Implementation of Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Pract

1. Implementationof Interagency Guidance on Concentrations in Commercial Real Estate Lending,Sound Risk Management Practices Denise Dittrich denise.c.dittrich@frb.gov Federal Reserve Board January 30, 2007

2. Background • Proposed guidance issued in January 2006 • Considerable feedback from the industry • Final guidance issued by the Federal Reserve, OCC and FDIC on December 12, 2006 • OTS separately issued similar CRE guidance

3. Why are Supervisors Concerned about CRE Concentrations? • CRE lending is a significant business line for many small to medium-sized institutions • CRE has historically been highly cyclical which led to large losses in the banking industry • CRE concentration ratios are at record levels • Rising interest rates could affect debt service coverage ratios and property values • Risk management practices and strategic and capital planning have not always kept pace with growth in CRE lending

4. Source: Call Report

5. What’s Different From the Past? • More disciplined underwriting • Regulatory lending standards • Appraisal profession better regulated • Transactions not tax driven • More liquid CRE markets • Better market data

6. What’s Happening Now? • Frothy CRE markets – cap rates, prices, debt service coverage • Slowing housing markets – residential construction • New sources of market liquidity – CMBS, hedge funds • Plus, lender surveys reveal: • Declining underwriting standards • Hyper competition • Expectations for declining asset quality

7. A Tour of The Guidance • Directed to institutions with significant CRE lending • Applies to banks but principles are broadly applicable to bank holding companies and their non-bank subsidiaries • Outlines key risk management expectations • Reinforces and builds upon existing regulations and supervisory guidelines

8. Focus of the Guidance • Focus is on concentrations in types of CRE loans that expose institutions to cyclical conditions in real estate markets, includes: • “Non-owner occupied loans” where repayment is dependent on the rental income or sale or refinancing of the real estate held as collateral • Residential and commercial construction and development loans • Excludes “owner-occupied” RE loans where repayment is from cash flow from operations • Consistent with Call Report changes • Excludes real estate taken as a secondary source of repayment or in an abundance of caution

9. Supervisory Monitoring Criteria • Guidance establishes numerical criteria for identifying institutions with potentially significant CRE concentration risk • Using Call Report data, supervisors will focus on institutions with: • (1) Construction & land development loans ≥ 100% of capital; or • (2) Total CRE loans ≥ 300% of capital and ≥ 50% growth in CRE portfolio over last 36 months

10. Purpose of Supervisory Criteria • Used to identify institutions with potential concentration risk • Criteria should not be viewed as limits on lending activity • There is no “safe harbor” if other risk indicators are present, such as: • Rapid growth in CRE lending • Significant growth in CRE credit concentrations • Concentrations in certain property types • Criteria is only to be used as a starting point for conducting further analysis

11. Purpose of Supervisory Criteria (cont.) • Institutions meeting criteria would be expected to be able to demonstrate the risk characteristics of their CRE portfolio by property type, market, and borrower • Institutions are expected to perform their own assessment of CRE concentration risk • Examiners will avoid an extended discussion on segmentation of individual loans, focus should be on the portfolio management

12. Implementation of Guidance • Effective as of December 12, 2006 • This is not a “one size fits all” process • Examiners will use a risk-based approach and exercise examiner discretion • Examiners will be flexible with institutions on the timeframe for meeting risk management expectations • Agencies will provide training to examiners on proper implementation of the guidance

13. Expectations for Risk Management • Guidance applies to institutions of all sizes • Sophistication of risk management systems will vary with CRE portfolio’s risk characteristics, size and complexity • Evaluation of risk management systems will consider varying risk profiles of loans secured by different property types • Relatively simple systems may work for some banks

14. Expectations for Risk Management • Board and management oversight • Management information systems • Market analysis • Portfolio stress testing and sensitivity analysis • Credit underwriting standards

15. Board and Management Oversight • The Board has ultimate responsibility for risk assumed • Approve overall CRE strategy and risk tolerance levels • Monitor how the strategy is progressing and if its policies are being complied with • Approve contingency plan • Management is responsible for implementing the CRE strategy on a day-to-day basis in compliance with board approved policies • Design operating policies and procedures that enable it to identify, manage, monitor, and control CRE risks • Provide the board with reports showing strategic targets including portfolio risk levels

16. Management Information Systems • Identify key data elements relevant to portfolio • Produce reports relevant to board and management oversight of strategy and policy implementation • Provide useful stratifications including loan type, property type, geographic location, risk grade, delinquency status • Provide for systematic review and evaluation of portfolio risk levels and changes • Facilitate portfolio level stress testing of alternative scenarios

17. Market Analysis • Provide management with sufficient information on current market conditions and factors that could influence those conditions in the future • Incorporate data and anecdotal information to develop a reasoned view of market conditions and prospects • Should utilize multiple sources of information for a balanced view • Should be integrated into the strategic plan development and risk management

18. Market Analysis (cont.) • Types and sources will vary depending on composition of portfolio and markets served • Frequency of updates depends on size, scope and complexity of portfolio and stability of market conditions • Analysis may contribute variables for stress testing

19. Portfolio Stress Testing and Sensitivity Analysis • Analysis will assist management and the board in understanding how changes in relevant economic or market factors could affect the portfolio or key portfolio segments • Sophistication of process will vary with complexity of the portfolio • Analysis should measure the effect on earnings and capital and portfolio quality • Results should be considered in strategic planning and risk management • Results should be updated periodically and shared in writing with senior management and the board

20. Underwriting Standards • Lending policies should reflect the level of risk that is acceptable to the board • Underwriting criteria should be clear and measurable • Maximum loan amount by type of property • Loan terms • Pricing • LTV limits • Collateral valuation • Debt service coverage • Tight control over policy exceptions • Review and amend standards, as needed, based on results of market analysis

21. Evaluation of Capital Adequacy • Guidance does not imply that banks will necessarily need to increase capital just because they have a concentration • Institutions should consider the level of capital support for CRE concentrations in their strategic, financial and capital planning • Supervisors will take into account inherent risk and quality of risk management practices

22. Points of Emphasis • Supervisory criteria are not limits, rather they are to be used as supervisory monitoring tools • Banks should perform internal risk assessments • Board and management oversight is critical • Expectations for risk management practices will be commensurate with risk profile of institution • Capital adequacy will be evaluated on a case-by-case basis • Guidance does not supercede the Agencies’ real estate lending and appraisal standards