Regulatory Guidance on CRE Concentrations and Risk Management Practices

Based on concerns about the increase in CRE concentrations at  community banks and the risks associated with such concentrations,  FDIC, the Federal Reserve, and OCC jointly issued guidance in  December 2006 on CRE concentrations and sound risk management  practices. The guidance described the regulators’ expectations for  sound risk management practices for banks with concentrations in CRE  loans. The regulators have taken steps to  address our recommendation. In December 2015, federal banking regulators issued a joint statement to  remind banks of the 2006 regulatory guidance on prudent risk  management practices for CRE lending activity through economic cycles. Credit and Other Risks Related to Bank CRE Lending Have Increased over the Past Several Years

Although the CRE sector has recovered since the 2007–2009 financial  crisis, our trend and econometric analyses generally indicate that credit  and other risks related to bank CRE lending have increased over the past  several years. Based on indicators of CRE market conditions and loan performance, the  CRE sector has recovered from the 2007–2009 financial crisis. CRE property prices, particularly for multifamily properties, have  increased rapidly in recent years, and CRE property valuations have  similarly increased. The  models incorporate measures of CRE property prices, bank lending, and  underwriting standards. Based largely on the simultaneous  increase in bank CRE lending and CRE prices observed over the last  several years, these models suggest that credit risk has increased,  though it remains lower than the level of risk associated with the 2007– 2009 financial crisis. Regulators Examined Risk Management Practices of Banks with CRE Concentrations

We found that regulators generally subjected banks with relatively high  concentrations in CRE loans to greater supervisory scrutiny in  comparison to banks with relatively lower concentrations in CRE loans in  our review of 54 examinations for 40 banks conducted from 2013 through  2016. Regulators Examined Whether Banks with Relatively High CRE Concentrations Had Adequate Practices and Capital to Manage Their CRE Concentration Risk

In our review of a nongeneralizable sample of 54 examinations conducted  from 2013 through 2016, we found that FDIC, Federal Reserve, and OCC  subjected banks with relatively high concentrations in CRE loans to  greater supervisory scrutiny. In 15 of the 41 examinations we reviewed, FDIC, Federal Reserve, and  OCC examiners found the banks had CRE-related risk management  weaknesses in at least one of the seven internal control areas. In 12 of the examinations, examiners included MRAs, MRBAs, or  MRIAs in their reports of examination that directed the banks to  correct their risk management weaknesses. Thirteen of the 54 examinations we reviewed  covered banks that did not exceed the CLD or CRE thresholds. Appendix I: Objectives, Scope, and Methodology

Our objectives in this report were to examine: (1) trends in the  commercial real estate (CRE) lending markets, including changes in the  level of credit and concentration risk in the markets, and (2) actions  federal banking regulators took through their examinations to help ensure  that banks with CRE concentrations are effectively managing the related  risks. Specifically, we  interviewed officials at the Board of Governors of the Federal Reserve  System (Federal Reserve), the Federal Deposit Insurance Corporation  (FDIC), and the Office of the Comptroller of the Currency (OCC) to help  identify potential indicators of risk in CRE markets. Specifically, we used the concentration formulas in the 2006 CRE  concentration guidance (jointly issued by the federal banking regulators)  to calculate banks’ CLD and CRE concentrations and identify banks  whose CRE concentrations exceeded, in full or in part, the guidance’s  CRE concentration thresholds during part or all of the time frame.
Why GAO Did This Study

In 2006, federal banking regulators jointly issued guidance that described their expectations for sound risk management practices for banks with CRE concentrations. The guidance includes two CRE thresholds that regulators use to identify banks that are potentially exposed to significant CRE concentration risk and could be subject to greater supervisory scrutiny. Concentrations in CRE loans at U.S. banks have been steadily increasing—raising safety and soundness concerns. In December 2015, the regulators jointly issued a public statement to remind banks of the 2006 CRE guidance.
In light of the joint 2015 statement and GAO's ongoing monitoring of regulatory efforts to identify and respond to emerging threats to the banking system, GAO examined (1) trends in the CRE lending market, including changes in risk, and (2) actions taken by regulators to help ensure that banks with CRE concentrations are effectively managing the related risks. To address these issues, GAO analyzed CRE-related data; reviewed agency policies and guidance; and reviewed a nongeneralizable sample of 54 bank examinations conducted from 2013 through 2016 based on the banks' CRE concentrations, total assets, primary regulator, and geographic location. GAO also interviewed officials from the federal banking regulators.

What GAO Found

While the commercial real estate (CRE) sector has recovered since the 2007–2009 financial crisis, GAO's trend and econometric analyses generally indicate that risk in CRE lending by banks has increased over the past several years. Since the early 2000s, community banks have tended toward providing CRE loans more than other kinds of loans. Indicators of CRE market conditions and loan performance have been improving since 2011. At the same time, GAO's analyses of changes in CRE underwriting standards, property prices, and other data suggest that credit and concentration risks have increased in bank CRE lending. For example, the number of banks with relatively high CRE concentrations—measured by the ratio of a bank's CRE loans to its total capital—has been increasing. In addition, commercial property prices have been increasing rapidly, and property valuations also have risen in recent years. Similarly, GAO's predictive econometric models of CRE loan performance suggest that risk has increased, based largely on the simultaneous increase in bank CRE lending and CRE prices observed over the last several years, but is lower than the level associated with the 2007–2009 financial crisis.
GAO found that federal banking regulators subjected banks with relatively high CRE concentrations to greater supervisory scrutiny based on its review of a nongeneralizable sample of 54 bank examinations covering 40 banks done by the Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, and Office of the Comptroller of the Currency from 2013 through 2016. Of the 54 examinations that GAO reviewed, 41 of them covered banks with relatively high CRE concentrations. In all of these examinations, regulators examined whether the banks had adequate risk management practices and capital to manage their CRE concentration risk. In 26 of the 41 examinations, regulators did not find any risk management weaknesses. However, in 15 of the 41 examinations, regulators found the banks had weaknesses in one or more risk management areas, such as board and management oversight, management information systems, or underwriting. The regulators generally communicated their findings to the banks in the reports of examination and directed the banks to correct their risk management weaknesses.