By: Jay Lucas, Director
The Federal Deposit Insurance Corporation (FDIC) issued new guidance for financial institutions in December 2023 for managing concentrations in a challenging economic environment. Amid concerns about bank performance and unstable markets, the FDIC wanted to “reemphasize the importance of strong capital, appropriate credit loss allowance levels, and robust credit risk-management practices for institutions with commercial real estate (CRE) concentrations.” While the advisory itself was neither surprising nor unwelcome, its title reflected an ongoing challenge that’s kept lenders focused on risk management for a few years now.
Has Commercial Real Estate Weathered the Worst of the Storm?
Commercial real estate (CRE) has performed well and has had several good years of positive growth, with the low cost of capital combined with deal volumes that soared. The rapid rise in interest rates put intense pressure on investors to increase rents and leases, and many lenders faced strain in the CRE space due to loans starting to reprice at the new higher rates. In addition, higher payments and CAP rates starting to rise have caused the values of properties in many CRE classes to start to drop.
Bankers aren’t feeling overly optimistic about CRE lending portfolios just yet, but the peak panic moments appear to have subsided for now. Although the US has had record inflation over the past several years, the economy has been fighting to stay afloat. Some positive inflation and employment news over the past few months should lead to the possibility of a decrease in interest rates in the coming quarters ahead. When rates go down, some CRE deals which may have been on hold due to such high rates will finally look to get funded or to start back up.
As interest rates are poised to begin a slow decrease, Multi-family units should soon reach a lasting phase where demand outstrips supply. Industrial properties have maintained demand and have not been nearly as affected as other CRE categories, such as retail. With the Fed’s policy easing, it is still a possibility to see some bright spots appearing in certain CRE asset classes; it’s reasonable to expect a moderate pace of improvement and stabilization, perhaps in most regional CRE markets.
What to Do as Deals Increase?
As deals start to ramp back up, it will be important to focus on good fiscal housekeeping and proper management of the Bank’s CRE portfolio.
Regulator’s also reminded institutions that if they have significant CRE holdings, they should practice sound risk management strategies. Increased portfolio analytics and board reporting is a must.
In addition, the FDIC has pointed out basic tenets of risk management that can help banks with CRE loans weather tough economic climates:
- When markets are stressed, boost capital to withstand unexpected losses.
- Stay within appropriate credit loss allowances and assess collectability often.
- Actively monitor and manage CRE and construction and development portfolios.
- Keep detailed, current borrower financial data and continuously updated analytics.
- Increase the robustness of the institution’s loan workout infrastructure.
- Be proactive about monitoring and controlling liquidity in response to funding risks.
- Identify and test ample funding sources, including contingent funding mechanisms.
All this is solid advice, but it also represents a heads-up for lenders — a formal notification that it’s time to get your house in order. Regulators are providing explicit standards and clearly communicating that they expect your institution to meet them. In accordance with their updated and reissued guidance, the FDIC is ramping up scrutiny on CRE concentrations as well as financial institutions’ diligence with analysis and reporting.
As loans transition from construction development into longer term asset classifications such as owner and nonowner occupied CRE it will be important to make sure that a proper tracking is in place. Proper asset classifications is not only important at origination, but should be reviewed based on the structure changes from construction A&D to the eventual permanent financing.
Robust Reporting Helps Banks and Regulators
Banks submit quarterly call reports to the FDIC. These reports show detailed profiles of the institution’s loan portfolio, including concentrations by asset class and the percentage of capital each loan and class represents.
While it creates valuable transparency, the Call Report Code system can be a complex tool that isn’t always easy to apply correctly. Despite the challenges, it’s important for banks review their buckets regularly to achieve impeccable reporting accuracy. Not only does proper reporting contribute to sound risk management at the institution level, but it’s also key to regulatory compliance. Reporting accuracy looms large in the FDIC’s sights, so always seek professional assistance if you have any uncertainty about the proper application of call codes. It is important to make sure that loans are appropriately recorded on the call reports to properly identify Non-owner Occupied loans or Multifamily loans vs Owner Occupied loans. Is the financial institution using the Commercial & Industrial call code correctly? What about Construction and A&D Loans?
Protect your Institution with the Right Support
Like the economy, the bank regulatory environment is always evolving. Navigating this complex and ever-changing landscape can expose you to excessive financial and regulatory risk. Reach out to the knowledgeable advisors at Mauldin & Jenkins for help. We understand how to keep your financial institution strong, financially sound, and in full regulatory compliance.
