6/1/17 - CRE Lending: Managing Risk and Meeting Regulatory Expectations
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6/1/17 - CRE Lending: Managing Risk and Meeting Regulatory Expectations

Commercial real estate lending is an area of ongoing regulatory focus. Banks have always been required to have adequate policies, procedures, and practices to identify, measure, monitor, and manage CRE credit risk. Regulators expect such programs to be commensurate with the size and complexity of banks’ portfolios.

Over the past year and a half, in response to various market trends, regulators have intensified their focus on CRE lending, which we believe will continue for the foreseeable future. This scrutiny is likely to lead to severe regulatory outcomes for banks that fail to meet supervisory expectations.

In December 2015, regulators issued an interagency statement on prudential risk management for CRE lending, which noted that:

“The agencies have observed that many CRE asset and lending markets are experiencing substantial growth, and that increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values. At the same time, other indicators of CRE market conditions (such as vacancy and absorption rates) and portfolio asset quality indicators (such as non-performing loan and charge-off rates) do not currently indicate weaknesses in the quality of CRE portfolios. Influenced in part by the continuing strong demand for such credit and the reassuring trends in asset-quality metrics, many institutions’ CRE concentration levels have been rising.”1

In the fall of 2016, the Office of the Comptroller of the Currency again highlighted concerns about CRE lending, stating that “easing of underwriting standards in commercial, CRE, and auto lending presents increasing credit risk,” and that “rapid CRE loan growth over the past year and recent underwriting reviews raise concern over the quality of CRE risk management, particularly managing concentrations.”2

The OCC also noted that:

“Supervisory reviews have identified concerns regarding the quality of underwriting, concentration risk management, and weaknesses in stress testing for CRE lending. These concerns are amplified by strong growth in CRE portfolios over the past three years. Strong CRE growth is evident in all sizes of banks, but CRE concentration build-up is primarily in smaller banks.”

In addition, the Federal Reserve Board in 2017 stated that:

“Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels. While CRE debt remains modest relative to the overall size of the economy and the tightening in bank lending standards for CRE loans in the second half of last year may reflect some reduction in the appetite for CRE lending, the heightening of valuation pressures may leave some smaller banks vulnerable to a sizable CRE price decline.”3

Focus on Banks with Concentration and Significant CRE Growth

Regulators are closely monitoring CRE growth across banks, particularly where CRE concentrations already exist, identifying trends and comparing practices to pre-crisis indicators. 

In 2006, prior to the financial crisis, regulators published interagency guidance on managing concentrations in CRE lending. The guidance does not establish specific lending limits, but it does focus on sound risk management practices once concentration levels or growth becomes significant. It also created supervisory criteria for defining significant CRE concentrations as:

  • Total reported loans for construction, land development, and other land representing 100% or more of the institution’s total capital
  • Or, total CRE loans representing 300% or more of the institution’s total capital, and the outstanding balance of the institution’s CRE portfolio having increased by 50% or more during the prior 36 months4

Post-crisis CRE loan growth, the risks of a rising-interest-rate environment (i.e., the impact of higher rates on debt-service coverage ratios, cap rates, and valuations), and indications of easier underwriting standards have sparked concerns among regulators, which have reminded the industry of the level of risk management necessary for significant CRE lending.

According to the Federal Deposit Insurance Corp., at the end of the third quarter 2016, there were 521 FDIC-insured institutions, or about 7% of all insured institutions, that breached one or both of the above two interagency criteria. This is up from a recent low of 5% during the third quarter 2013 but below the third quarter 2010 high of 14%.5

Moreover, the top 20 U.S. banking companies with the largest CRE portfolios increased their exposure from September 2015 to September 2016 by 12% on average.6 Comparable Federal Reserve data identified 339 banks with 1) CRE loans with at least 25% of total capital and 2) 30% annual CRE loan growth between year-end 2013 and year-end 2016.

The table and chart below break down CRE growth by the asset size of banks.

Historical CRE Weaknesses

During the 2008 crisis, aggressive growth, poorly managed CRE concentrations, weak underwriting standards, and deficiencies in loan administration were highly correlated with bank failure. The last real estate cycle revealed a number of key risks, including:

  • The absence of, or inadequate, limit setting or management
  • Inadequate underwriting standards
  • Reliance on wholesale funding
  • Ineffective CRE credit policies
  • Inadequate management of loan-policy exceptions
  • Insufficient attention to meaningful stress testing
  • Inadequate reporting, including identifying concentrations
  • Lack of effective challenge of second line of defense
  • Unreliable appraisal evaluations and outdated market analyses
  • Insufficient loan reviews of CRE activities
  • The availability of financing overshadowing fundamentally sound credit-risk practices

In the current environment, examiners are focusing more on exercising prudent underwriting and managing concentrations in banks’ risk management practices.

Key Regulatory Expectations for CRE Lending

A well-rounded CRE lending framework is expected to include the following components:

1 BOARD-APPROVED RISK APPETITE AND LENDING FRAMEWORK The board is responsible for approving the real estate lending framework and associated concentration limits. These limits should reflect the board’s risk appetite.
2 UNDERWRITING STANDARDS Underwriting standards should be documented and in line with the board’s established risk tolerance. Compliance should be evidenced by acceptable levels of exceptions.
3 CONTROLS Management must establish and maintain effective controls around the lending and appraisal processes.
4 MARKET TRENDS Awareness of market trends and general market analysis are critical to managing CRE exposures and valuations. Management and the board should be well informed of the impact of market trends on concentrations.
5 PORTFOLIO MANAGEMENT Loan-portfolio management should focus on identifying current and prospective growth, concentrations, and performance trends.
Banks should have escalation protocols and plausible strategies to reduce risks when reaching internal limits.
6 MIS AND RISK REPORTING Management risk reporting should include concentration and correlation analysis, market analysis, underwriting exceptions, and other key drivers.
7 STRESS TESTING Regulatory guidance on CRE concentrations emphasizes the importance of a forward-looking strategic focus to identify vulnerabilities posed by current or planned concentrations.
8 LOAN REVIEW Effective credit-review functions should provide challenge and oversight of key credit elements. Loan review is a key internal control and an element of the safety and soundness standards that are described.

Analyzing global cash flow and monitoring vacancy and absorption rates, capitalization rates, and market conditions are other components of a CRE program.

How We Can Help

Promontory, an IBM company, is uniquely positioned to help firms with their CRE lending frameworks in the following ways:

  • Reviewing CRE risk management practices on governance, risk appetite, policies and procedures, underwriting standards, loan administration, and risk reporting against regulatory requirements and industry best practices and identifying gaps and weaknesses
  • Developing phased remediation plans and providing key solutions in areas where weaknesses or gaps are identified
  • Developing target operating models and recommending staffing and/or expertise enhancements
  • Conducting a file review to identify gaps in depth of analysis or valuation processes
  • Reviewing appraisal processes to confirm independence and regulatory compliance 
  • Reviewing CRE problem-loan management, including watch list, workout, and ALLL processes; identifying gaps and recommending enhancements to ensure compliance with regulatory guidance
  • Developing and refining idiosyncratic and hypothetical stress scenarios, including an assessment of plausibility and materiality
  • Undertaking independent model review, with validation and calibration where necessary 
  • Reviewing the effectiveness of the credit-review process and outputs
  • Designing a training program on CRE lending principles

Promontory’s Credit Risk Management Team

Our credit risk management team is comprised of leading professionals with deep industry and regulatory experience

Arthur Angulo, Managing Director
aangulo@promontory.com | +1 212 542 6845

Kathy Dick, Managing Director
kdick@promontory.com | +1 202 384 1092

Jeff Glibert, Managing Director
jglibert@promontory.com | +1 212 365 6990

William Lang, Managing Director
wlang@promontory.com | +1 212 542 6790

David Samuels, Managing Director
dsamuels@promontory.com | +1 212 542 6776

Margaret Cheever, Director
mcheever@promontory.com | +1 212 542 6853

Steven Hubbard, Director
shubbard@promontory.com | +1 202 370 0504

Reggy Robinson, Director
rrobinson@promontory.com | +1 202 384 1168

Jame Sloan, Director
jsloan@promontory.com | +1 202 370 0384

Rachel Anderika, Senior Principal
randerika@promontory.com | +1 646 771 4286

Additional CRE Regulatory Guidance


1.Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending,” Federal Reserve Board, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency (December 2016)

2.Semiannual Risk Perspective,” Office of the Comptroller of the Currency (fall 2016)

3.Monetary Policy Report,” Federal Reserve Board (Feb. 14, 2017)

4.Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,” Office of the Comptroller of the Currency, Federal Reserve Board, and Federal Deposit Insurance Corp. (Dec. 12, 2006)

5. Supervisory Insights, Federal Deposit Insurance Corp. (winter 2016)