Concentration Alert: Why You Should Adopt Better Commercial Real Estate Risk Management Practices Even before New Guidelines Take Effect

Over the past decade, banks and thrifts of all sizes have significantly increased their exposure to commercial real estate (CRE) lending. The largest percentage increases have occurred at institutions with $10 billion or less in total assets. At the end of the third quarter of 2005, construction and land development loans accounted for three times their 1995 percentage of gross loans and leases at institutions within this asset tier, and non-farm, non-residential CRE loans were nearly double their 1995 percentage. In response to this trend, the Federal Reserve, the FDIC, the OCC, and the OTS published proposed interagency guidelines and best on Jan. 9, 2006. It is unclear at the time of this writing if final guidance will be issued later this year and what it will say. [The comment period was extended in March to April 13.] Regardless of the final outcome, the guidelines as initially proposed are far-reaching and make for prudent business practices. More plainly, real estate lenders that do not adhere to the principles outlined in the proposed guidelines may underestimate the risk in their portfolios and subject themselves to substandard portfolio credit performance. The implications of enhancing risk monitoring--i.e., adopting the guidelines if and when they are finalized--are significant. First, many banks may be forced to change their current business model. Roughly one quarter to one third of all supervised institutions have portfolio CRE concentrations that exceed proposed capital thresholds. As a result, these lenders will need to meet heightened risk management practices and/or carry more capital to avoid enhanced scrutiny. Either way, the profitability of real estate lending may be diminished, and severely impacted banks will likely need to find alternative lending opportunities. Second, these same consequences will force many lenders to reconsider CRE pricing. Specifically, they will need to analyze and offset increased capital allocations and monitoring costs to maintain profitability. Banks with inadequate risk monitoring must also determine how to implement an improved risk management infrastructure. While the proposed guidelines specify board and management responsibilities as well as what banks must measure, getting there--i.e., changing day-to-day practices, and, even, more so, the lending culture--can be very daunting. The remainder of this article presents a framework for meeting two of the more esoteric yet intrinsic requirements implied in the proposed guidelines: achieving consensus on the bank's tolerance for risk and defining the model portfolio. These are also the most fundamental elements of sound risk management and critical first steps to setting loan policy and establishing effective portfolio monitoring. Tolerance for risk At the industry level, it is easy to distinguish the risk tolerance between sub- and superprime lenders. Ask a number of bankers at a single institution, however, and you often find inconsistency in how they articulate their own bank's tolerance for risk. This is alarming, as risk tolerance drives lending strategy and model portfolio definition, which in turn influences risk policies, procedures, systems, and controls. Lack of understanding and disagreement over risk tolerance also lead to disconnects between growth and credit quality goals; may cause frontline lenders to focus on the wrong opportunities; lead to wasted time in the credit committee; and ultimately, create unhappy management, lenders, borrowers, and shareholders. How do you achieve consensus regarding tolerance for risk? First and foremost by involving people at all levels of the organization. Consensus is not easy. Often, the board of directors and line have polar opposite goals. It is therefore critical for centers of influence-formal and informal thought leaders across the bank--to participate in the definition process to help drive cultural acceptance and companywide adoption. …

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