Ten Questions that Banks with High CRE Concentrations Should Answer

The pressure is continuing to increase on banks with CRE concentrations. First it was the FDIC, which  put community banks with CRE concentrations in its crosshairs when the supervisory division released its update on commercial real estate concerns in  Supervisory Insights in early August.

We can now officially add the OCC to the list of regulatory agencies that have fired a warning shot at community banks with CRE concentrations. On October 6, the OCC released its Fiscal 2023 Bank Supervision Operating Plan, which highlights the areas that bank examiners will “heighten its focus” on in the coming year.  The list includes credit risk with an emphasis on commercial real estate and portfolios that “represent concentrations.”

It is easy for community banks with CRE concentrations to fall into the trap of thinking their existing processes for managing concentration risk are sufficient. Just because your examiner-in- charge blessed your practices in your last exam circa 12-15 months ago doesn’t mean they’ll be acceptable in this current climate.

Stress testing is one of the most important processes that examiners look at when evaluating a bank’s capabilities to manage CRE concentrations. Banks historically have been able to skate by this expectation by doing a run-of-the-mill, loan-level CRE transaction sensitivity test in which they shock NOI levels and cap rates. Moving forward, this will not be enough. While this exercise is likely to earn banks a “pat on the back”, they run the risk of winning the battle while losing the war.

This is because the focus on CRE concentrations is shifting from the tactical arena to the strategic one. Examiners are now focusing on capital plans, strategic plans, and concentration limits. If your strategic plan has even the whiff of aggressive loan growth in CRE, you must be prepared to be poked and prodded in ways you have never experienced before. You will be presumed guilty unless you prove yourself innocent.

And don’t blame the regulators for taking this posture.  The regulators are treating 2022 and 2023 like it’s a do-over of 2007. The lesson they learned from the 2008 Global Financial Crisis was that they were not tough enough on the banks with concentrations in the years leading up the crisis. Their post-mortem internal studies showed that banks with CRE concentrations were more likely to fail.

Examiners won’t be making that mistake again, irrespective of how hard of a landing our economy ends up suffering due to the Federal Reserve’s determination to crush inflation via aggressive monetary policies.

Despite all the concerns about how commercial real estate will perform in a perfect storm of rising inflation, rising interest rates, and a slowing economy, CRE prices have held up relatively strong thus far. They are even up on a year-to-date basis for nearly every property type, including the much-maligned office sector. However, to satisfy the coming examiner scrutiny, you need to have answers to the following 10 questions:

Ten Questions you Should be Prepared to Answer

1. How have you adjusted your internal regulatory capital thresholds to reflect your concentration risk?
2. How have you created, revisited or validated your internal concentration triggers and limits?
3. How have you determined concentration triggers and limits for each relevant property type (multifamily, office, industrial, retail, hospitality, etc.)?
4. How have you stress tested your strategic plan to confirm you have sufficient capital to support it?
5. How have you reconciled your loan portfolio stress test results with your CECL allowance?
6. If you have a meaningful negative AOCI position, how have you adjusted your capital plan for it?
7. How have you updated your capital plan to include key warning indicators such as the Classified Assets to Capital Ratio?
8. How have you assessed the impact that a Stagflation scenario that encompasses both a recession and rising interest rates could inflict on your bank?
9. The benchmark 10-year Treasury yield is approaching 4 percent and there is meaningful risk it could increase further over the next 6 to 12 months. How are you adjusting your strategy and risk management to reflect the risk that CRE cap rates are likely to increase and cause CRE prices to decline as a result?
10. How has the bank’s Board of Directors been involved?

Invictus Can Help

Invictus specializes in assisting banks with CRE and construction concentrations. We help banks use data and analytics to quantify customized internal capital thresholds, concentration triggers and limits, and integrate stress testing into capital plans and CECL frameworks. If you have a CRE concentration and either have an upcoming exam or recently had an exam that included formal actions (such as MRAs or MRBAs)  related to managing CRE concentrations, please reach out to Patti Casaleggio pcasaleggio@invictusgrp.com to schedule a consultative session to learn how Invictus can help.