[Federal Register Volume 71, Number 9 (Friday, January 13, 2006)]
[Notices]
[Pages 2302-2307]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-340]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 06-01]

BOARD OF THE GOVERNORS OF THE FEDERAL RESERVE SYSTEM

[Docket No. OP-1248]

FEDERAL DEPOSIT INSURANCE CORPORATION

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 2006-01]


Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices

AGENCIES: Office of the Comptroller of the Currency, Treasury (OCC); 
Board of Governors of the Federal Reserve System (Board); Federal 
Deposit Insurance Corporation (FDIC); and Office of Thrift Supervision, 
Treasury (OTS).

[[Page 2303]]


ACTION: Proposed guidance with request for comment.

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SUMMARY: The OCC, Board, FDIC, and OTS (the Agencies), request comment 
on this proposed guidance entitled, Concentrations in Commercial Real 
Estate Lending, Sound Risk Management Practices (Guidance). The 
Agencies have observed that some institutions have high and increasing 
concentrations of commercial real estate loans on their balance sheets 
and are concerned that these concentrations may make the institutions 
more vulnerable to cyclical commercial real estate markets. This 
proposed Guidance helps identify institutions with commercial real 
estate loan concentrations that may be subject to greater supervisory 
scrutiny. As provided in the proposed Guidance, such institutions 
should have in place risk management practices and capital levels 
appropriate to the risk associated with these concentrations.

DATES: Comments must be submitted on or before March 14, 2006.

ADDRESSES: The Agencies will jointly review all of the comments 
submitted. Therefore, interested parties may send comments to any of 
the Agencies and need not send comments (or copies) to all of the 
Agencies. Please consider submitting your comments by e-mail or fax 
since paper mail in the Washington area and at the Agencies is subject 
to delay. Interested parties are invited to submit comments to:
    OCC: You should include ``OCC'' and Docket Number 06-01 in your 
comment. You may submit your comment by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     OCC Web site: http://www.occ.treas.gov. Click on ``Contact 
the OCC,'' scroll down and click on ``Comments on Proposed 
Regulations.''
     E-Mail Address: [email protected].
     Fax: (202) 874-4448.
     Mail: Office of the Comptroller of the Currency, 250 E 
Street, SW., Mail Stop 1-5, Washington, DC 20219.
     Hand Delivery/Courier: 250 E Street, SW., Attn: Public 
Information Room, Mail Stop 1-5, Washington, DC 20219.
    Instructions: All submissions received must include the agency name 
(OCC) and docket number for this notice. In general, the OCC will enter 
all comments received into the docket without change, including any 
business or personal information that you provide. You may review 
comments and other related materials by any of the following methods:
     Viewing Comments in person: You may inspect and photocopy 
comments at the OCC's Public Information Room, 250 E Street, SW., 
Washington, DC. You can make an appointment to inspect comments by 
calling (202) 874-5043.
     Viewing Comments Electronically: You may request that we 
send you an electronic copy of comments via e-mail or mail you a CD-ROM 
containing electronic copies by contacting the OCC at 
[email protected].
     Docket Information: You may also request available 
background documents and project summaries using the methods described 
above.
    Board: You may submit comments, identified by Docket No. OP-1248, 
by any of the following methods:
     Agency Web site: http://www.federalreserve.gov. Follow the 
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: [email protected]. Include the 
docket number in the subject line of the message.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.
    All public comments are available from the Board's Web site at 
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as 
submitted, unless modified for technical reasons. Accordingly, your 
comments will not be edited to remove any identifying or contact 
information. Public comments may also be viewed in electronic or paper 
form in Room MP-500 of the Board's Martin Building (20th and C Streets, 
NW.) between 9 a.m. and 5 p.m. on weekdays.
    FDIC: You may submit comments by any of the following methods:
     Agency Web site: http://www.fdic.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments 
on the Agency Web site.
     E-Mail: [email protected].
     Mail: Robert E. Feldman, Executive Secretary, Attention: 
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW., 
Washington, DC 20429.
     Hand Delivery/Courier: Guard station at the rear of the 
550 17th Street Building (located on F Street) on business days between 
7 a.m. and 5 p.m.
    Instructions: All submissions received must include the agency 
name. All comments received will be posted without change to http://www.fdic.gov/regulations/laws/federal/propose.html including any 
personal information provided.
     Public Inspection: Comments may be inspected and 
photocopied in the FDIC Public Information Center, Room 100, 801 17th 
Street, NW., Washington, DC, between 9 a.m. and 4:30 pm. on business 
days.
    OTS: You may submit comments, identified by docket number 2006-01, 
by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail address: [email protected]. Please 
include docket number 2006-01 in the subject line of the message and 
include your name and telephone number in the message.
     Fax: (202) 906-6518.
     Mail: Regulation Comments, Chief Counsel's Office, Office 
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552, 
Attention: No. 2006-01.
     Hand Delivery/Courier: Guard's Desk, East Lobby Entrance, 
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days. Address 
envelope as follows: Attention: Regulation Comments, Chief Counsel's 
Office, Attention: No. 2006-01.
    Instructions: All submissions received must include the agency name 
and docket number for this proposed Guidance. All comments received 
will be posted without change to the OTS Internet Site at http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1, including any 
personal information provided.
    Docket: For access to the docket to read background documents or 
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1. In addition, you may inspect comments 
at the OTS's Public Reading Room, 1700 G Street, NW., by appointment. 
To make an appointment for access, call (202) 906-5922, send an e-mail 
to public.info@ots.treas.gov">public.info@ots.treas.gov, or send a facsimile transmission to (202) 
906-7755. (Prior notice identifying the materials you will be 
requesting will assist us in serving you.) We schedule appointments on 
business days between 10 a.m. and 4 p.m. In most cases, appointments 
will be available the next business day following the date we receive a 
request.

FOR FURTHER INFORMATION CONTACT: OCC: Daniel Bailey, National Bank

[[Page 2304]]

Examiner, Credit Risk Division, (202) 874-5170, Office of the 
Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.
    Board: Denise Dittrich, Supervisory Financial Analyst, (202) 452-
2783; or Virginia Gibbs, Senior Supervisory Financial Analyst, (202) 
452-2521; or Sabeth I. Siddique, Assistant Director, (202) 452-3861, 
Division of Banking Supervision and Regulation; or Mark Van Der Weide, 
Senior Counsel, Legal Division, (202) 452-2263. For users of 
Telecommunications Device for the Deaf (``TDD'') only, contact (202) 
263-4869.
    FDIC: James Leitner, Senior Examination Specialist, Division of 
Supervision and Consumer Protection, (202) 898-6790, or Benjamin W. 
McDonough, Attorney, Legal Division, (202) 898-7411.
    OTS: William Magrini, Senior Project Manger, (202) 906-5744, or 
Karen Osterloh, Counsel, (202) 906-6639.

SUPPLEMENTARY INFORMATION:

I. Background

    The Agencies have observed that some institutions have high and 
increasing concentrations of commercial real estate loans on their 
balance sheets and are concerned that these concentrations may make the 
institutions more vulnerable to cyclical commercial real estate 
markets. The Agencies have previously issued regulations and guidelines 
that outline supervisory expectations for a safe and sound commercial 
real estate lending program. This proposed statement is intended to 
reinforce that guidance as it relates to institutions with 
concentrations in commercial real estate loans.

II. Principal Elements of the Guidance

    For the purposes of the proposed Guidance, the Agencies are 
focusing on concentrations in those types of commercial real estate 
(CRE) loans that are particularly vulnerable to cyclical commercial 
real estate markets. These include CRE exposures where the source of 
repayment primarily depends upon rental income or the sale, 
refinancing, or permanent financing of the property. Loans to REITs and 
unsecured loans to developers that closely correlate to the inherent 
risk in CRE markets would also be considered CRE loans for purposes of 
the proposed Guidance.
    The proposed Guidance sets forth thresholds for assessing whether 
an institution has a CRE concentration and should employ heightened 
risk management practices. This Guidance is based upon the principles 
contained in the Agencies' real estate lending standards regulations 
and guidelines.
    The proposed Guidance also reminds institutions with CRE 
concentrations that they should hold capital higher than regulatory 
minimums and commensurate with the level of risk in their CRE lending 
portfolios. In assessing the adequacy of an institution's capital, the 
proposed Guidance states that the Agencies will take into account the 
level of inherent risk in its CRE portfolio and the quality of its risk 
management practices.

III. Request for Comment

    The Agencies are requesting public comment on all aspects of the 
proposed Guidance. In particular, the Agencies request comment on the 
scope of the definition of CRE and on the appropriateness of the 
thresholds for determining elevated concentration risk.
    The text of the proposed Guidance entitled, Concentrations in 
Commercial Real Estate Lending, Sound Risk Management Practices 
follows:

Purpose

    The Office of the Comptroller of the Currency, the Board of 
Governors of the Federal Reserve System, the Federal Deposit Insurance 
Corporation, and the Office of Thrift Supervision (the Agencies) are 
jointly issuing this Guidance to address the increasing concentrations 
of commercial real estate loans at many institutions. The Agencies are 
concerned that concentrations in commercial real estate loans where 
repayment is primarily dependent on rental income or from the proceeds 
of the sale, refinancing or permanent financing of the property may 
expose institutions to unanticipated earnings and capital volatility 
due to adverse changes in the general commercial real estate market.
    This Guidance reinforces the Agencies' existing guidelines for real 
estate lending and safety and soundness.\1\ This Guidance also provides 
criteria for identifying institutions with commercial real estate loan 
concentrations that may be subject to greater supervisory scrutiny. As 
provided in the Guidance, such institutions should have in place risk 
management practices and capital levels appropriate to the risk 
associated with these concentrations.
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    \1\ Refer to the Agencies' regulations on real estate lending 
standards and the Interagency Guidelines for Real Estate Lending 
Policies: 12 CFR part 34, subpart D and appendix A (OCC); 12 CFR 
part 208, subpart E and appendix C (FRB); 12 CFR part 365 and 
appendix A (FDIC); and 12 CFR 560.100-101 (OTS). Refer to the 
Interagency Guidelines Establishing Standards for Safety and 
Soundness: 12 CFR part 30, appendix A (OCC); 12 CFR part 208, 
Appendix D-1 (FRB); 12 CFR part 364, appendix A (FDIC); and 12 CFR 
part 570, appendix A (OTS).
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    For purposes of this Guidance, commercial real estate (CRE) loans 
are exposures secured by raw land, land development and construction 
(including 1-4 family residential construction), multi-family property, 
and non-farm nonresidential property where the primary or a significant 
source of repayment is derived from rental income associated with the 
property (that is, loans for which 50 percent or more of the source of 
repayment comes from third party, non-affiliated, rental income) or the 
proceeds of the sale, refinancing, or permanent financing of the 
property. Loans to REITs and unsecured loans to developers that closely 
correlate to the inherent risk in CRE markets would also be considered 
CRE loans for purposes of this Guidance.

Background

    In the past, weak CRE loan underwriting and depressed CRE markets 
have contributed to significant bank failures and instability in the 
banking system. While underwriting standards are generally stronger 
than those during previous CRE cycles, the Agencies have observed high 
concentrations in CRE loans at some institutions. The Agencies are 
concerned that these concentrations may make the institutions more 
vulnerable to cyclical CRE markets. Accordingly, institutions with such 
CRE concentrations should have both heightened risk management 
practices and levels of capital that are higher than the regulatory 
minimums and appropriate to the risk in their CRE lending portfolios.
    Recent examinations have indicated that the risk management 
practices and capital levels of some institutions are not keeping pace 
with their increasing CRE concentrations. In some cases, the Agencies 
have observed that institutions have rapidly expanded their CRE lending 
operations into new markets without establishing adequate control and 
reporting processes, including the preparation of market analyses. The 
Agencies are also concerned when institutions with high CRE 
concentrations maintain capital levels near regulatory minimums. 
Minimum levels of regulatory capital do not provide institutions with 
an adequate cushion to absorb unexpected losses arising from loan 
concentrations and are inconsistent with the Agencies' capital adequacy 
guidelines. Institutions with a concentration in CRE loans should 
ensure the maintenance of capital levels

[[Page 2305]]

that are commensurate with the risk of such concentrations.

Identification of Institutions With CRE Concentrations

    Institutions with CRE concentrations should have in place risk 
management practices consistent with this Guidance to mitigate the 
increased risks associated with such concentrations. To determine 
whether it has a concentration in CRE lending that warrants the use of 
heightened risk management practices, an institution, as a preliminary 
step, should use regulatory reports to determine whether it exceeds or 
is rapidly approaching the following thresholds:
    (1) Total reported loans for construction, land development, and 
other land \2\ represent one hundred percent (100%) or more of the 
institution's total capital; \3\ or
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    \2\ For commercial banks as reported in the Call Report FFIEC 
031 and 041 schedule RC-C item 1a. For Savings associations as 
reported in the Thrift Financial Report, schedule SC lines SC230, 
SC235, SC240, and SC265.
    \3\ For purposes of this Guidance, the term ``total capital'' 
means the total risk-based capital as reported for commercial banks 
in the Call Report (FFIEC 031 and 041 schedule RC-R--Regulatory 
Capital, line 21). For savings associations as reported in the 
Thrift Financial Report, CCR, Line CCR39.
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    (2) Total reported loans secured by multifamily and nonfarm 
nonresidential properties and loans for construction, land development, 
and other land \4\ represent three hundred percent (300%) or more of 
the institution's total capital.
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    \4\ For commercial banks as reported in the Call Report FFIEC 
031 and 041 schedule RC-C items 1a, 1d, and 1e. For savings 
associations as reported in the Thrift Financial Report Schedule SC 
lines SC230, SC235, SC240, SC256, SC260, and SC 265.
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    Institutions exceeding threshold (1) would be deemed to have a 
concentration in CRE construction and development loans and should have 
heightened risk management practices appropriate to the degree of CRE 
concentration risk of these loans in their portfolios and consistent 
with the Guidance set forth below. If an institution exceeds threshold 
(2), the institution should further analyze its loans and quantify the 
dollar amount of those that meet the definition of a CRE loan contained 
in this Guidance. If the institution has a level of CRE loans meeting 
the CRE definition of 300 percent or more of total capital, it should 
have heightened risk management practices that are consistent with the 
Guidance set forth below. The Agencies have excluded loans secured by 
owner-occupied properties from the CRE definition because their risk 
profiles are less influenced by the condition of the general CRE 
market.
    This Guidance may be applied on a case-by-case basis to any 
institution that has had a sharp increase in CRE lending over a short 
period of time or has a significant concentration in CRE loans secured 
by a particular property type.

Risk Management Principles

    The Agencies have previously issued regulations and guidance that 
outline supervisory expectations for a safe and sound real estate 
lending program. This statement is intended to reinforce that guidance 
as it relates to institutions with concentrations in CRE loans. The 
risk management and capital adequacy principles contained in this 
guidance are broadly prudent for all institutions involved in CRE 
lending.
    Board and Management Oversight. The board of directors has ultimate 
responsibility for the level of risk taken by its institution. 
Directors, or a committee thereof, should explicitly approve the 
overall CRE lending strategy and policies of the institution. They 
should receive reports on changes in CRE market conditions and the 
institution's CRE lending activity that identify the size, 
significance, and risks related to CRE concentrations. Directors should 
use this information to provide clear guidance to management regarding 
the level of CRE exposures acceptable to the institution. The board 
also has the responsibility to ensure that senior management implements 
the procedures and controls necessary to comply with adopted policies. 
The board should periodically review and approve CRE aggregate risk 
exposure limits and appropriate sublimits (for example, by property 
type and geographic area) to conform to any changes in the 
institution's strategies and to respond to changes in market 
conditions. Directors should also ensure that management compensation 
policies are compatible with the institution's strategy and do not 
create incentives to assume unintended risks.
    Management is responsible for implementing the CRE strategy in a 
manner that is consistent with the institution's stated risk tolerance. 
Management should develop and implement policies, procedures, and 
limits that provide for adequate identification, measurement, 
monitoring, and control of the CRE risks. The Agencies' real estate 
lending regulations require that each institution adopt and maintain a 
written policy that establishes appropriate limits and standards for 
all extensions of credit that are secured by liens on or interests in 
real estate, including CRE loans. The Interagency Guidelines for Real 
Estate Lending Policies state that loans exceeding the interagency 
loan-to-value (LTV) guidelines should be recorded in the bank's records 
and the aggregate amount of loans exceeding the LTV guidelines reported 
to the board at least quarterly. Examiners will continue to review 
these reports to determine whether the institution's exceptions are 
adequately documented and are appropriate in view of all relevant 
credit considerations. Further, the Agencies' appraisal regulations and 
related guidance require that each institution have an effective real 
estate appraisal and evaluation program that adequately supports its 
CRE lending activity.\5\
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    \5\ Refer to the Agencies' appraisal regulations: 12 CFR part 
34, subpart C (OCC); 12 CFR part 208, subpart E and 12 CFR part 225, 
subpart G (FRB); 12 CFR part 323 (FDIC); and 12 CFR part 564 (OTS).
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    Strategic Planning. An institution's strategic plan should address 
the rationale for its CRE concentration levels relative to the 
institution's overall growth objectives and financial targets and 
capital levels. In developing its strategy as well as in continuous 
monitoring of CRE exposure, an institution should perform an analysis 
of the potential effect of a downturn in real estate markets on both 
earnings and capital. The strategy should also include a contingency 
plan for responding to adverse market conditions. The contingency plan 
should address possible actions for mitigating CRE concentration risk 
and ensuring the adequacy of capital and reserves. If management 
believes the institution could reduce its CRE exposure by selling 
exposures, it should assess the marketability of the portfolio. This 
should include an evaluation of the institution's capabilities in 
accessing the secondary market and a comparison of its underwriting 
standards with those that exist in the secondary market.
    Underwriting. An institution's lending policies should define the 
level of risk that is acceptable to its board of directors. Therefore, 
lending policies should provide clear and measurable underwriting 
standards and be consistent with the Agencies' real estate lending 
regulations and guidelines. Policy guidelines should be based on a 
careful review of internal and external factors that affect the 
institution, such as its market position, historical experience, 
present and prospective trade area, probable future loan and funding 
trends, staff capabilities, and technology.
    Consistent with the Agencies' real estate lending standards, 
underwriting standards should include standards for:

[[Page 2306]]

     Maximum loan amount by type of property,
     Loan terms,
     Pricing structures,
     LTV limits by property type,
     Requirements for feasibility studies and sensitivity 
analysis or stress-testing,
     Minimum requirements for initial investment and 
maintenance of hard equity by the borrower, and
     Minimum standards for borrower net worth, property cash 
flow, and debt service coverage for the property.
    Credit analysis should reflect both the borrower's overall 
creditworthiness and project-specific considerations.\6\ Management 
should also compare the institution's underwriting standards for 
individual property types with those that exist in the secondary 
market. When an institution's standards are substantially more lenient, 
management should justify the reasons why the institution's risk 
criteria deviate from those of the secondary market and should document 
their long-term plans for these credits. Additionally, for development 
and construction loans, the institution should have sound policies and 
procedures governing loan disbursements to ensure that disbursements do 
not exceed actual development and construction costs. Prudent controls 
should include an inspection process, documentation on construction 
progress, tracking presales and preleasing, and exception reporting.
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    \6\ Refer to the Interagency Guidelines for Real Estate Lending 
Policies: 12 CFR part 34, appendix A (OCC); 12 CFR part 208, 
appendix C (FRB); 12 CFR part 365, appendix A (FDIC); and 12 CFR 
560.100-101 (OTS).
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    An institution's lending policies should permit exceptions to 
underwriting standards only on a limited basis. When an institution 
does permit an exception, it should document how the transaction does 
not conform to the institution's policy or underwriting standards, 
obtain appropriate management approvals, and provide reports to the 
board of directors detailing the number, nature, justifications, and 
trends for exceptions in a timely manner. Exceptions to both the 
institution's internal lending standards and the Agencies' supervisory 
LTV limits should be monitored and reported on a regular basis. 
Further, institutions should analyze trends in exceptions to ensure 
that risk remains within the institution's established risk tolerance 
limits.
    Risk Assessment and Monitoring of CRE Loans. Institutions should 
establish and maintain thoroughly articulated policies that specify 
requirements and criteria for risk rating CRE exposures, ongoing 
account monitoring, identifying loan impairment, and recognizing 
losses. Risk ratings should be risk sensitive, objective, and tailored 
to the CRE exposure types underwritten by the institution. A strong 
risk rating system is important for maintaining the integrity of an 
institution's risk management system and in providing an early warning 
of emerging weaknesses. An institution's internal rating systems should 
consider an assessment of a borrower's creditworthiness and of an 
exposure's estimated loss severity to ensure that both the risk of the 
obligor and the transaction itself are clearly evaluated. When 
assigning risk ratings to CRE loans, an institution should consider the 
property's sensitivity to changes in macro and project-specific factors 
including variations in vacancy and rental rates, interest rates, and 
inflation rates.
    Policies should address the ongoing monitoring of individual loans, 
including the frequency of account reviews, updating of borrower credit 
information, and status of leasing. Policies should require periodic 
comparisons of actual property performance information with projections 
at the time of original underwriting and the appraisal assumptions (for 
example, lease-up assumptions) to determine if any credit deterioration 
or value impairment has occurred. In addition, policies should specify 
the frequency with which transaction risk ratings should be reviewed to 
ensure they appropriately reflect the transaction's level of credit 
risk.
    Portfolio Risk Management. Even when individual CRE loans are 
underwritten conservatively, large aggregate exposures to related 
sectors can expose an institution to an unacceptable level of risk. 
Therefore, an institution should measure and control CRE credit risk on 
a portfolio basis by identifying and managing concentrations, 
performing market analysis, and stress testing. A strong management 
information system is key to the successful implementation of a 
portfolio management system.
    Management Information System (MIS). To accurately assess and 
manage portfolio concentration risk, the MIS should provide meaningful 
information on CRE portfolio characteristics that are relevant to the 
institution's lending strategy, underwriting standards, and risk 
tolerances. Institutions are encouraged, on either an automated or 
manual basis, to stratify the portfolio by property type, geographic 
area, tenant concentrations, tenant industries, developer 
concentrations, and risk rating. Institutions should be able to 
aggregate total exposure to a borrower including their credit exposure 
related to derivatives, such as interest rate swaps. MIS should 
maintain the appraised value at origination and subsequent valuations. 
Other useful stratifications include loan structure (for example, fixed 
rate or adjustable), loan type (for example, construction, mini perm, 
or permanent), loan-to-value limits, debt service coverage, policy 
exceptions on newly underwritten credit facilities, and related loans 
(for example, loans to tenants). Management reporting should be timely 
and in a format that clearly shows changes in the portfolio's risk 
profile, including risk-rating migrations. In addition, the MIS should 
provide management with the ability to conduct stress test analysis of 
the CRE portfolio for varying scenarios. There should also be a well-
defined, formal process through which management reviews and evaluates 
concentration and risk management reports, as well as special ad hoc 
analyses in response to market events.
    Identifying and Managing Concentrations. Active oversight and 
monitoring by management is an important component of the management of 
CRE concentration risk. Management should continually evaluate the 
degree of potential correlation between related sectors and establish 
internal lending guidelines and limits that control the institution's 
overall risk exposure. An institution should combine and view as 
concentrations any groups or classes of CRE loans sharing significant 
common characteristics and similar sensitivity to adverse economic, 
financial, or business developments. Using established limits relevant 
to its lending strategy and portfolio characteristics, an institution 
should monitor and control its CRE concentrations.
    Management should have strategies for managing concentration 
levels. The use of secondary market sales to institutional investors or 
securitizations is one example of a strategy for actively managing 
concentration levels without curtailing new originations. In addition, 
executing market sales provides corroboration that the institution's 
underwriting and pricing are consistent with market standards. 
Moreover, as firm take-out commitments have become rare, many 
institutions require that commercial construction loans be written to 
secondary market standards. Institutions with high levels of 
construction and development loans should closely monitor market 
conditions particularly when relying on permanent loan take-outs as a 
way of managing concentration levels.

[[Page 2307]]

    In managing CRE concentration levels, institutions are also 
encouraged to consider other credit exposures correlated to the CRE 
market such as commercial mortgage-backed securities.
    Market Analysis. Institutions should perform ongoing evaluations of 
the market conditions for the various property types and geographic 
areas or markets represented in their portfolio. Market analysis is 
particularly important as an institution expands its geographic scope 
of operations into new markets. In making decisions about new markets 
and new originations, market analysis should be an important evaluation 
criterion for individual credits as well as for the portfolio. 
Institutions should utilize multiple sources for obtaining market 
information such as published research data, monitoring new building 
permits, and maintaining contacts with local contractors, builders, 
real estate agents, and community development groups.
    Management should ensure that the institution's CRE lending 
strategy and portfolio risk assessments integrate the findings of its 
market analysis and evaluation. Moreover, market information should 
provide management with sufficient information to determine whether 
revisions to its CRE lending strategy and policies are necessary to 
respond to identified market trends, and to form the basis for its 
stress testing.
    Portfolio Stress Testing. Institutions should consider performing 
portfolio level stress tests of their CRE exposures to quantify the 
impact of changing economic scenarios on asset quality, earnings, and 
capital. The Agencies recognize that portfolio level stress testing is 
an evolving process and encourage institutions to consider its use as a 
risk management tool and to review periodically the adequacy of stress 
testing practices relative to their CRE exposures. The sophistication 
of stress testing practices should be consistent with the size and 
complexity of the institution's CRE loan portfolio.
    Portfolio stress testing does not necessarily require the use of a 
sophisticated portfolio model. Depending on the risk characteristics of 
the CRE portfolio, it may be appropriate for a stress test to be as 
simple as an aggregation of the results of individual loan stress 
tests, testing the impact of ratings migration, or applying stressed 
historical loss rates to the portfolio. Stress tests should focus on 
the more vulnerable segments of an institution's CRE portfolio, given 
the prevailing market environment and the institution's business 
strategy.
    Allowance for Loan Losses. Institutions also should consider CRE 
concentrations in their assessment of the adequacy of the allowance for 
loan and lease losses. The Interagency Policy Statement on Allowance 
for Loan and Lease Losses Methodologies and Documentation for Banks and 
Savings Institutions provides guidance on criteria that institutions 
should consider when evaluating groups of loans with common risk 
characteristics.

Capital Adequacy

    The Agencies' capital adequacy guidelines note that institutions 
should hold capital commensurate with the level and nature of the risks 
to which they are exposed and that institutions with high or inordinate 
levels of risk are expected to operate well above minimum regulatory 
capital requirements. Minimum levels of regulatory capital \7\ do not 
provide institutions with sufficient buffer to absorb unexpected losses 
arising from loan concentrations.\8\ Failure to maintain an appropriate 
cushion for concentrations is inconsistent with the Agencies' capital 
adequacy guidelines. Moreover, an institution with a CRE concentration 
should recognize the need for additional capital support for CRE 
concentrations in its strategic, financial, and capital planning, 
including an assessment of the potential for future losses on CRE 
exposures.
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    \7\ Most CRE exposures are risk-weighted at 100 percent. By 
statute, however, certain loans made for the construction of single-
family housing and certain multifamily housing loans are risk-
weighted at 50 percent. See 12 U.S.C. 1831n note (Risk-Weighting of 
Housing Loans for Purposes of Capital Requirements). The Agencies 
have codified these statutory risk-weighting requirements in their 
regulations at 12 CFR Part 3, Appendix A, Section 3 (OCC); 12 CFR 
Part 208, Appendix A, Section III. C. (FRB); 12 CFR Part 325, 
Appendix A, Section II.C. (FDIC); and 12 CFR 567.6(a)(1)(iii) (50% 
risk-weights for ``qualifying multifamily mortgage loan'' and 
``qualifying residential construction loan'' as defined in 12 CFR 
567.1) (OTS).
    \8\ Depending upon the level and nature of the CRE 
concentration, an institution may need to maintain capital at levels 
exceeding the ``well capitalized'' standard to ensure the overall 
sound financial condition of the institution.
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    In performing its internal capital analysis, an institution should 
make use of the results of any stress testing and other quantitative 
and qualitative analysis. The internal capital analysis should also 
reflect the possibility that any historical correlations used might not 
remain stable under stress conditions. For larger, more complex 
institutions that employ formal quantitative economic capital systems, 
the analysis of concentrations should provide for an adequate 
``cushion'' above model outputs to compensate for potential 
uncertainties in risk measurement.
    In assessing the adequacy of an institution's capital, the Agencies 
will take into account analysis provided by the institution as well as 
an evaluation of the level of inherent risk in the CRE portfolio and 
the quality of risk management based on the sound practices set forth 
in this Guidance.

Supervisory Evaluation and Action

    The CRE sound practices set forth in this Guidance are effective 
methods for addressing the increased risks associated with CRE 
concentrations, and illustrate the types of practices that the Agencies 
consider important elements of sound risk management and adequate 
capital. An institution that is unable to adequately assess and meet 
its capital needs may be required to develop a plan for reducing its 
concentrations or for achieving higher capital ratios.
    This concludes the text of the proposed Guidance entitled, 
Concentrations in Commercial Real Estate Lending, Sound Risk Management 
Practices.

    Dated: January 6, 2006.
John C. Dugan,
Comptroller of the Currency.

    By order of the Board of Governors of the Federal Reserve 
System, January 10, 2006.
Jennifer J. Johnson,
Secretary of the Board.

    Dated at Washington, DC, this 9th day of January, 2006.

    By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.

    Dated: January 9, 2006.

    By the Office of Thrift Supervision.
John M. Reich,
Director.
[FR Doc. 06-340 Filed 1-12-06; 8:45 am]
BILLING CODE 4810-33-U; 6210-01-U; 6714-01-U; 6720-01-U