[Federal Register Volume 71, Number 238 (Tuesday, December 12, 2006)]
[Notices]
[Pages 74580-74588]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-9630]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 06-14]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1248]

FEDERAL DEPOSIT INSURANCE CORPORATION


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); and Federal 
Deposit Insurance Corporation (FDIC).

ACTION: Final guidance.

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SUMMARY: The OCC, Board, and FDIC (the Agencies) are issuing final 
joint Guidance on Concentrations in Commercial Real Estate Lending, 
Sound Risk Management Practices (Guidance). This Guidance has been 
developed to reinforce sound risk management practices for institutions 
with high and increasing concentrations of commercial real estate loans 
on their balance sheets. This Guidance applies to national banks and 
state chartered banks (institutions). Further, the Board believes that 
the Guidance is broadly applicable to bank holding companies.

DATES: Effective Date: The final Guidance is effective December 12, 
2006.

FOR FURTHER INFORMATION CONTACT:
    OCC: Dena G. Patel, Credit Risk Specialist, (202) 874-5170; or 
Vance Price, National Bank Examiner, (202) 874-5170.
    Board: Denise Dittrich, Supervisory Financial Analyst, (202) 452-
2783; 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: Patricia A. Colohan, Senior Examination Specialist, (202) 
898-7283; or Serena L. Owens, Chief, Planning and Program Development, 
(202) 898-8996, Division of Supervision and Consumer Protection; or 
Benjamin W. McDonough, Attorney, Legal Division, (202) 898-7411.

SUPPLEMENTARY INFORMATION:

I. Background

    The Agencies have observed that commercial real estate (CRE) 
concentrations have been rising over the past several years and have 
reached levels that could create safety and soundness concerns in the 
event of a significant economic downturn. To some extent, the level of 
CRE lending reflects changes in the demand for credit within certain 
geographic areas and the movement by many financial institutions to 
specialize in a lending sector that is perceived to offer enhanced 
earnings. In particular, small to mid-size institutions have shown the 
most significant increase in CRE concentrations over the last decade. 
CRE concentration levels \1\ at commercial and savings banks with 
assets between $100 million and $1 billion have doubled from 
approximately 156 percent of total risk-based capital in 1993 to 318 
percent in third quarter 2006. This same trend has been observed at 
commercial and savings banks with assets of $1 billion to $10 billion 
with concentration levels rising from approximately 127 percent in 1993 
to approximately 300 percent in third quarter 2006.
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    \1\ CRE concentration levels for loans secured by real estate 
for (a) construction, land development, and other land loans; (b) 
multifamily residential properties; and (c) nonfarm nonresidential 
properties.
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    While current CRE market fundamentals remain generally strong, and 
supply and demand are generally in balance, past history has 
demonstrated that commercial real estate markets can experience fairly 
rapid changes. For institutions with significant concentrations, the 
ability to withstand difficult market conditions will depend heavily on 
the adequacy of their risk management practices and capital levels. In 
recent examinations, the Agencies' examiners have observed that some 
institutions have relaxed their underwriting standards as a result of 
strong competition for business. Further, examiners also have 
identified a number of institutions with high CRE concentrations that 
lack appropriate policies and procedures to manage the associated risk 
arising from a CRE concentration. For these reasons, the Agencies are 
concerned with institutions' CRE concentrations and the risks arising 
from such concentrations.
    To address these concerns, the Agencies published for comment 
proposed Interagency Guidance on Concentrations in Commercial Real 
Estate Lending, Sound Risk Management Practices, 71 FR 2302 (January 
13,2006). The proposal set forth thresholds to identify institutions 
with CRE loan concentrations that would be subject to greater 
supervisory scrutiny. As provided in the proposal, an institution 
exceeding these thresholds would be deemed to have a CRE concentration 
and expected to have appropriate risk management practices as described 
in the proposed guidance.
    After reviewing the public comment letters \2\ on the proposal, the 
Agencies are now issuing final Guidance to remind institutions that 
there are substantial risks posed by CRE concentrations and that these 
risks should be recognized and appropriately addressed. The final 
Guidance describes sound risk management practices that are important 
for an institution that has strategically decided to concentrate in CRE 
lending. These risk management practices build upon existing real 
estate lending regulations and guidelines. The Agencies also have 
clarified that they are not establishing a limit on the amount of 
commercial real estate lending that an institution may conduct.

[[Page 74581]]

In addition, the final Guidance includes supervisory criteria to help 
the Agencies' supervisory staff identify institutions that may have 
significant CRE concentration risk.
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    \2\ The Agencies did receive a number of comment letters 
requesting a 30-day extension of the comment period, which the 
Agencies granted. See 71 FR 13215 (March 14, 2006).
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II. Proposed Guidance

    The proposed guidance described the Agencies' expectations for 
heightened risk management practices for an institution with a 
concentration in CRE loans. Further, the proposal set forth two 
thresholds to identify institutions with CRE loan concentrations that 
would be subject to greater supervisory scrutiny. The proposal provided 
that such institutions should have in place the heightened risk 
management practices and capital levels set forth in the proposal.
    The first proposed threshold stated that if loans for construction, 
land development, and other land were 100 percent or more of total 
capital, the institution would be considered to have a CRE 
concentration and should have heightened risk management practices. 
Secondly, if loans for construction, land development, and other land 
and loans secured by multifamily and nonfarm nonresidential property 
(excluding loans secured by owner-occupied properties) were 300 percent 
or more of total capital, the institution would also be considered to 
have a CRE concentration and should employ heightened risk management 
practices.
    The proposal described the key risk management elements for an 
institution's CRE lending activity with an emphasis on those components 
of the risk management process that are particularly applicable to an 
institution with a CRE concentration, including: board and management 
oversight, strategic planning, underwriting, risk assessment and 
monitoring of CRE loans, portfolio risk management, management 
information systems, market analysis, and stress testing. The proposal 
also reminded institutions with CRE concentrations that they should 
hold capital exceeding regulatory minimums and commensurate with the 
level of risk in their CRE lending portfolios.

III. Overview of Public Comments

    Collectively, the Agencies received over 4,400 comment letters on 
the proposed guidance. The OCC received approximately 1,700 comment 
letters, the Board had approximately 1,700 letters, and the FDIC had 
approximately 1,000 letters. The majority of comment letters were from 
regulated financial institutions and their trade groups.
    Among the trade or other groups submitting comments were seven 
nationwide banking trade associations, 26 state banking trade 
associations, the Conference of State Bank Supervisors, three state 
financial institution regulatory agencies, the Appraisal Institute, the 
National Association of Home Builders, National Association of REITs, 
and Real Estate Roundtable. Additionally, during the comment period, 
the Agencies met with several industry groups.
    The vast majority of commenters expressed strong opposition to the 
proposed guidance and believe that the Agencies should address the 
issue of CRE concentration risk on a case-by-case basis as part of the 
examination process. Many commenters contended that existing 
regulations and guidance are sufficient to address the Agencies' 
concerns regarding CRE concentration risk and the adequacy of an 
institution's risk management practices and capital.
    Several commenters asserted that today's lending environment is 
significantly different than that of the late 1980s and early 1990s 
when regulated financial institutions suffered losses from their real 
estate lending activities due to weak underwriting standards and risk 
management practices. These commenters contended that regulated 
financial institutions learned their lessons from past economic cycles 
and that underwriting practices are now stronger.
    Many community-based institutions, particularly Florida-based and 
Massachusetts-based institutions, opposed the proposed guidance and 
contended that the proposal would discourage community-based 
institutions from CRE lending and serving the needs of their 
communities. If community-based institutions were forced to reduce 
their CRE lending activity, these commenters asserted that there was 
the potential for a downturn in the economy, creating systemic problems 
beyond the risks in CRE loans.
    While smaller institutions acknowledged that many community banks 
do concentrate in commercial real estate loans, they contended that 
there are few other lending opportunities in which community-based 
institutions can successfully compete against larger financial 
institutions. Community-based institutions commented that secured real 
estate lending has been their ``bread and butter'' business and, if 
required to reduce their commercial real estate lending activity, they 
would have to look to other types of lending, which have been 
historically more risky. Moreover, these commenters noted that 
community-based institutions are actively involved in their local 
communities and markets, which affords them a significant advantage 
when competing for CRE loan business. Community-based institutions also 
noted that their lending opportunities have dwindled as a result of 
competition from other types of financial institutions, such as finance 
companies, Farm Credit banks, and credit unions.

IV. Overview of Final Guidance

    After carefully reviewing the comments on the proposed guidance, 
the Agencies have made significant changes to the proposal to clarify 
the purpose and scope of the Guidance. The Agencies continue to believe 
that it is important for institutions with CRE credit concentrations to 
assess the risk posed by the concentration and to maintain sound risk 
management practices and an adequate level of capital to address the 
risk. Therefore, while the final Guidance continues to emphasize these 
principles, the Agencies have revised the proposal to clarify that 
financial institutions play a vital role in providing credit for 
commercial real estate activity and to make clear that the Guidance 
does not establish a limit on an institution's CRE lending activity.
    A discussion of the changes in the final Guidance from the 
proposal, major comments on the proposal, and the Agencies' responses 
follows.

A. Purpose

    The final Guidance reminds institutions that sound risk management 
practices and appropriate capital levels are important when an 
institution has a CRE concentration. Like the proposal, the final 
Guidance reinforces and builds upon the Agencies' existing regulations 
and guidelines for real estate lending and loan portfolio management.
    Commenters expressed concern that the proposal placed additional 
burden on institutions that already have sound practices in place to 
manage their CRE lending activity. Further, commenters contended that 
the Agencies have sufficient existing authority to address their 
concerns with an institution's CRE lending activity and that the 
Agencies' examination process affords the Agencies with ample 
opportunity to address weaknesses in an institution's lending 
practices.
    The Agencies are issuing the final Guidance to remind institutions 
of the substantial potential risks posed by credit concentrations, 
especially in sectors such as CRE, which history has shown to have 
cycles that can, at much lower concentration levels, inflict large 
losses upon institutions. While most institutions are practicing sound 
credit

[[Page 74582]]

risk management on a transaction basis, the Agencies believe this 
Guidance is necessary to emphasize the importance of portfolio risk 
management practices to address CRE concentration risk.

B. Scope

    The final Guidance, like the proposal, focuses on CRE loans that 
have risk profiles sensitive to the condition of the general CRE 
market. This includes loans for land development and construction 
(including 1- to 4-family residential and commercial properties), other 
land loans, and loans secured by multifamily and nonfarm nonresidential 
properties (where the primary source of repayment is cash flows from 
the real estate collateral). Loans to REITs and unsecured loans to 
developers also are considered CRE loans for purposes of this Guidance 
if their performance is closely linked to the performance of the 
general CRE market.
    Commenters noted that the identification of CRE loans in the 
current Consolidated Reports of Condition and Income (Call Report) did 
not correspond to the proposed guidance's CRE definition and did not 
constitute an accurate measurement of the volume of an institution's 
CRE loans that would be vulnerable to cyclical CRE markets. Commenters 
did acknowledge that the revisions to the Call Reports, effective in 
2007, would address this inconsistency.
    In response to these comments, the Agencies have clarified that the 
focus of the Guidance is on those CRE loans where the cash flow from 
the real estate collateral is the primary source of repayment rather 
than on loans to a borrower where real estate is a secondary source of 
repayment or is taken as collateral through an abundance of caution. 
This is consistent with the 2007 revisions to the Call Report.
    Many commenters found the proposal's definition of CRE loans overly 
broad and failed to recognize unique risks posed by loans with 
different risk characteristics. Further, commenters asked for 
clarification as to the types of properties included in the scope of 
the Guidance, such as loans secured by motels, hotels, mini-storage 
warehouse facilities, and apartment complexes where the primary source 
of repayment is rental or lease income. A number of commenters 
contended that loans on certain types of CRE properties should not be 
considered CRE loans, including: Presold 1- to 4-family residential 
construction loans, multifamily loans, and loans to REITs.
    Commenters recommended that the proposal should not cover 
residential construction loans where a house has been sold to a 
qualified borrower prior to the start of the construction. These 
commenters argued that presold 1- to 4-family residential construction 
loans carry far less risk than speculative home construction loans 
because the future homeowners are known and contractually obligated to 
purchase the home, and have passed a credit review prior to the 
commencement of construction. Commenters noted that their rationale for 
excluding presold 1- to 4-family residential construction is consistent 
with the proposal's exclusion of CRE loans on owner-occupied 
properties.
    Further, commenters recommended that multifamily construction loans 
with firm takeouts or loans on completed multifamily properties with 
established rent rolls be excluded from the scope of the guidance. 
Commenters contended that multifamily residential loans have much less 
risk than CRE loans that have no firm takeout or established cash flow 
history.\3\ One commenter noted that over the last 20 years, 
institutions have incurred minimal losses on multifamily loans and 
attributed this performance to strong underwriting and stability in 
rental properties.
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    \3\ Another commenter, representing REITs, sought clarification 
as to whether the proposed guidance would apply to both secured and 
unsecured loans to REITs. This commenter asserted that unsecured 
loans to REITs should not be considered a CRE loan for purposes of 
the proposed guidance as the commenter believes that the risk of an 
unsecured loan to a REIT is mitigated by well-diversified cash flow 
comprising the sources of repayment. The final Guidance, like the 
proposal, applies to both secured and unsecured loans to REITs where 
repayment capacity is sensitive to conditions of the general CRE 
market. The Agencies note that the structure of such loans would be 
considered a mitigating factor when an institution analyzes the risk 
posed by such a concentration.
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    The Agencies note that because the Guidance does not impose lending 
limits, its scope is purposely broad so that it includes those CRE 
loans, including multifamily loans, with risk profiles sensitive to the 
condition of the general CRE markets, such as market demand, changes in 
capitalization rates, vacancy rates, and rents. However, the Agencies 
believe that institutions are in the best position to segment their CRE 
portfolios and group credit exposures by common risk characteristics or 
sensitivities to economic, financial, or business developments. As 
explained in the final Guidance, institutions should be able to 
identify potential concentrations in their CRE portfolios by common 
risk characteristics, which will differ by property type. The final 
Guidance notes that factors, such as portfolio diversification, 
geographic dispersion, levels of underwriting standards, level of 
presold buildings, and portfolio liquidity, would be considered in 
evaluating whether an institution has mitigated the risk posed by a 
concentration. Further, the Agencies acknowledge in the final guidance 
that consideration should be given to the lower risk profiles and 
historically superior performance of certain types of CRE such as well-
structured multifamily housing loans, when compared to others, such as 
speculative office construction.

C. CRE Concentration Assessment

    The final Guidance contains a new section referred to as ``CRE 
Concentration Assessment'' that provides that institutions should 
perform their own assessment of concentration risk in their CRE loan 
portfolios. While the final Guidance does not establish a CRE 
concentration limit, the Agencies have retained high-level indicators 
to assist examiners in identifying institutions potentially exposed to 
CRE concentration risk. These are described in section IV.E of this 
preamble.
    Many commenters noted that the proposal did not recognize the 
different segments in an institution's CRE portfolio and treated all 
CRE loans as having equal risk. A commenter noted that a concentration 
test cannot reflect the distinct risk profile within an institution's 
loan portfolio and that the risk profile is a function of many factors, 
including the institution's risk tolerance, portfolio diversification, 
the prevalence of guarantees and secondary collateral, and the 
condition of the regional economy.
    In response to such comments, the Agencies have added a section on 
CRE Concentration Assessments to the final Guidance. The Agencies 
recognize that risk characteristics vary by different property types of 
CRE loans and that institutions are in the best position to identify 
potential concentrations by stratifying their CRE portfolios into 
segments with common risk characteristics. The Agencies believe an 
institution's board of directors and management should identify and 
monitor credit concentrations and establish internal concentration 
limits. The final Guidance clarifies that an institution actively 
involved in CRE lending should be able to identify concentrations in 
its CRE portfolio and to monitor concentration risk on an ongoing 
basis.
    Commenters raised concern that the proposed thresholds would be 
perceived by examiners as de facto limits on an institution's CRE 
lending activity. The Agencies believe that the

[[Page 74583]]

final Guidance addresses the concerns of commenters by placing the 
emphasis on the institution's own assessment of its CRE concentration 
risk rather than on the proposed concentration thresholds. In the final 
Guidance, the Agencies have responded to these concerns by specifically 
stating that the Guidance does not establish any specific limits on 
institutions' CRE lending activity. Moreover, in implementing the 
Guidance, the Agencies will take the necessary steps to communicate the 
purpose of the Guidance to their supervisory staffs to prevent any 
unintended consequences.
    The final Guidance does incorporate the proposed concentration 
thresholds as part of the Agencies' supervisory oversight criteria for 
examiners to use as a starting point for identifying institutions that 
are potentially exposed to significant CRE concentration risk. The 
Agencies believe that these numerical supervisory screens will serve to 
promote consistent application of this Guidance across the Agencies as 
well as within an agency. The supervisory oversight and evaluation of 
an institution's CRE concentration risk are discussed in more detail in 
section IV.E. of the preamble.

D. Risk Management

    The final Guidance, like the proposal, builds upon the Agencies' 
existing regulations and guidance for real estate lending and loan 
portfolio management, emphasizing those risk management practices that 
will enable an institution to pursue CRE lending in a safe and sound 
manner.
    Many commenters acknowledged that the risk management principles 
described in the proposal should be viewed as prudent industry 
standards for an institution engaged in CRE lending. However, some 
commenters alleged that the proposed guidance would create additional 
regulatory burden at a time when institutions are already faced with 
other compliance responsibilities. Further, commenters noted that the 
Agencies needed to consider an institution's size and complexity in 
assessing the adequacy of risk management practices. This particular 
concern was raised with regard to the expectations for management 
information systems and portfolio stress testing that commenters found 
to be burdensome for smaller institutions.
    In response to these comments, the Agencies have revised the final 
Guidance's risk management section to make the discussion more 
principle-based and to focus on those aspects of existing regulations 
and guidelines that deserve greater attention when an institution has a 
CRE concentration or is pursuing a CRE lending strategy leading to a 
concentration. As a result, the risk management section in the final 
Guidance sets forth the key elements of an institution's risk 
management framework for managing concentration risk. Further, the 
final Guidance recognizes the sophistication of an institution's risk 
management processes will depend upon the size of the CRE portfolio and 
the level and nature of its CRE concentration risk.
    The final Guidance describes the key elements that an institution 
should address in board and management oversight, portfolio management, 
management information systems, market analysis, credit underwriting 
standards, portfolio stress testing and sensitivity analysis, and 
credit risk review function. In general, an institution with a CRE 
concentration should manage not only the risk of the individual loans 
but also the portfolio risk. Recognizing that an institution's board of 
directors has ultimate responsibility for the level of risk assumed by 
the institution, the Agencies believe that appropriate board oversight 
should address the rationale for an institution's CRE lending levels in 
relation to its growth objectives, financial targets, and capital plan.
    The Agencies believe that the final Guidance's discussion of 
management information systems (MIS), market analysis, and portfolio 
stress testing addresses the concerns of smaller institutions regarding 
regulatory burden. The Agencies recognize that the level of 
sophistication of an institution's MIS, market analysis and stress 
testing will depend upon the size and complexity of the institution. 
Therefore, the focus of the final Guidance is on the ability of the 
institution to provide its management and board of directors with the 
necessary information to assess its CRE lending strategy and policies 
in light of changes in CRE market conditions. Regardless of its size, 
an institution should be able to identify and monitor CRE 
concentrations and the potential effect that changes in market 
conditions may have on the institution.
    Some commenters requested clarification on the Agencies' 
expectations for stress testing. These commenters expressed concern 
that, as a result of the proposal, management's time would be diverted 
to creating reports and statistics with not much value. These 
commenters represented that an institution's focus should be on a loan 
review program, portfolio monitoring procedures, and loan loss 
reserves.
    The Agencies agree with these comments and have revised the 
discussion on market analysis and stress testing. The final Guidance 
acknowledges that an institution's market analysis will vary by its 
market share and exposure levels as well as the availability of market 
data. Further, the final Guidance notes that portfolio stress testing 
does not require the use of sophisticated portfolio models. Depending 
on the institution, stress testing may be as simple as analyzing the 
potential effect of stressed loss rates on the institution's CRE 
portfolio, capital, and earnings. The important objective is that an 
institution should have the information necessary to assess the 
potential effect of market changes on its CRE portfolio and lending 
strategy.
    Commenters questioned the proposed guidance's suggestion that 
institutions should compare their underwriting standards to those of 
the secondary commercial mortgage market. Commenters noted that there 
is not a ready secondary market for CRE loans made by smaller 
institutions as the loans are smaller in dollar size and have 
characteristics that make them unsuitable for securitization.
    The Agencies recognize that smaller institutions do not have ready 
access to the secondary market and had not intended that the proposal 
be viewed in this way. Therefore, in the final Guidance, the Agencies 
have clarified the situations when an institution should conduct 
secondary market comparisons. If an institution's portfolio management 
strategy includes selling or securitizing CRE loans as a contingency 
plan for managing concentration levels, an institution should evaluate 
its ability to do so and compare its underwriting standards to those of 
the secondary market.

E. Supervisory Oversight

    In the final Guidance, the Agencies have retained the concept of 
concentration thresholds as a supervisory tool for examiners to screen 
institutions for potential CRE concentration risk. The intent of these 
indicators is to encourage a dialogue between the Agency supervisory 
staff and an institution's management about the level and nature of CRE 
concentration risk. While the final Guidance is effective immediately 
upon publication in the Federal Register, the Agencies will provide 
institutions with CRE concentrations a reasonable timeframe over which 
to demonstrate that their risk management practices are appropriate for 
the level and nature of the concentration risk.

[[Page 74584]]

    Commenters encouraged the Agencies to evaluate institutions' CRE 
concentrations on a bank-by-bank basis and not to take a ``one-size-
fits-all'' approach to evaluating concentrations. Commenters asserted 
that an assessment of concentration risk based on the Agencies' 
proposed thresholds did not consider the differing risk characteristics 
of the subcategories of CRE loans. Further, commenters noted that the 
proposed thresholds did not consider whether or not an institution had 
an established history of managing a high CRE concentration.
    In the final Guidance, the Agencies addressed the commenters' 
concerns by stating that numeric indicators do not constitute limits; 
rather they will be used as a supervisory monitoring tool. These 
indicators will assist examiners in identifying institutions with CRE 
concentrations. These indicators will function similarly to other 
analytical screens that the Agencies use to evaluate an institution. By 
including these indicators in the final Guidance, institutions will 
have an understanding of the Agencies' supervisory monitoring criteria. 
The Agencies also have tried to strike a balanced tone in the final 
Guidance to promote an appropriate and consistent application of these 
indicators by their supervisory staffs.
    As explained in the final Guidance, an institution that has 
experienced rapid growth in CRE lending, has notable exposure to a 
specific type of CRE, or is approaching or exceeds the following 
supervisory criteria may be identified for further supervisory analysis 
of the level and nature of its CRE concentration risk. The supervisory 
criteria are:
    (1) Total reported loans for construction, land development, and 
other land \4\ represent 100 percent or more of the institution's total 
capital; \5\ or
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    \4\ For commercial banks, this total is reported in the Call 
Report FFIEC 031 and 041 schedule RC-C item 1a.
    \5\ 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.
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    (2) Total commercial real estate loans as defined in the Guidance 
\6\ represent 300 percent or more of the institution's total capital 
and the outstanding balance of the institution's CRE loan portfolio has 
increased 50 percent or more during the prior 36 months.
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    \6\ For commercial banks, this total is reported in the Call 
Report FFIEC 031 and 041 schedule RC-C items 1a, 1d, 1e, and 
Memorandum Item 3.
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    While the criteria will serve as a screen for identifying 
institutions with potential CRE concentration risk, the final Guidance 
notes that institutions should not view the criteria as a ``safe 
harbor'' if other risk indicators are present, regardless of the 
measurements under criteria (1) and (2). Further, the final Guidance 
notes that institutions experiencing recent, significant growth in CRE 
lending will receive closer supervisory review than other institutions 
that have demonstrated a successful track record of managing the risks 
in CRE concentrations.
    In response to comments that the proposal concentration thresholds 
did not consider an institution's track record for managing CRE 
concentrations, the Agencies have included an additional condition to 
the 300 percent screen. The Agencies also will consider whether the 
institution's CRE portfolio increased by 50 percent or more during the 
prior 36 months. This additional screen acknowledges that the Agencies 
will be focusing on those institutions that have recently experienced a 
significant growth in their CRE portfolio and may not have been subject 
to prior supervisory review.
    While most commenters opposed the adoption of any concentration 
thresholds, several commenters did comment on the appropriateness of 
the proposed CRE concentration thresholds. These commenters asserted 
that the proposed 300 percent threshold was too low and suggested that 
a benchmark from 400 to 600 percent of capital would be more 
appropriate.
    As previously discussed, the Agencies have retained the 300 percent 
screen with an additional screen (that is, an institution's CRE 
portfolio increased by 50 percent or more during the prior 36 months). 
In developing the supervisory criteria, the Agencies relied on 
historical trends in concentration levels over real estate cycles, the 
relationship of CRE concentration levels to bank failures, and 
supervisory experience. Further, the final Guidance clarifies that the 
Agencies' supervisory staffs will consider other factors, and not just 
these indicators, in evaluating the risk posed by an institution's CRE 
concentration.

F. Assessment of Capital Adequacy

    In the final Guidance, the section on the ``Assessment of Capital 
Adequacy'' was significantly revised to address the commenters' 
concerns that the proposal was too restrictive and did not take into 
account the institution's lending and risk management practices. The 
proposal stated that institutions should hold capital commensurate with 
the level and nature of their CRE concentration risks and that an 
institution with high or inordinate levels of risk would be expected to 
operate well above minimum regulatory capital requirements. In the 
final Guidance, the discussion on the adequacy of an institution's 
capital has been incorporated into the Supervisory Oversight section to 
clarify that the assessment of an institution's capital will be 
performed in connection with the supervisory assessment of an 
institution's risk management.
    Commenters asserted that many institutions already hold capital at 
levels above minimum standards and should not be required to raise 
additional capital simply because their CRE concentrations exceeded a 
threshold. There also was concern that the proposal would give 
examiners the ability to arbitrarily assess additional capital 
requirements solely due to a high concentration.
    The Agencies agree with commenters that the majority of 
institutions with CRE concentrations presently have capital exceeding 
regulatory minimums and would generally not be expected to increase 
their capital levels. However, since an institution's capital serves as 
a buffer against unexpected losses from its CRE concentration, an 
institution with a CRE concentration and inadequate capital should 
develop a plan for reducing its concentration or maintaining capital 
appropriate for the level and nature of the concentration risk. To the 
extent an institution with a CRE concentration has effective risk 
management practices or is addressing the need for such practices, the 
Agencies' concerns regarding capital adequacy are reduced. However, an 
institution with a CRE concentration and with no prospects of enhancing 
its risk management practices should address the need for additional 
capital. Therefore, the final Guidance reminds institutions that they 
should hold capital commensurate with the level and nature of the risks 
to which they are exposed.
    Commenters noted that the allowance for loan and lease losses 
(ALLL) is another means of protection for an institution and, 
therefore, should be considered in determining whether capital is 
adequate for the level and nature of concentration risk. The Agencies 
agree with this comment and have addressed ALLL within the context of 
the capital adequacy section.

V. Text of the Final Joint Guidance

    The text of the final joint Guidance on Concentrations in 
Commercial Real Estate Lending, Sound Risk Management Practices 
follows:

[[Page 74585]]

Concentrations in Commercial Real Estate Lending, Sound Risk Management 
Practices

Purpose
    The Office of the Comptroller of the Currency, the Board of 
Governors of the Federal Reserve System, and the Federal Deposit 
Insurance Corporation (collectively, the Agencies), are jointly issuing 
this Guidance to address institutions' increased concentrations of 
commercial real estate (CRE) loans. Concentrations of credit exposures 
add a dimension of risk that compounds the risk inherent in individual 
loans.
    The Guidance reminds institutions that strong risk management 
practices and appropriate levels of capital are important elements of a 
sound CRE lending program, particularly when an institution has a 
concentration in CRE loans. The Guidance reinforces and enhances the 
Agencies' existing regulations and guidelines for real estate lending 
\1\ and loan portfolio management in light of material changes in 
institutions' lending activities. The Guidance does not establish 
specific CRE lending limits; rather, it promotes sound risk management 
practices and appropriate levels of capital that will enable 
institutions to continue to pursue CRE lending in a safe and sound 
manner.
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    \1\ Refer to the Agencies' regualtions 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); and 12 CFR part 365 and 
appendix A (FDIC). 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); and 12 CFR part 364, 
appendix A (FDIC).
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Background
    The Agencies recognize that regulated financial institutions play a 
vital role in providing credit for business and real estate 
development. However, concentrations in CRE lending coupled with weak 
loan underwriting and depressed CRE markets have contributed to 
significant credit losses in the past. While underwriting standards are 
generally stronger than during previous CRE cycles, the Agencies have 
observed an increasing trend in the number of institutions with 
concentrations in CRE loans. These concentrations may make such 
institutions more vulnerable to cyclical CRE markets. Moreover, the 
Agencies have observed that some institutions' risk management 
practices are not evolving with their increasing CRE concentrations. 
Therefore, institutions with concentrations in CRE loans are reminded 
that their risk management practices and capital levels should be 
commensurate with the level and nature of their CRE concentration risk.
Scope
    In developing this guidance, the Agencies recognized that different 
types of CRE lending present different levels of risk, and that 
consideration should be given to the lower risk profiles and 
historically superior performance of certain types of CRE, such as 
well-structured multifamily housing finance, when compared to others, 
such as speculative office space construction. As discussed under ``CRE 
Concentration Assessments,'' institutions are encouraged to segment 
their CRE portfolios to acknowledge these distinctions for risk 
management purposes.
    This Guidance focuses on those CRE loans for which the cash flow 
from the real estate is the primary source of repayment rather than 
loans to a borrower for which real estate collateral is taken as a 
secondary source of repayment or through an abundance of caution. Thus, 
for the purposes of this Guidance, CRE loans include those loans with 
risk profiles sensitive to the condition of the general CRE market (for 
example, market demand, changes in capitalization rates, vacancy rates, 
or rents). CRE loans are land development and construction loans 
(including 1 - to 4-family residential and commercial construction 
loans) and other land loans.
    CRE loans also include loans secured by multifamily property, and 
nonfarm nonresidential property where the primary 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, nonaffiliated, rental income) or the proceeds of the 
sale, refinancing, or permanent financing of the property. Loans to 
real estate investment trusts (REITs) and unsecured loans to developers 
also should be considered CRE loans for purposes of this Guidance if 
their performance is closely linked to performance of the CRE markets. 
Excluded from the scope of this Guidance are loans secured by nonfarm 
nonresidential properties where the primary source of repayment is the 
cash flow from the ongoing operations and activities conducted by the 
party, or affiliate of the party, who owns the property.
    Although the Guidance does not define a CRE concentration, the 
``Supervisory Oversight'' section describes the criteria that the 
Agencies will use as high-level indicators to identify institutions 
potentially exposed to CRE concentration risk.
CRE Concentration Assessments
    Institutions actively involved in CRE lending should perform 
ongoing risk assessments to identify CRE concentrations. The risk 
assessment should identify potential concentrations by stratifying the 
CRE portfolio into segments that have common risk characteristics or 
sensitivities to economic, financial or business developments. An 
institution's CRE portfolio stratification should be reasonable and 
supportable. The CRE portfolio should not be divided into multiple 
segments simply to avoid the appearance of concentration risk.
    The Agencies recognize that risk characteristics vary among CRE 
loans secured by different property types. A manageable level of CRE 
concentration risk will vary by institution depending on the portfolio 
risk characteristics, the quality of risk management processes, and 
capital levels. Therefore, the Guidance does not establish a CRE 
concentration limit that applies to all institutions. Rather, the 
Guidance encourages institutions to identify and monitor credit 
concentrations, establish internal concentration limits, and report all 
concentrations to management and the board of directors on a periodic 
basis. Depending on the results of the risk assessment, the institution 
may need to enhance its risk management systems.
Risk Management
    The sophistication of an institution's CRE risk management 
processes should be appropriate to the size of the portfolio, as well 
as the level and nature of concentrations and the associated risk to 
the institution. Institutions should address the following key elements 
in establishing a risk management framework that effectively 
identifies, monitors, and controls CRE concentration risk:
     Board and management oversight.
     Portfolio management.
     Management information systems.
     Market analysis.
     Credit underwriting standards.
     Portfolio stress testing and sensitivity analysis.
     Credit risk review function.
    Board and Management Oversight. An institution's board of directors 
has ultimate responsibility for the level of risk assumed by the 
institution. If the institution has significant CRE concentration risk, 
its strategic plan should address the rationale for its CRE levels in 
relation to its overall growth objectives, financial targets, and 
capital

[[Page 74586]]

plan. In addition, 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. Therefore, the board of directors or a designated 
committee thereof should:
     Establish policy guidelines and approve an overall CRE 
lending strategy regarding the level and nature of CRE exposures 
acceptable to the institution, including any specific commitments to 
particular borrowers or property types, such as multifamily housing.
     Ensure that management implements procedures and controls 
to effectively adhere to and monitor compliance with the institution's 
lending policies and strategies.
     Review information that identifies and quantifies the 
nature and level of risk presented by CRE concentrations, including 
reports that describe changes in CRE market conditions in which the 
institution lends.
     Periodically review and approve CRE risk exposure limits 
and appropriate sublimits (for example, by nature of concentration) to 
conform to any changes in the institution's strategies and to respond 
to changes in market conditions.
    Portfolio Management. Institutions with CRE concentrations should 
manage not only the risk of individual loans but also portfolio risk. 
Even when individual CRE loans are prudently underwritten, 
concentrations of loans that are similarly affected by cyclical changes 
in the CRE market can expose an institution to an unacceptable level of 
risk if not properly managed. Management regularly should evaluate the 
degree of correlation between related real estate sectors and establish 
internal lending guidelines and concentration limits that control the 
institution's overall risk exposure.
    Management should develop appropriate strategies for managing CRE 
concentration levels, including a contingency plan to reduce or 
mitigate concentrations in the event of adverse CRE market conditions. 
Loan participations, whole loan sales, and securitizations are a few 
examples of strategies for actively managing concentration levels 
without curtailing new originations. If the contingency plan includes 
selling or securitizing CRE loans, management should assess 
periodically the marketability of the portfolio. This should include an 
evaluation of the institution's ability to access the secondary market 
and a comparison of its underwriting standards with those that exist in 
the secondary market.
    Management Information Systems. A strong management information 
system (MIS) is key to effective portfolio management. The 
sophistication of MIS will necessarily vary with the size and 
complexity of the CRE portfolio and level and nature of concentration 
risk. MIS should provide management with sufficient information to 
identify, measure, monitor, and manage CRE concentration risk. This 
includes meaningful information on CRE portfolio characteristics that 
is relevant to the institution's lending strategy, underwriting 
standards, and risk tolerances. An institution should assess 
periodically the adequacy of MIS in light of growth in CRE loans and 
changes in the CRE portfolio's size, risk profile, and complexity.
    Institutions are encouraged to stratify the CRE portfolio by 
property type, geographic market, tenant concentrations, tenant 
industries, developer concentrations, and risk rating. Other useful 
stratifications may include loan structure (for example, fixed rate or 
adjustable), loan purpose (for example, construction, short-term, or 
permanent), loan-to-value limits, debt service coverage, policy 
exceptions on newly underwritten credit facilities, and affiliated 
loans (for example, loans to tenants). An institution should also be 
able to identify and aggregate exposures to a borrower, including its 
credit exposure relating to derivatives.
    Management reporting should be timely and in a format that clearly 
indicates changes in the portfolio's risk profile, including risk-
rating migrations. In addition, management reporting should include a 
well-defined process through which management reviews and evaluates 
concentration and risk management reports, as well as special ad hoc 
analyses in response to potential market events that could affect the 
CRE loan portfolio.
    Market Analysis. Market analysis should provide the institution's 
management and board of directors with information to assess whether 
its CRE lending strategy and policies continue to be appropriate in 
light of changes in CRE market conditions. An institution should 
perform periodic market analyses for the various property types and 
geographic markets represented in its portfolio.
    Market analysis is particularly important as an institution 
considers decisions about entering new markets, pursuing new lending 
activities, or expanding in existing markets. Market information also 
may be useful for developing sensitivity analysis or stress tests to 
assess portfolio risk.
    Sources of market information may include published research data, 
real estate appraisers and agents, information maintained by the 
property taxing authority, local contractors, builders, investors, and 
community development groups. The sophistication of an institution's 
analysis will vary by its market share and exposure, as well as the 
availability of market data. While an institution operating in 
nonmetropolitan markets may have access to fewer sources of detailed 
market data than an institution operating in large, metropolitan 
markets, an institution should be able to demonstrate that it has an 
understanding of the economic and business factors influencing its 
lending markets.
    Credit Underwriting Standards. An institution's lending policies 
should reflect the level of risk that is acceptable to its board of 
directors and should provide clear and measurable underwriting 
standards that enable the institution's lending staff to evaluate all 
relevant credit factors. When an institution has a CRE concentration, 
the establishment of sound lending policies becomes even more critical. 
In establishing its policies, an institution should consider both 
internal and external factors, such as its market position, historical 
experience, present and prospective trade area, probable future loan 
and funding trends, staff capabilities, and technology resources. 
Consistent with the Agencies' real estate lending guidelines, CRE 
lending policies should address the following underwriting standards:
     Maximum loan amount by type of property.
     Loan terms.
     Pricing structures.
     Collateral valuation.\2\
     Loan-to-Value (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.
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    \2\ Refer to the Agencies' appraisal regualtins: 12 CFR part 34, 
subpart C (OCC); 12 CFR part 208 subpart E and 12 CFR part 225, 
subpart G (FRB); and 12 CFR part 323 (FDIC).
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     Minimum standards for borrower net worth, property cash 
flow, and debt service coverage for the property.
    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

[[Page 74587]]

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 or designated 
committee detailing the number, nature, justifications, and trends for 
exceptions. Exceptions to both the institution's internal lending 
standards and the Agencies' supervisory LTV limits \3\ 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.
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    \3\ The Interagency Guidelines for Real Estate Lending state 
that loans exceeding the supervisory LTV guidelines should be 
recorded in the institution's records and reported to the board at 
least quarterly.
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    Credit analysis should reflect both the borrower's overall 
creditworthiness and project-specific considerations as appropriate. In 
addition, for development and construction loans, the institution 
should have policies and procedures governing loan disbursements to 
ensure that the institution's minimum borrower equity requirements are 
maintained throughout the development and construction periods. Prudent 
controls should include an inspection process, documentation on 
construction progress, tracking pre-sold units, pre-leasing activity, 
and exception monitoring and reporting.
    Portfolio Stress Testing and Sensitivity Analysis. An institution 
with CRE concentrations should perform portfolio-level stress tests or 
sensitivity analysis to quantify the impact of changing economic 
conditions on asset quality, earnings, and capital. Further, an 
institution should consider the sensitivity of portfolio segments with 
common risk characteristics to potential market conditions. The 
sophistication of stress testing practices and sensitivity analysis 
should be consistent with the size, complexity, and risk 
characteristics of its CRE loan portfolio. For example, well-margined 
and seasoned performing loans on multifamily housing normally would 
require significantly less robust stress testing than most acquisition, 
development, and construction loans.
    Portfolio stress testing and sensitivity analysis may not 
necessarily require the use of a sophisticated portfolio model. 
Depending on the risk characteristics of the CRE portfolio, stress 
testing may be as simple as analyzing the potential effect of stressed 
loss rates on the CRE portfolio, capital, and earnings. The analysis 
should focus on the more vulnerable segments of an institution's CRE 
portfolio, taking into consideration the prevailing market environment 
and the institution's business strategy.
    Credit Risk Review Function. A strong credit risk review function 
is critical for an institution's self-assessment of emerging risks. An 
effective, accurate, and timely risk-rating system provides a 
foundation for the institution's credit risk review function to assess 
credit quality and, ultimately, to identify problem loans. Risk ratings 
should be risk sensitive, objective, and appropriate for the types of 
CRE loans underwritten by the institution. Further, risk ratings should 
be reviewed regularly for appropriateness.
Supervisory Oversight
    As part of their ongoing supervisory monitoring processes, the 
Agencies will use certain criteria to identify institutions that are 
potentially exposed to significant CRE concentration risk. An 
institution that has experienced rapid growth in CRE lending, has 
notable exposure to a specific type of CRE, or is approaching or 
exceeds the following supervisory criteria may be identified for 
further supervisory analysis of the level and nature of its CRE 
concentration risk:
    (1) Total reported loans for construction, land development, and 
other land \4\ represent 100 percent or more of the institution's total 
capital;\5\ or
    (2) Total commercial real estate loans as defined in this Guidance 
\6\ represent 300 percent or more of the institution's total capital, 
and the outstanding balance of the institution's commercial real estate 
loan portfolio has increased by 50 percent or more during the prior 36 
months.
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    \4\ For commercial banks as reported in the Call Report FFIEC 
031 and 041, schdule RC-C, item la.
    \5\ For purposes of this Guidance, the term ``total capital'' 
means the total risk-based capital as reported fro commercial banks 
in the Call Report FFIEC 031 and 041 schedule RC-R--Regulatory 
Capital, line 21.
    \6\ For commercial banks as reported in the Call Report FFIEC 
031 and 041 schedule RC-C, items 1a, 1d, 1e, and Memorandum Item 
3.
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    The Agencies will use the criteria as a preliminary step to 
identify institutions that may have CRE concentration risk. Because 
regulatory reports capture a broad range of CRE loans with varying risk 
characteristics, the supervisory monitoring criteria do not constitute 
limits on an institution's lending activity but rather serve as high-
level indicators to identify institutions potentially exposed to CRE 
concentration risk. Nor do the criteria constitute a ``safe harbor'' 
for institutions if other risk indicators are present, regardless of 
their measurements under (1) and (2).
    Evaluation of CRE Concentrations. The effectiveness of an 
institution's risk management practices will be a key component of the 
supervisory evaluation of the institution's CRE concentrations. 
Examiners will engage in a dialogue with the institution's management 
to assess CRE exposure levels and risk management practices. 
Institutions that have experienced recent, significant growth in CRE 
lending will receive closer supervisory review than those that have 
demonstrated a successful track record of managing the risks in CRE 
concentrations.
    In evaluating CRE concentrations, the Agencies will consider the 
institution's own analysis of its CRE portfolio, including 
consideration of factors such as:
     Portfolio diversification across property types.
     Geographic dispersion of CRE loans.
     Underwriting standards.
     Level of pre-sold units or other types of take-out 
commitments on construction loans.
     Portfolio liquidity (ability to sell or securitize 
exposures on the secondary market).
    While consideration of these factors should not change the method 
of identifying a credit concentration, these factors may mitigate the 
risk posed by the concentration.
    Assessment of Capital Adequacy. The Agencies' existing capital 
adequacy guidelines note that an institution should hold capital 
commensurate with the level and nature of the risks to which it is 
exposed. Accordingly, institutions with CRE concentrations are reminded 
that their capital levels should be commensurate with the risk profile 
of their CRE portfolios. In assessing the adequacy of an institution's 
capital, the Agencies will consider the level and nature of inherent 
risk in the CRE portfolio as well as management expertise, historical 
performance, underwriting standards, risk management practices, market 
conditions, and any loan loss reserves allocated for CRE concentration 
risk. An institution with inadequate capital to serve as a buffer 
against unexpected losses from a CRE concentration should develop a 
plan for reducing its CRE concentrations or for maintaining capital 
appropriate to the level and nature of its CRE concentration risk.


[[Page 74588]]


    Dated: December 5, 2006.
John C. Dugan,
Comptroller of the Currency.

    By order of the Board of Governors of the Federal Reserve 
System, December 6, 2006.
Jennifer J. Johnson,
Secretary of the Board.
    Dated at Washington, DC, this 6th day of December 2006.

    By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
[FR Doc. 06-9630 Filed 12-11-06; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P