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From Banking and Finance Law Daily, March 16, 2018

Regulatory scrutiny responding to increased risk in commercial real estate lending: GAO

By Lee P. Dunham, J.D.

The Government Accountability Office has issued a report entitled "Commercial Real Estate Lending: Banks Potentially Face Increased Risk; Regulators Generally Are Assessing Banks’ Risk Management Practices," in which it found that regulators have subjected banks to increased supervisory scrutiny in response to increased risk in commercial real estate (CRE) lending in recent years.

The report was issued in response to concerns raised in a December 2015 statement by federal banking regulators about the risks posed to the safety and soundness of the banking system by recent increases in concentrations of CRE loans at U.S. banks. As an asset class, the report found that CREs pose a relatively high level of risk as they are prone to volatility and cyclical behavior, as observed following the 2007-2009 financial crisis.

Trends. In its report, the GAO examined: trends in the CRE lending market, including changes in risk; and actions taken by regulators to help ensure that banks with CRE concentrations are effectively managing the related risks.

The GAO’s predictive econometric models of CRE loan performance suggested that risk in CRE lending has generally increased over the past several years, based on the following factors:

  • since the early 2000s, community banks have tended toward providing CRE loans more than other kinds of loans;
  • indicators of CRE market conditions and loan performance have been improving since 2011, but credit and concentration risks have increased in bank CRE lending; and
  • commercial property valuations have risen.

Despite the increase in risk, the GAO found that the current level of risk is lower than the level associated with the 2008 financial crisis.

Findings. The GAO found that federal banking regulators, including the Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of the Comptroller of the Currency, mitigate this risk by subjecting banks with relatively high CRE concentrations to greater supervisory scrutiny. Regulators examined whether the banks had adequate risk management practices and capital to manage their CRE concentration risk.

Where weaknesses were found in risk management areas, such as board and management oversight, management information systems, or underwriting, the regulators generally communicated their findings to the banks in reports and directed the banks to take corrective action. Additionally, federal banking regulators took both informal and formal enforcement actions against banks which failed to adequately manage their CRE concentration risk.

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