For the month of November the FDIC alone issued thirty-four formal cease and desist orders against banks. Of the thirty-four, twenty nine enforcement actions contained provisions related to “Concentrations of Credit” and order the bank to systematically reduce them. This is the issue that continues to plague the nations’ community banks. The condition of the CRE market is a major concern to top regulators. Several Federal Reserve governors have made recent speeches cautioning that the CRE market is still under major stress. In a speech on January 11, 2010, Atlanta Federal Reserve Bank President Dennis P. Lockhart stated that “the risk associated with commercial real estate is linked to banks, small business credit, jobs, and ultimately consumption. The overall commercial real estate debt in the financial system is smaller than residential, but it is disproportionately concentrated in small and regional banks.”
The FDIC risk examination manual states “concentrations generally are not inherently bad, but do add a dimension of risk which the management of the institution should consider when formulating plans and policies”. At this point in the time that appears to be a very big understatement. It is most likely that the lending policies in these institution’s do have a section for concentrations or quite possibly a stand- alone concentration policy but the field examiners have found it to be deficient.
If you find yourself at a bank with an enforcement action containing this provision whether the action is formal or informal, such as MOU or a Board Resolution, or if you are lucky enough to be employed by a healthy bank that wants to remain that way…..how do you write a Concentration Policy that will be considered adequate?
Here are some tips:
I – Opening Statement
Begin the policy with a definition of concentrations and an opening statement evidencing the commitment on the part of management and the board of directors to effectively manage the institution in a safe and sound manner. Acknowledge that concentrations of credit raise the risk level of the institution and require greater oversight and increased management processes.
For example: “We, the Board of Directors and Senior Management of Any Bank, strive to run this institution in a safe and sound manner while also providing an adequate return on equity and credit to our defined market. We recognize that credit concentrations have been inherent in our portfolio since the bank’s organization and that concentrations can also arise unintentionally. As such we have prepared and adopted this policy statement on Date. Concentrations are defined as a significantly large volume of economically related assets that an institution has advanced or committed to one person, entity, or affiliated group. Concentrations can also be any other group deemed important by the Bank.”
II – General Information
To begin the policy statement, describe the institution in general terms with a statement detailing its historical profile: such as the date opened, whether it has a parent holding company and affiliates, asset size, charter type, and the general philosophy of the senior management and board of directors.
For example, “The Bank of Any Town was organized as a denovo institution during 2008 and opened its doors for business on March 1, 2009, as an independent state non-member bank. Budgeted growth projections are on target with the bank’s total assets reaching $140 Million as of quarter end 2010. The Bank was formed by the directors to serve the retail banking and commercial and residential credit needs of the local community within Any Town County, Any State. Any Town County is a residential “bedroom” suburb of Any City and consists largely of residential subdivisions, strip shopping centers, a major shopping mall, office buildings housing businesses typically with fewer than 100 employees, and some small warehouse facilities. Deposit and loan products were tailored to fit the needs of this customer base”.
II – Products and Services Offered
For this section list the credit products the institution offers such as commercial real estate loans, commercial real estate construction, commercial and industrial loans, floor plan loans etc. Also be sure to list any credit related products related to deposit accounts, such as overdraft lines of credit, letters of credit, suspense assets, leases, repurchase agreements, as well as any other actual or contingent liability. This can be in list form and be sure to include the terms offered, such as residential mortgages with repayment terms up to 5 years based on a 30 year amortization with a balloon payment.
III – Concentration Identification and Limits
Concentrations can be clearly evident almost as soon as an institution opens. Typically senior management and the board of directors have contacts in a particular business, industry, and a certain geographic area. These relationships are often the impetus behind a new institution being formed and the growth, profitability, and ultimately the success of the institution can be attributed to them. These concentrations also form because the chief lending officer or other senior management official’s has expertise is a particular type of lending, or a certain geographic area, performs it well, and feels comfortable in this role. These concentrations are readily identifiable. However, concentrations can develop that are unintentional and can go undetected without proper mechanisms in place. Identifying concentrations of credit is ongoing function within any institution and it’s in every institution’s best interest to have mechanisms in place to identify these groups in the early stages especially before auditors and examiners discover them during a review or examination.
Open this section of the policy with a brief description of concentrations and define them for your institution in terms of dollar amounts and percentages for the group and in the aggregate.
Segments
The FDIC’s examination manual does not define a percentage for concentrations but Section 216 of the Comptroller’s Handbook states that a concentration exists if the credit in the form of direct, indirect, or contingent obligations exceeds 25 percent of the bank’s capital structure. However, the Handbook is dated March 1990 and it would be safe to say that lowering that threshold to 15 percent would be wise. Some suggestions for your segments:
1)Individual - Single developer/builder
2) Product Type
3)Geographic Distribution – by MSA, zip code, submarket
4) Underlying Collateral
5) Industry/Major Employer
6) Same Manufacturer’s Product –or if agricultural lender, by herd or crop
Concentrations are typically thought of in terms of a percentage of capital which is a very important analysis but what is even more important for a bank to do is break down and identify the most profitable product line or type. This segment is crucial to the bank for many reasons, some of which are to: sustain profitability; fund the loan loss reserve to ensure the ability to absorb losses in the entire loan portfolio; augment the capital base; and ultimately ensure the future viability of the institution.
Aggregate
The Interagency guidance on Concentrations in Commercial Real Estate Lending issued by the FDIC, OCC, and Federal Reserve System on December 6, 2006, defines the supervisory criteria as:
1) Total reported loans for construction, land development, and “other land” represents 100% or more of the institution’s total capital: or
(2)Total commercial real estate loans represent 300% or more of total capital and the outstanding balance have increased 50% or more during the prior 36 months.
The term “total capital” is defined as the total risk-based capital stated on Schedule RC-R Line 21.
Regulators received many negative public comment letters on the guidance threshold levels while in the proposal phase but history has clearly shown that concentrations are very dangerous for a bank. Steve Fritts, Associate Director of the FDIC’s Risk Management Policy Branch, said at the RMA Conference in November 2009 in Orlando Florida that “concentrations are bank killers”. With that in mind adopting more conservative limits, such as 150% which has appeared in public cease and desist orders, may be in your institution’s best interest.
IV – Mitigating Steps
The policy should clearly define what steps the bank can and should take if the concentration reports disclose that thresholds limits have been exceeded. Also included timeframes for which management must take action to reduce the concentration to within policy limits. Some suggestions include:
1)Participating out a portion or selling loan(s) to another lender;
2)Ceasing new loan originations or refinancing opportunities upon renewal;
3)Obtaining a government guarantee for all or a portion; and
4)Securing loan(s) with cash collateral;
V- Concentration Reporting and Frequency
This section should define the reports used to identify and monitor concentration limits. Reports can be derived from the bank’s core system, loan documentation system, excel spreadsheets, and any other software product installed in the bank. Hopefully banks are complying with the 2006 Guidance and performing stress testing on a portfolio level. If so, segmentation analysis performed for concentration analysis should be consistent with stress testing exercises. Also, periodic reports should be checked for accuracy by someone other than the preparer prior to being submitted to the board of directors. This person should clearly notate their review with date and signature.
Concentration analysis should be performed monthly and reported to and discussed with the board of directors with notation in the meeting minutes.
Don’t forget to present the policy to the board of directors and notate the approval in the meeting minutes.
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