Early warning systems are great, but sometimes they need to be revisited to preserve their value. This is often the case with lending concentration limits as a percentage of capital at community and mid-sized banks. Your bank may be approaching internal concentration limits that were set too low, or are nearing an external checkpoint such as the 300 percent CRE threshold that triggers increased regulatory scrutiny.

It is easy to think that the simple solution is to raise the bank’s internal concentration limit. If you are approaching 300 percent CRE and your internal limit is 300 percent CRE, why not just raise it to 350 percent or 400 percent?

You can.  And sometimes, you can without any trouble. But you are playing with fire.

There are several problems with this approach:

1. You put your directors in a bind because they may be perceived as rubber stamping management’s request to increase the limit without any trade-offs and with limited information. That is not sound concentration risk management.
2. Your examiner may tell you that you must “pay to play.” In other words, “Sure, you want to run at 400 percent CRE instead of 300 percent, but you must first kick in more capital.” Next thing you know, you are running on a proverbial hamster wheel. You’re constantly injecting capital to keep your concentration ratio in check and support loan growth that is happening in real time.
3. Management and the board become desensitized to concentration limits and view them as an unnecessary obstacle instead of what they should be, which is a key piece of your first-class enterprise risk management and capital planning infrastructure.

What is the Solution?

The short answer is that if you want to increase a concentration limit, you must have the right data and analysis to back up the proposed new limit.

That data does not include your lack of loss history. Fairly or unfairly, historical losses have been perceived as poor predictors of future performance. This is why the regulators have emphasized forward-looking risk analysis in the years since the 2008 Financial Crisis. This is also why regulators aren’t going to wait for defaults to start accelerating before scrutinizing the office space segment of your CRE portfolio.

What a bank must do is demonstrate that it can remain sufficiently capitalized at the proposed higher concentration limit. The best way to do this is with a stress test. Not a stress test of your bank as of today, but of your bank at the proposed concentration limit. And it must be a well-designed stress test that captures the unique risk characteristics of different loan types in a post-pandemic economy.

Armed with this information, management can go to the board and pair a request to increase a concentration limit with an analysis that shows it’s safe to do so. Management can also pre-empt the regulators’ “pay-to- play” card by demonstrating that raising additional capital is unnecessary, or that the bank needs less additional capital than expected. Most importantly, the analysis can show that your bank is at the right limit, not one that is too high or too low. This preserves the value and respect for the intended regulatory purpose of concentration limits: to effectively manage risk and capital.

Invictus Group has developed InFocus, a tool specifically designed to help banks determine their concentration limits using stress testing techniques. Many banks have successfully raised concentration limits supported by Invictus analytics without having to raise additional capital or face unnecessary increased scrutiny from regulators. For more information on InFocus, please contact pcasaleggio@invictusgrp.com.