Pointing to potential stresses ahead in commercial real estate lending, Comptroller of the Currency John C. Dugan said community banks engaged in this business need to assess the strength of borrowers and identify problem credits at an early stage.
In a speech to the Independent Bankers Association of Texas, Mr. Dugan said community banks with significant concentrations of commercial real estate need to be especially prepared.
“You need to make sure your officers and loan review staff realistically assess the strength of your borrowers, and identify problem credits early,” Comptroller Dugan said. “You should also ensure that you have adequate loan loss reserves to cover the increase in losses that may occur.” ... Community banks have begun using stress testing, at least to analyze different interest rate scenarios, the Comptroller said.
“But given the high level of concentrations, banks should also be stress testing other business variables that affect risk, such as vacancy rates, lease rates, and expense scenarios – not only at the time the loan is made, but also periodically throughout the life of the credit relationship,” he added.
The result of enhanced risk management will also affect loan loss reserves. “I firmly believe that in this environment, increases in loan loss reserves for many banks are both warranted and prudent,” Mr. Dugan said.
Haha. Believe me, if they haven't done this analysis before, it's too late now. Btw, this contradicts the prior guidance about loan loss reserves, in which they were telling banks that they shouldn't reserve for uncertain events. Then they were worried about contracting credit. Now they are worried about keeping banks afloat. What a difference ten months makes! From the Q&A:
Question # 1 May institutions project or forecast changes in facts and circumstances that arise after the balance sheet date when estimating the amount of loss under FAS 5 in a group of loans with similar risk characteristics at the balance sheet date?
Answer: No. In developing loss measurements for groups of loans with similar risk characteristics, an institution should consider the impact of current qualitative or environmental factors that exist as of the balance sheet date, and should document how those factors were used in the analysis and how they affect the loss measurements. For any adjustments to the historical loss rate reflecting current environmental factors, an institution should support and reasonably document the amount of its adjustments and how the adjustments reflect current information, events, circumstances, and conditions.
For example, assume an institution’s borrowers depend upon revenues and personal incomes generated from a local military base. If a public announcement was made prior to the balance sheet date that the base would be closed within the next six to eight months, the event of the impending closure changes the collectibility of, and the estimated credit losses within, the loan portfolio in the current period. Therefore, the ALLL level would likely require adjustment based upon the event of the announcement. As the institution is able to obtain additional information about its loans to borrowers affected by the impending military base closure, the estimated credit losses would likely change over time. The institution should not, however, wait until the actual closure to estimate the credit losses resulting from this event.
In contrast, suppose there is a rumor circulating that a local military base may close. However, the institution has not been able to substantiate the rumor as of the balance sheet date. Since the rumor is unsubstantiated, it is not an event that would likely require adjustments to the ALLL level.