Publications & Resources
August/September 2007
Focus: Technology
Top Regulatory Concerns & Examiner Expectations
By Robert F. Cunningham
In reaction to increased competition, spread compression and consolidation, community banks have sought profitable growth based on their strengths, which has meant principally from loans in the commercial real estate (CRE) segment. While credit experience to date has been favorable, banks with assets of between $1 billion and $10 billion have seen CRE loans grow from 28% of portfolio to 42% and concentration levels have soared.[i]
The increased concentrations of CRE assets may pose a direct threat to a bank’s capital adequacy – and invite scrutiny by bank regulators. The inter-agency guidance issued by bank regulators in December 2006 focuses directly on the systematic management of risk in the banks’ CRE portfolios. The guidance does not require specific limits on CRE assets, and recognizes the community banks’ distinctive competence in real estate lending; but is also not a “safe harbor” and does require that institutions with CRE concentrations have in place “heightened risk management practices”.[ii]
Best practices in risk management are now expected; and that means measuring the credit risks and allocating capital appropriately to manage those risks. Risk measurement requires both knowing the risk one “expects” and the risk of volatility – “unexpected risk” – that capital must cover. The expected risk must be estimated at origination; the on-going risk in a loan or portfolio may be measured by stress-testing.
Measuring risk requires a dual risk approach: the risk that the obligor will default on the loan is measured separately from the risk of loss or inadequate recovery of loan principal from the collateral or other claims on the borrower due to the structure and terms of the facility. These are quite distinct risks and proper risk management requires that they be distinctly measured. The obligor risk is the probability of default (PD) and the facility risk is the loss given default (LGD).
The dual risk approach provides the opportunity to institute risk-based provisioning which accurately reflects the risk associated with each transaction. Accurate provisioning requires the use of a precise measure of expected loss to calculate the bank’s ALLL as the basis for management’s judgment about what reserves to take. The basic formula for expected loss (EL) on a loan is simply:
EL = PD * EAD * LGD
where:
PD = Probability of Default
EAD = Exposure at Default (Unamortized Balance)
LGD = Loss Given Default (%)
An estimate of an obligor’s PD may appear to be a difficult measure for smaller institutions to obtain; however, the pressure of Basel II on the global banking system has led to the development of analytical models and benchmark data that are increasingly available in appropriate forms for community banks to use effectively.
The basic method of measuring the “unexpected” risk in a portfolio is stress testing. Stress testing is a sensitivity analysis – credit management can apply a comprehensive set of “what if?” scenarios to any sub-portfolio and determine quickly and accurately the impact of “shocks” in market fundamentals. For CRE portfolios these include such “macro” factors as the level of interest rates, the capitalization rate of rentals/NOI, regional vacancy rates and general economic conditions.[iii] In turn these factors affect PD and LGD and, ultimately, expected loss in an extreme scenario – one that could affect the institution’s capital. The figure below is a schematic of the stress testing process.
The output of the stress test is an analysis of the change in the portfolio’s overall risk – its risk migration – as measured by a change in its expected loss. Sophisticated stress-testing models provide an extensive array of reporting capabilities to segment the portfolio, measure concentrations, and identify problem situations. Indeed, knowing the portfolio’s potential risk migration is critical to measuring capital adequacy. Sub-portfolios or concentrations of obligors and even individual obligors with the potential to react adversely in the greatest magnitude to extreme or “unexpected” changes in “macro” factors may be targeted for active risk management.
The ability through stress-testing to measure risk migration is the key to satisfying the regulatory agencies that community banks have an “effective framework” for managing the concentration of CRE assets in their portfolios.[iv] Management can demonstrate not only that current provisioning is adequate for the actual risks in the portfolio – as measured objectively, transparently and consistently – but also that capital adequacy covers the portfolio even in a “stressed” economic environment.
Robert F. Cunningham is senior vice president, client services at Inmatrix, Inc., in San Francisco . He leads risk consulting activities for Inmatrix clients, applying the company’s analytical products to the development of superior risk metrics, primarily for community banks and the SME business segment. Inmatrix, Inc., is a WIB-endorsed Value & Income Program partner (VIP). He can be reached at rcunningham@inmatrixinc.com.
[i] The New Commercial Real Estate Guidance, American Bankers Association, 2007, p.4.
[ii] Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, December 12, 2006; (OTS, December 14, 2006).
[iii] The New Commercial Real Estate Guidance, American Bankers Association, 2007, p.10.
[iv] Regulatory Outlook: Key Areas on the Horizon for Banks, Deloitte & Touche, LLP, Center for Banking Solutions, 2007, p. 8.
Robert F. Cunningham is senior vice president, client services at Inmatrix, Inc., in San Francisco . He leads risk consulting activities for Inmatrix clients, applying the company’s analytical products to the development of superior risk metrics, primarily for community banks and the SME business segment. Inmatrix, Inc., is a WIB-endorsed Value & Income Program partner (VIP). He can be reached at rcunningham@inmatrixinc.com.
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