Five Tactics to Mitigate Risk as Concentrations Rise

Bank regulators frequently shift the focus of their examinations to address specific areas of concern, as they should. An appropriate level of scrutiny to high-risk practices can help prevent industry-wide risk levels from becoming unmanageable, as they did in the mortgage lending sector in the early aughts. Today's "hot topic" is commercial real estate (CRE) lending. Fueled by market forces, many banks—in Wisconsin and nationwide—are holding more of these loans and in higher dollar amounts than in the past. 

Generally, this increase in CRE concentrations is being driven by "expectations of loan growth in a very competitive environment," said Nicholas Hahn, director of risk advisory services at RSM US LLP. "Many banks are more comfortable with the underlying collateral in CRE loans, so they've become very attractive." Tying compensation to loan growth has magnified the problem, as has intense competition for commercial and industrial (C&I) loans. Post-recession, many banks attempted to diversify into C&I lending, but ultimately those areas require special skill sets and infrastructure that most community banks didn't have, and competition for those C&I deals was more significant than many banks expected, Hahn explained. "Many banks had the same thought process at the same time," he said. Paul Kohler, president and CEO of Charter Bank, Eau Claire, says that changing demographics are a factor, as well. "We see more rentals and homeownership is declining," he explained. "More people are renting, so we're financing more multi-family projects in our community." Kohler also says that where people want to live is shifting along with the demographics. "A lot more people want to be in or close to downtown," he said, which adds to the demand for multi-family housing. 

With all of these pressures pushing bank CRE lending thresholds higher, effective risk management practices have never been more critical. "It's a very competitive environment, and any time it's very competitive, institutions make decisions they might not otherwise make," said Hahn. "Banks need to make sure if they're doing something they're less comfortable with, there's a corresponding increase in their credit risk management." Below are five tactics to consider implementing at your bank, if you haven't already.

1. Understand and embrace your bank's uniqueness. When it comes to your concentration thresholds, loan policies and procedures, and customer/client traits, every bank is unique. Copy/pasting regulatory standards is not necessarily the best approach for your particular institution, though they are valuable starting points. "The conversation always starts with strong policies, procedures, and underwriting criteria," said Hahn. "Most institutions have those, but they need to be tailored to the specific loan types the bank is making now." He recommends tailoring the bank's internal guidelines to address the specific risks of the current loan portfolio and growth plan. It is important for banks to incorporate their depth of relationship with their customers into their guidelines, as well. "One thing about community banking is we know our borrowers," Kohler said. "This is just one piece of their financial picture. Part of the risk management is knowing your customer." For example, documenting that the bank knows a CRE loan applicant has diversified business holdings in other sectors and a strong knowledge of the industry. That information may or may not be articulated during the application process, but is helpful in measuring risk. 

2. Ensure useful reporting. Long gone are the days where bank management heaped information on the board when discussing concentration risks. Today, it is vital to deliver specific, useful information—quality over quantity. "Ultimately, you want discussions at the Board and committee level about where you're increasing your risk exposure," said Hahn. "Depending on the type of lending that's happening, there's a lot of different data you could be monitoring." For example, in the multi-family space occupancy rates and average rents are important. Key data points to consider are those that the bank uses in its underwriting decisions. To effectively communicate that data, many banks are developing concise dashboard reports for the board and management. "It's incumbent upon the board to push management to articulate their case and really understand the risk the bank is taking on," Hahn explained. "Ultimately, they're the ones charged with governance, so they need to be aware of what's in the portfolio, know what's being done to manage the risk, and understand that they have the ability to effectuate change as needed."

Bank management should also consider that their directors may have direct knowledge of the bank's commercial clients, as well. "With having a local board, they often know the customer," Kohler pointed out. "It's about keeping them informed and being transparent." Kohler says the bank reviews and reports on its concentrations on a quarterly basis, paying more attention to the trends than the dollar amounts. "There are regulatory requirements, but we're looking at the trend from quarter to quarter and report that to the board," he said. "We talk extensively about the trends."

The way management monitors and reports on concentration trends is also very important. One strategy some banks employ is to subdivide their concentrations into sub-concentrations; common categories include property type, amortization structure, geography, and payment history. While this strategy can be helpful in certain circumstances, bank management should ensure that it isn't over-utilized. "You could subdivide down to the individual loan level, and that won't fly," said Hahn. "Understand the elements you can point to that truly impact the risk level of the loans. Make your own determination into what the differing risk profiles are."

3. Link stress test results to strategy decisions. Since you need to perform stress tests anyway, leverage those results and the scenarios you input to help guide the bank's lending strategy. "Regardless of the framework or methodology you're using for stress testing, link the results to the portfolio strategy decisions you're making," Hahn advised. "Use those stress testing activities as a tool to aid decision-making rather than a siloed activity to check a box." This practice can reveal growth opportunities as well as potential challenges. 

4. Conduct a regular independent loan review. Independent loan reviews provide management with valuable information on concentration trends, loan structure, policy exceptions, and other data points key to effectively monitoring risk. According to Hahn, it also shows where the bank may be stretching either the expertise of its staff or its available capital. Whether the review is performed by an independent party internally or via a third-party firm, it should be conducted at least annually. 

5. Watch for red flags. It's obvious, but monitoring areas of concentration for key warning signs is a critical component of your risk management system. So obvious, in fact, that sometimes these flags aren't documented in the loan policies and procedures or communicated clearly to lending staff. One common red flag is "any significant growth in unfamiliar property types or niche lending areas where you don't have specialized staff knowledge or policy and procedures," said Hahn, who also cautions banks to ensure they have not only the front-end expertise to make the "go, no-go" decision on a loan, but also the back-office expertise to process and administer that loan. 

Other common red flags are found in the loan's structure. One is long-term interest-only requests, especially if they don't include significant equity contributions. "Those indicate a potentially longer stabilization period," said Hahn. "You want that to match up with what the appraisal says." Another is extended amortization requests (especially beyond 25 years) and requests for non-recourse structures, which limit the bank's ability to collect if the borrower defaults. 

Management must also carefully monitor the bank's capital ratios in terms of concentration thresholds. "If there's a large increase, we'll look closer," Kohler said. While it doesn't necessarily mean the loan can't be made, a significant spike indicates a need for close attention. Loan concentrations are not inherently bad, but the bank must pay attention to the dynamics in its local markets and lending niche. "Different banks have different niches, so they may have more of a concentration in their specialty," Kohler said. "We have a pretty diverse economy in Eau Claire, so that helps. As a community banker, you get to see what you're doing in your community."

 ​RSM US LLP is a WBA Bronze Associate Member.