth in multifamily loans. In the wake of these precedents, their reminder comes as a strong warning to follow the primary guidance issued in 2006.

So if you’re a bank or financial institution with a high or growing CRE concentration, now is an opportune time to make sure your house is in order. Here are a few steps to consider:

• Make sure your management information system is up to snuff. Regulators have high expectations here, so make sure the data base and technology that drives your book’s quantitative and qualitative reporting is sophisticated enough to effectively manage portfolio risk. Regulators expect an intimate knowledge of geographies, property types, loan-to-value ratios and debt service coverage. Having that intimate knowledge reflected in good quality data allows firms to leverage this foundation for other important risk management responsibilities, such as stress testing, capital planning and credit loss provisioning.
• Evaluate lending and underwriting standards. These rank high among the activities that raise red flags with regulators. Now is the time to evaluate risk appetite, set appropriate underwriting policies and enforce them. One sign of slipping discipline cited by regulators is an increase in policy exceptions. Tracking these exceptions, and questioning whether they are warranted by changing market conditions and risk appetite, is essential to avoiding outsized future losses.
• Test for stress. It is impossible to overemphasize the importance of continually stress-testing portfolios when it comes to managing concentration risk, monitoring market risks and even assessing a borrower’s ability to service debts. In the next three years, $346 billion worth of CMBS loans are scheduled to mature that regulators did not cite in their reminder, so be careful not to leave major risk factors on the table during testing. Refinancing these CMBS loans will require active participation from banks.

Regulators may not yet be ready to drive examiners toward every CRE loan, but they are certainly interested in investigating where concentrations exceed established thresholds. So take time to evaluate your portfolio now, instead of waiting until it’s too late.

Steven Bandolik is a director with Deloitte Services LP and a senior leader in Deloitte’s real estate services practice. A 30-year industry veteran, Bandolik provides advisory services in a wide range of business areas, including capital markets, corporate finance, mergers and acquisitions, investments, restructuring and reorganization, workout and asset recovery.

Chris Spoth is an executive director with the Deloitte Center for Regulatory Strategies. He has more than 35 years of bank regulatory and advisory experience, spending the majority of his career at the Federal Deposit Insurance Corp. where he oversaw examinations, enforcement actions, applications, consumer protection and anti-money laundering programs at more than 4,600 banks nationwide.