Banking Regulation: Enhanced Guidance on Commercial Real Estate Risks Needed
Published: 2011-05-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since the onset of the financial crisis in 2008, commercial real estate (CRE) loan delinquencies have more than doubled. The federal banking regulators have issued statements and guidance encouraging banks to continue lending to creditworthy borrowers and explaining how banks can work with troubled borrowers. However, some banks have stated that examiners' treatment of CRE loans has hampered their ability to lend. This report examines, among other issues, (1) how the Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System (Federal Reserve), and the Office of the Comptroller of the Currency (OCC) responded to trends in CRE markets and the controls they have for helping ensure consistent application of guidance and (2) the relationships between bank supervision practices and lending. GAO reviewed agency guidance, examination review procedures, reports of examination, and relevant literature and interviewed agency officials, examiners, bank officials, and academics..
section_title: What GAO Found
paragraphs: Aware of the potential risks of growing CRE concentrations at community banks, federal banking regulators issued guidance on loan concentrations and risk management in 2006 and augmented it with guidance and statements on meeting credit needs and conducting CRE loan workouts from 2008 to 2010. The regulators also conducted training on CRE treatment for examiners and internal reviews to help ensure compliance with CRE guidance. Nevertheless, a number of banks reported that examiners have been applying guidance more stringently since the financial crisis and believe that they have been too harsh in treatment of CRE loans. Regulators have incorporated lessons learned from the crisis into their supervision approach, which may help explain banks' experiences of increased scrutiny. GAO found that examiners generally provided support for exam findings on loan workouts, but identified some inconsistencies in applying the 2006 CRE concentration guidance-- which is similar to what some of the regulators uncovered in their internal reviews. Moreover, regulatory officials had varying views on the adequacy of the 2006 guidance, and some examiners and bankers noted that the guidance lacked clarity on how to comply with it. As a result, examiners and bankers may not have a common understanding about CRE concentration risks. Although many factors influence banks' lending decisions, research shows that the capital banks hold is a key factor. Capital provides an important cushion against losses, but if a bank needs to increase it, the cost of raising capital can raise the cost of providing loans. High CRE concentrations also can limit a bank's ability to lend because the bank may need to raise capital to mitigate the concentration risk during a downturn. Economic research on the effect of regulators' examination practices on banks' lending decisions is limited, but shows that examiners' increased scrutiny during credit downturns can have a small impact on overall lending. Although isolating these impacts is difficult, the recent severe cycle of credit upswings followed by the downturn provides a useful reminder of the balance needed in bank supervision to help ensure the banking system can support economic recovery. Federal banking regulators should enhance or supplement the 2006 CRE concentration guidance and take steps to better ensure that such guidance is consistently applied. The Federal Reserve and OCC agreed with the recommendations. FDIC said that it had implemented strategies to supplement the 2006 guidance.

section_title: Letter
paragraphs: The financial crisis, and the economic downturn that followed it, largely  arose out of problems related to the residential mortgage sector, but the  commercial real estate (CRE) market also has experienced significant  setbacks, that in turn, have affected community banks. More than a third  of community bank lending is tied to CRE, and delinquencies for such  loans have more than doubled since 2008. While segments of the CRE  market have shown some improvement, problems in CRE lending are  expected to continue, and refinancing such loans could present further  challenges to the market in coming years. Banks are addressing these  problems in many ways, including modifying borrowers’ loan terms so that  they can continue to make payments, increasing bank capital and reserves  as protection against future losses, and, in some cases, reducing lending.  However, reduced lending to creditworthy borrowers can exacerbate  credit tightening and inhibit economic recovery.
The federal banking regulators have been monitoring the increasing CRE  concentrations for a number of years and have responded to the current  CRE downturn and its impact on the banks they supervise. The regulators  have issued interagency statements and guidance—most recently from  2006 through 2010—on managing the risks of CRE concentrations,  encouraging banks to continue lending to creditworthy borrowers,  clarifying to banks how examiners will review loans secured by CRE, and  explaining how banks can work with troubled borrowers. Regulators have  also noted concerns they have about the risk-management systems of  banks with high CRE concentrations and have “classified” more loans  (that is, identified loans that pose a risk of loss to banks). In doing so,  examiners have been criticized by some in the banking industry for being  too harsh in their treatment of CRE loans in banks’ portfolios, and some  argue that this has hampered lending more broadly in communities across  the country.
In light of these questions about examiners’ treatment of CRE loans, you  asked us to review whether examiners’ practices related to CRE were  consistent with recent regulatory statements and guidance; whether  regulatory views on regulators’ bank ratings, capital, and liquidity have  changed; and what the potential impact of regulatory practices might be  on lending by community banks. This report examines (1) the condition of  the CRE market and the implications for community banks; (2) how three  federal banking regulators—the Federal Deposit Insurance Corporation  (FDIC), Board of Governors of the Federal Reserve System (Federal  Reserve), and the Office of the Comptroller of the Currency (OCC)— responded to trends in CRE markets through their supervision of  community banks and what controls they have to help ensure consistent  application of policy guidance; and (3) what is known about the  relationships between bank supervision practices and lending.
To address our objectives related to the condition of the CRE market and  its implications for community banks, we analyzed data from 1996 through  2010 (when available) from Moody’s/REAL Commercial Property Price  Index for CRE values and call report data for CRE loan concentrations and  performance. We reviewed CRE-related reports from the Congressional  Oversight Panel, Congressional Research Service, FDIC, Federal Reserve,  and academic journals, and conducted interviews with bank examiners,  regulatory officials, and community bankers. We also examined material  loss reviews (MLR) conducted by the inspectors general (IG) of the bank  regulators and previous GAO products. To understand how FDIC, the  Federal Reserve, and OCC have responded to the CRE downturn, we  collected and analyzed regulatory guidance related to CRE loan treatment  and interagency statements on lending, and also assessed regulatory  efforts to address CRE-related concerns. As part of this work, we  observed training provided by the Federal Financial Institutions  Examination Council (FFIEC) to examiners related to CRE guidance and  loan classifications.
To understand bank officials’ concerns about examiners’ treatment of CRE  loans, we spoke with officials from 43 community banks and analyzed 55  bank reports of examination (ROE). For our bank official interviews, we  contacted 62 banks and spoke with all 21 that responded to us based on a  nonprobability sample of banks in California, Georgia, Massachusetts, and  Texas. We chose those states because banks in the first two states have  had a relatively greater share of CRE-related nonperforming loans (as  measured by the percentage of CRE loans past due or on nonaccrual) and  banks in the last two a relatively smaller share. From these states, we  selected banks that had a federal bank regulator examination after  October 2009; elevated concentrations in CRE; or elevated concentrations  in acquisition, development, and construction (ADC) loans. This sampling  approach also was used to select the 55 ROEs for analysis. Our sample is  not designed to be generalizable to all banks, but instead provides  information on a range of banks working under different supervisors,  having different conditions, and operating in different economic  environments. For our bank official interviews, we supplemented the  sample by interviewing officials from 22 additional banks that testified  before Congress on the issue of CRE, were identified through bank  associations, or requested an interview after learning about our work.
To understand examiners’ practices and views on certain regulatory  measures, especially on the CRE loan workout guidance, we spoke with  regulatory staff at district, regional, and field offices in California,  Colorado, Georgia, Massachusetts, and Texas, and in headquarters at  Washington, D.C. We spoke with more than 230 field staff in various roles  (either directly involved in drafting and reviewing ROEs or participating in  oversight of the review process)—both in group settings and individually.  While not representative of the population of examiners and regulatory  staff, our interviews with examiners and other regulatory staff provide a  broad range of views. To understand the controls the regulators have in  place to help ensure consistent application of policy guidance, we  collected, compared, and analyzed examination review reports and quality  assurance processes for the three regulators, and also interviewed  officials. To understand what is known about the relationships between  regulators’ supervision practices, lending, and CRE values, we conducted  a literature review dating to 1991 and focusing on comprehensive,  empirical, published research that reviewed such topics and also  interviewed academics, regulatory officials, and bank officials.
We conducted this performance audit from May 2010 through May 2011 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
subsections: section_title: Background
paragraphs: As of December 31, 2010, there were 6,364 community banks (commercial  banks with total assets of $1 billion or less). This represents about 92  percent of all commercial banks, although only about 10 percent of  commercial bank assets nationwide.
Banks in the United States are supervised by one of the following three  federal regulators:    FDIC supervises all FDIC-insured state-chartered banks that are not  members of the Federal Reserve System.
The Federal Reserve supervises commercial banks that are state-chartered  and members of the Federal Reserve System.
OCC supervises federally chartered national banks.
Table 1 summarizes the regulators’ oversight responsibilities for  community banks.
The purpose of federal banking supervision is to help ensure that banks  throughout the financial system are operating in a safe and sound manner,  and are complying with banking laws and regulations in the provision of  financial services. As we have identified in previous work, financial  regulation more broadly has sought to achieve four goals: to (1) ensure  adequate consumer protections, (2) ensure the integrity and fairness of  markets, (3) monitor the safety and soundness of institutions, and (4) act  to ensure the stability of the overall financial system. Federal banking  regulators use a number of tools to achieve these goals.
Capital requirements: Regulators require banks to maintain certain  minimum capital requirements to help ensure the safety and soundness of  the banking system, and generally expect banks to hold capital above  these minimums—commensurate with their risks. Capital provides an  important cushion against losses for banks, and represents the amount of  money that can cover losses the bank may face related to nonpayment of  loans and other losses on assets. Capital can be measured as total capital  or tier 1 capital. Regulators oversee the capital adequacy of their  regulated institutions through ongoing monitoring, including on-site  examinations and off-site tools. When regulators require banks to hold  capital above regulatory minimums, these requirements may result from  an enforcement action through an agreement between the regulator and  the bank. However, requiring banks to hold more capital may reduce the  availability of bank credit and reduce returns on equity to shareholders.
Examinations and ratings: Federal banking laws and regulatory  guidance require on-site examinations, which serve to evaluate a bank’s  overall risk exposure and its ability to identify and manage those risks— especially as they affect a bank’s financial health. At each full-scope  examination, examiners review the bank’s risk exposure on a number of  components using what is known as the CAMELS rating system (Capital  adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity  to market risk). Evaluations of CAMELS components consider the  institution’s size and sophistication, the nature and complexity of its  activities, and its risk profile. In examinations, a bank is rated for each of  the CAMELS components and given a composite rating, which generally  bears a close relationship to the component ratings. However, the  composite is not an average of the component ratings. The component  rating and the composite ratings are scored on a scale of 1 (best) to 5  (worst). Regulatory actions typically correspond to the composite  CAMELS ratings, with the actions generally increasing in severity as the  ratings become worse. Table 2 describes the definitions of the composite  scores under the Uniform Financial Institutions Rating System.
Loan classifications: In examinations, examiners review a sample of  banks’ internal ratings of loans to determine the adequacy of credit risk  administration and identify loans that show undue risk and may be  uncollectible. As part of this review, examiners determine which loans are  considered “pass,” with no concerns noted, as well as those that are  special mentioned or “classified”—that is, subject to criticism because  they are not performing or may not perform in the future. There are three  classification categories used by the federal banking regulators:  substandard, doubtful, and loss (see table 3). These loan classifications,  and the internal ratings that banks produce for all of their loans, are  incorporated into how each bank calculates its allowance for loan and  lease loss (ALLL), which is an estimate made according to accounting  guidance of incurred losses on loans and leases. Therefore, if additional  loans are classified substandard or doubtful, this information is included  in a bank’s updated ALLL estimates. If loans are classified loss, they are  charged off the bank’s balance sheet.
The end result of an on-site examination is an ROE that includes the  CAMELS ratings and other findings on the bank’s condition, which is  provided to the bank’s management and board of directors.
subsections: section_title: CRE Property Types and Associated Risks
paragraphs: CRE encompasses many different property types that present different  risks. Table 4 describes the key CRE property types.
Regulators define CRE loans to include construction loans, loans to  finance CRE that are not secured by CRE, loans secured by multifamily  property, and loans secured by nonfarm, nonresidential property in which  the primary source of repayment derives from the rental income  associated with the property or the proceeds of the sale, refinancing, or  permanent financing of the property. CRE loans in which the primary  source of repayment is not the property itself are called owner-occupied  loans and can include loans to businesses for working capital purposes  that use real estate as collateral. For example, a line of credit for a  business’s operating expenses might be secured in part by commercial  property, such as an office.
Owner-occupied properties generally are considered to carry less risk than  non-owner-occupied properties because regulators consider them to be  less sensitive to the condition of the CRE market. In ADC loans, also  called construction and land development (CLD) loans, generally are  considered to be the riskiest class of CRE, due to their long development  times and because they can include properties (such as housing  developments or retail space in a shopping mall) that are built before  having firm commitments from buyers or lessees. In addition, by the time  the construction phase is completed, market demand may have fallen,  putting downward pressure on sales prices or rents—making this type of  loan more volatile. In recent years, this type of loan also has tended to  have a much higher loss volatility than loans secured by properties such as  multifamily housing and other nonfarm, nonresidential commercial  properties.
Banks report on four broad categories of CRE in their quarterly call  reports:    CLD: loans secured by real estate to finance land development and  construction. This includes new construction, as well as additions and  alterations on existing properties.
Multifamily: loans for residential properties with five or more dwelling  units, such as apartment buildings.
Nonfarm nonresidential: loans secured by real estate for business and  industrial properties, as well as properties such as hotels, churches,  hospitals, schools, and charitable organizations. This category includes  offices, retail, and warehouse space.
Loans to finance CRE, construction, and land development (not secured  by CRE).
Interagency guidance issued in 2006 on concentrations in CRE and sound  risk-management practices define CRE loans within these categories to  include those in which repayment is dependent on the cash flow generated  from the real estate itself. When evaluating concentrations in CRE,  examiners are instructed not to include owner-occupied properties in  which the income or value of the property is not the primary source of  repayment.
section_title: Deterioration of the CRE Market Negatively Affected Community Banks, Which Could Impact Small Business Lending
subsections: section_title: The CRE Market Has Experienced a Significant Downturn
paragraphs: CRE as an asset class—and especially properties in the ADC category—is  prone to volatility and cyclical behavior, as illustrated in the current CRE  market downturn. This volatility and cyclical behavior is attributed to  characteristics such as information-gathering difficulties, infrequent  transactions, high transaction costs, rigid and constrained supply, long  construction times, and a two-fold reliance on external finance (shorter- term to cover construction, and longer-term for the occupancy period).  Additionally, CRE is by nature diverse and localized. For example,  shopping centers are one type of CRE, but even within this category  properties can have significant differences depending on design, types of  tenants, and other factors that can affect their value. Because of these  factors, the supply of CRE in the marketplace is slow to respond to an  increase in demand, which drives prices up when investor optimism rises.  Conversely, the marketplace is slow to respond when the market supply of  CRE catches up and new construction projects are delivered, resulting in  oversupply and declining property values. According to regulatory  officials, the weakness in the ADC sector during this crisis was primarily  due to residential housing construction, and that weakness affected the  performance of other areas of CRE (for example, failed residential housing  developments will affect the ability of nearby strip malls to attract and  generate rental income from tenants).
The recent downturn in the CRE markets can be seen in the market values  for commercial property and the condition of the commercial mortgage- backed securities (CMBS) market. Market values for all major  commercial property types have declined significantly. As of December  2010, overall CRE market values were down more than 42 percent from  their peak in 2007. This decline followed a rapid appreciation in CRE asset  values during which CRE values increased by more than 85 percent from  2002 to the market’s peak in October 2007 (see fig. 1). Overall  deterioration in CRE markets can be found in the condition of the CMBS  market as well. By January 2011, the delinquency rate on loans included in  CMBS was at a record high, above 9 percent. As we have reported, overall  CMBS issuance slowed severely since the CRE downturn started. After  peaking in 2007, the CMBS market came to a complete halt by the end of  2008.
Although CRE market price deterioration appears to have leveled off  recently, vacancies at many properties remain high and signs of a market  recovery have been uneven in different areas of the country. High-value  properties in markets such as New York, Washington, San Francisco, and  Boston have performed well more recently. But low rental rates and high  vacancies indicate that demand for office, retail, multifamily housing, and  warehouse space remains relatively weak. Furthermore, although CRE  markets nationally have experienced a downturn, some regions have  experienced more distress than others. For example, the CRE markets in  the South, Midwest, and West have experienced greater stress and  deterioration than the East. These areas that have experienced greater  CRE market stress also have experienced more bank failures, according to  FDIC data.
section_title: The Decline of the CRE Market Has Adversely Affected Community Banks
paragraphs: Community banks increasingly have moved toward providing CRE loans  more than other kinds of loan products, in part because of competitive  pressures. During the last decade, large banks and other financial  institutions increased their market share for consumer loans, credit cards,  and residential mortgages. As a result, community banks shifted their  focus to CRE lending. Some market observers argue that community  banks’ focus on CRE lending, and, therefore, the long-term trend of  increased CRE concentrations, came about because community banks  generally know their local CRE markets better than larger banks and are  well-positioned to gather location-specific information for CRE properties.
The increased exposure of community banks to CRE loans has been  pronounced over the last 10–15 years. While CRE collateral backed about  30 percent of total loans and leases at community banks in 2000, a decade  later that rate increased to more than 43 percent. Concentrations have  been less pronounced at larger banks, which tend to rely less heavily on  CRE lending. Since 2000, CRE as a percent of total loans and leases has  ranged from about 15 percent to about 21 percent at commercial banks  with more than $1 billion in total assets.
Community banks also have come to hold large concentrations of CRE  loans in comparison to their total capital. The average CRE concentration  at community banks as a percentage of total risk-based capital increased  from about 168 percent in 1996–2000 to about 289 percent in 2005–2010  (see fig. 2).
Increased exposure to CRE has made community banks vulnerable to the  decline of this market. According to FDIC, nearly 30 percent of community  banks have concentrations of CRE to total capital above 300 percent, the  concentration threshold established in the 2006 interagency guidance on  CRE, above which regulators review banks’ risk-management controls  more closely. This means that nearly a third of community banks are  exposing three times their total capital to risks related to their CRE loans.  As noted by a Bank for International Settlements report on bank lending  and commercial property cycles, declining property prices increase the  proportion of nonperforming loans, lead to a deterioration in banks’  balance sheets, and weaken banks’ capital bases. In particular, the  decline in CRE values has contributed to more noncurrent CRE loans,  charge-offs, and bank failures.
Noncurrent CRE loans have increased. From the first quarter of 2008  through the fourth quarter of 2010, the percent of CRE loans at community  banks that were noncurrent increased from 2.2 to 5.3 percent, well above  the average rate of 0.9 percent from 2000 through 2007. The average from  2000 through 2010 is 1.94 percent. However, the data show that the volume  of noncurrent CRE loans has begun to level off (see fig. 3).
CRE loan charge-offs increased. From the end of 2007 through the end  of 2010, the percent of CRE loans that had to be charged off at community  banks rose from 0.19 to 1.34 percent. From 2000 through 2007, the average  charge off rate of CRE loans at community banks was 0.09 percent, and  from 2000 through 2010 it was 0.39 percent (see fig. 4). Charge-offs and  expected losses that may arise from increases in noncurrent CRE loans  have put stress on banks’ capital and ALLL.
Increased bank failures linked to high CRE and ADC  concentrations. Many bank failures are associated with high CRE and  ADC concentrations. In 2009 and 2010, 102 of 106 of the MLRs issued by  the IGs of the banking regulators cited high CRE concentrations, and 92 of  106 specifically cited ADC loans in particular as a contributing factor in  bank failures. In the 106 MLRs, 76 of the banks reviewed were community  banks. For example, the MLR for one failed bank—which contains  findings similar to many other MLRs we reviewed—states that the rapid  growth of its CRE portfolio “increased the institution’s exposure to a  sustained downturn in the real estate market and reduced its ability to  absorb losses due to unforeseen events.”
section_title: Depressed CRE Markets Could Reduce Small Business Lending
paragraphs: CRE market value declines could reduce overall small business lending by  community banks. As we previously reported, community banks tend to  have a larger portion of small-business related loans compared with larger  banks. Because CRE can be used as collateral for small business loans,  diminished CRE values also can negatively affect credit availability to  small businesses. Specifically, when the value of collateral declines, the  amount of financing a bank is willing to lend against that collateral  typically declines as well. Conversely, increases in collateral values lower  the premium on external financing—improving credit availability for  borrowers, boosting demand for real estate assets, and driving up prices.  Therefore, falling property prices can generate a cycle of declining CRE  values because they can accompany reduced credit. A report by the Bank  for International Settlements notes that falling CRE prices decrease the  value of collateral held by banks and, therefore, can give rise to significant  losses by these banks and ultimately contract the supply of credit.
The problem of CRE loan refinancing may exacerbate the negative CRE  trends and limit lending to small businesses. CRE loans usually are written  for 3–10 years, with a 20–30 year amortization schedule and a balloon  payment at the end. Instead of making the large balloon payment, the  borrower typically will sell the property or refinance the loan at the end of  the term. Small businesses that are looking to refinance a loan against a  property that has lost a significant amount of market value may have to  put up more equity. Alternatively, such borrowers might default on the  loan, or the bank could work with the borrower to restructure the loan  and avoid default. Trepp LLC, a commercial mortgage analysis firm,  estimates that about $1.7 trillion in CRE mortgages will mature between  2011 and 2015, with about half of that held at banks. Moreover, Trepp  estimates that approximately 60 percent of CRE debt maturing in 2011 is  “underwater”—meaning the value of the loan exceeds the value of the  underlying collateral. Due to price declines and stricter bank underwriting  standards compared to when these loans were originated, those mortgages  will be difficult to refinance.
Results from the Federal Reserve’s Senior Loan Officer Opinion Survey  have suggested that new CRE borrowers have faced tighter credit  conditions, due to banks tightening their underwriting standards in  response to the downturn. The January 2011 survey found that 10.6  percent of respondents reported easing credit standards over the previous  3 months, compared to 10.5 percent who reported tightening them.  However, this is a positive development from past results that showed  severe tightening. The trend of tighter credit standards suggests that  borrowers who previously were considered creditworthy might not meet  banks’ higher standards.
section_title: While Regulators Have Taken Steps to Address CRE Concentrations and Bank Concerns, Challenges Remain in Consistently Applying Guidance
paragraphs: The regulators have been aware for some time of the risk-management  challenges related to growing CRE concentrations at community banks  and have taken steps to address these challenges. The regulators, for  example, issued guidance to banks on managing CRE concentration risks,  conducted training on CRE treatment, and conducted internal reviews to  better ensure examiner compliance with CRE guidance. Even with the  training and reviews, a number of bank officials we interviewed stated that  regulators have applied guidance rigidly since the financial crisis and have  been too harsh in classifying loans and improperly applying the 2006 CRE  guidance, among other issues. Regulators have been incorporating lessons  from the financial crisis in their supervisory practices, which in part may  explain bank officials’ experience of increased stringency in supervision.  Based on our review of a nonprobability sample of 55 bank examinations,  examiners’ findings were consistent with CRE loan workout guidance,  although in some instances examiners did not clearly support  requirements for reduced CRE concentrations and did not calculate CRE  concentrations according to concentration and risk-management  guidance. Additionally, senior regulatory officials and examiners have  differing views on the adequacy of the 2006 guidance, which may affect  how consistently the guidance is applied.
subsections: section_title: Federal Banking Regulators Addressed CRE Issues before and after the Financial Crisis by Issuing Guidance on CRE Concentrations and Loan Workouts
paragraphs: The regulators began to address CRE concerns before the financial crisis.  Beginning in the early 2000s, the agencies reviewed CRE concentrations  and risk-management systems across banks. For example, an OCC review  found potential for improvement in banks’ risk-management processes for  CRE concentrations, including the sufficiency of stress testing. The  regulators issued draft guidance in January 2006 on CRE concentrations  and risk management, based in part on the trends they had observed in  CRE concentrations and risks. The draft guidance elicited considerable  feedback from bank representatives, many of whom stated it would curtail  their CRE lending, impose arbitrary limits on CRE concentrations, and  require additional capital without explicitly stating how much would be  required. The regulators revised the guidance based on the feedback  received. Issued in final form in December 2006, the interagency guidance  provides levels of CRE concentrations that will result in additional  regulatory attention on risk-management systems: (1) 300 percent of CRE  loans to total capital, (2) increases of 50 percent or more in CRE loans  during the prior 36 months, and (3) 100 percent of CLD (or ADC) loans to  total capital. In determining the concentration ratio, owner-occupied CRE  is removed. The guidance also states that the concentration numbers are  not limits, but rather indicate when banks will receive closer scrutiny of  risk-management systems and capital adequacy. Such thresholds are not  intended to be a “safe harbor”—that is, banks with lower concentrations  may still receive scrutiny of their CRE loans in examinations—and banks  that exhibit other risk factors can receive criticisms on their CRE  concentrations.
In October 2009, after the start of the financial crisis and the widespread  deterioration in CRE loan performance, regulators issued interagency  guidance on CRE loan workouts. According to the regulators, the  guidance was issued to (1) help ensure consistent CRE loan and workout  treatment among the regulators, (2) update and re-assert previous  guidance, (3) inform banks of examiner expectations, and (4) ensure that  supervisory practices do not inadvertently curtail the availability of credit  to sound borrowers. Officials told us that the guidance was not intended  as forbearance, but to encourage prudent loan workouts. While the 2009  guidance was similar to that issued in 1991 and 1993, regulatory officials  noted that it includes updates for changes in accounting (for example,  related to ALLL), information on risk management for CRE loan workouts,  and numerous examples to assist banks and examiners in interpreting the  guidance. The examples provide scenarios for different CRE loan  classification outcomes and whether loans should be considered troubled  debt restructurings (TDR), among other issues. Bankers with whom we  spoke stated that the examples were helpful in understanding how to  apply the guidance. Examiners told us that the examples have helped to  resolve differences of opinion with bankers on how to treat certain CRE- related loans. In addition to the 2009 CRE loan workout guidance, the  regulators issued statements on lending to creditworthy borrowers and  creditworthy small business borrowers to encourage prudent lending  among banks and balanced supervision among examiners.
section_title: Regulators Rely on a Variety of Processes to Help Ensure Examinations of CRE Portfolios Are Consistent and Appropriate, and Some Processes Have Identified Inconsistencies
paragraphs: Federal banking regulators help ensure consistency among examinations,  and appropriate application of guidance, primarily through the ROE  review process—but also through training, internal reviews, quality  assurance processes, and processes for obtaining input from banks. Such  processes reflect federal internal control standards, which provide  reasonable assurance that management directives are carried out. The  federal government standards for internal control state that managers  should have controls in place to compare actual performance to planned  or expected results over time throughout the organization and analyze  significant differences. All of the regulators’ processes were used in some  form to implement CRE guidance and ensure consistent treatment of CRE  loans. Some of the internal review processes have identified  inconsistencies in the application of CRE guidance.
subsections: section_title: ROE Review Process
paragraphs: The regulators’ examination drafting and review process is iterative, with  multiple levels of internal review. According to regulatory staff, this design  helps ensure consistent application of guidance and treatment of banks.  Figure 5 illustrates the examination process of the federal banking  regulators. The process and the staff involved vary slightly for each  regulator and based on a bank’s CAMELS rating.
For all examinations, a team of examiners will conduct on-site work, led  by an examiner-in-charge (EIC), who drafts the ROE. Other staff and  management also discuss findings with the examination team and review  the examination report. The case manager in particular helps ensure  consistency. Case managers review draft ROEs for consistency and  adequate support of findings for a portfolio of banks. The analyst function  at OCC serves a similar role: reviewing many ROEs, although not assigned  to a specific portfolio of banks. While case managers and senior  management generally do not review loan classification details, they  review loan classification writeups in ROEs for accuracy and support for  CAMELS ratings in a broad range of ROEs. According to Federal Reserve  officials, case managers and senior management hold discussions with the  examination teams as examination findings are being finalized, to ensure  that they are appropriate. Therefore, these roles help ensure consistent  application of guidance among various examiners. In certain instances, the  regulators’ headquarters offices in Washington, D.C., may participate to  help ensure consistent implementation of policy guidance.
section_title: Training
paragraphs: Regulators also provide training on new guidance to help ensure  consistent application. All the agencies offered multiple training  opportunities or conference calls on the 2006 CRE concentration and the  2009 CRE loan workout guidance. For the 2009 CRE loan workout  guidance, Federal Reserve and FDIC headquarters staff visited field  offices, and all regulators hosted conference calls with examiners to better  ensure that the field examiners were implementing it as intended. Some  field offices also included these CRE topics in their own training and team  meetings.
section_title: Internal Audits and Quality Assurance Processes
paragraphs: Regulators also have internal reviews and quality assurance processes to  help promote consistency, including consistent application of the CRE  guidance. Regulators’ internal reviews include comprehensive audits that  recur periodically, and real-time and post-ROE quality processes. Some  of these reviews identified inconsistencies or other needed improvements  related to examiner treatment of CRE loans. For example:    For certain FDIC regions, reviews found that examiners could have better  documented findings on CRE concentrations or could have provided  earlier or harsher criticism of CRE concentrations, and the regional office  could have better monitored CRE concentrations among the banks it  supervised. According to an FDIC official, the regions already have  addressed some of these findings.
Certain districts of the Federal Reserve System reviewed implementation  of the 2006 CRE concentration guidance and found instances of  inconsistency. The reports concluded that the guidance could have  clarified expectations for how examiners should review banks’  compliance with CRE-related risk-management practices and noted that a  common, mandatory process for reviewing banks’ compliance with the  2006 guidance would have resulted in better documentation and  consistency. In particular, these reviews found that examination  workpapers sometimes lacked sufficient documentation to determine if  the examiner adequately assessed compliance with the guidance,  particularly related to CRE portfolio-level stress testing. According to  Federal Reserve officials, Washington staff also coordinated separate  reviews related to implementation of the 2006 guidance, which resulted in  internal clarifications of the appraisal review process, ALLL assessment  guidance, examiner training sessions on the use of interest reserves and  TDRs, and contributions to the 2009 loan workout guidance.
According to a San Francisco Federal Reserve Bank official, the San  Francisco Federal Reserve Bank implemented a “look back” process in  June 2010 in which a senior official reviews the sufficiency of support for  downgraded CRE loans for all issued ROEs—in response to criticism that  examiners were being too harsh and curtailing credit. Of 11 CRE loan  downgrades reviewed in the third and fourth quarter of 2010, this official  stated that 2 should not have been downgraded. Specifically, according to  this official, the loans initially were considered collateral dependent, but  after closer review the official determined that the borrowers had some  capacity to repay, so the loans should have been classified but not yet  charged off. In these two cases, the loan downgrades were reviewed and  changed before the ROEs were finalized and were consistent with the  bank’s internal loan ratings. According to this official, the findings from  this quality process will be used to improve the accuracy of CRE loan  classification.
Similarly, all OCC districts instituted a real-time review process in which  experienced staff reviewed the accuracy of CRE loan classifications— before the ROE is finalized. For example, OCC’s central district in  January 2009 reported that 95 percent of examiners’ ratings decisions on  CRE loans, and 99 percent of their accrual decisions, were determined to  be accurate. Among those classifications that were corrected, 3 percent  were downgraded and 2 percent were upgraded. Based on these findings,  the district concluded that the vast majority of examiner loan  classifications were accurate but recommended more training to address  the discrepancies. The western district’s quality assurance process  concluded that 4 percent of risk ratings were incorrect.
section_title: Processes for Obtaining Bank Feedback
paragraphs: Regulators also use surveys to gather information on how to improve the  examination process and understand the impact of policies on the banking  industry. For example, the regulators issued an interagency survey for  examinations conducted between May 31 and July 9, 2010. According to an  FDIC analysis of the resulting data, more than 97 percent of respondents  stated that the 2009 CRE loan workout guidance has been helpful. In  addition, nearly 88 percent of banks stated that no specific guidance was  inhibiting them from working with troubled borrowers. Among the  remaining 12 percent, just over three-quarters of them raised concerns  about accounting-related guidance and reporting of TDRs. Based on this  information, regulatory officials from FDIC, the Federal Reserve, and OCC  believe that the 2009 CRE loan workout guidance has been helpful.
Comments provided to regulatory officials during the examination process  and through the formal appeals process provide information about banks’  concerns on ratings and whether regulatory guidance has been applied  consistently. According to bank and regulatory officials with whom we  spoke, when bank officials have raised concerns, they tend to first  approach the examination team. Bank officials also can contact the  ombudsman offices at the regulators to seek confidential assistance. In  addition to these avenues, banks formally can appeal regulatory decisions.  Although bankers have multiple options for raising concerns about  regulatory actions, our interviews with bank officials found that some  were cautious about raising issues because of potential repercussions  from regulatory officials. In contrast, other bank officials stated that they  do contact regulatory officials when warranted, although a few raised  concerns about the time and expense of pursuing formal appeals.  Regulatory officials told us that many bank officials regularly reach out to  them, and a few officials also noted that they provide information to bank  officials about the ombudsman and the appeals process—should banks  want to raise concerns.
section_title: Banks’ Concerns about Examiner Treatment of CRE Loans Highlight Challenges in Addressing CRE Downturn
paragraphs: Interviews with officials from 43 banks in different parts of the country  identified multiple concerns with examiner treatment of CRE loans and  related issues. Many bank officials’ overarching concern was that  examiners have been applying guidance more stringently than before the  financial crisis—a shift that a few bankers commented was a difficult  adjustment.
subsections: section_title: Loan Classifications and Effect on Earnings
paragraphs: Some bank officials we interviewed expressed concerns with examiner- required loan classifications. From the perspective of a few bank officials  we interviewed, a loan is performing when the borrower continues to pay  and should not be classified. However, according to regulatory guidance  and statements of regulatory officials, such a loan may be classified if  identified weaknesses suggest a reduction in the borrower’s capacity to  repay that in turn could lead to future nonpayment. According to bankers  and examiners with whom we spoke, “global cash flow” analysis always  has been part of reviewing loans, but in the current economic downturn  examiners have been focusing more closely on analysis and  documentation of borrowers’ and guarantors’ global cash flows. The  purpose of such analysis is to determine whether they have sufficient  income and liquid assets to support loan payments. In some cases, such  analysis shows that a borrower is unable to pay the loan, even if the  borrower is currently paying. For example, the borrower’s income and  other debt obligations, when reviewed as a whole, could show that the  borrower’s debt obligations exceed income, which raises questions about  whether the borrower will continue paying on the loan in the future.
The renewed focus on global cash flow analysis, in part, led many bank  officials to conclude that examiners were classifying loans based either on  collateral value or because the bank lacked updated financial statements.  Regulatory field staff acknowledged that global cash flow analysis can be  difficult to conduct because borrowers sometimes do not provide banks  with updated financial statements. However, regulatory officials told us  that examiners do not classify loans solely because of a lack of financial  statements, but a lack of such statements combined with other  weaknesses could provide sufficient support for classifying a loan. If the  borrower lacks the ability to repay, the loan then could be considered  “collateral dependent.” Such loans are classified based on the value of the  property, and tend to rely on values established in appraisals. According to  some bank officials we interviewed, examiners have been more critical of  recent appraisals. For example, these officials stated that examiners have  been requiring appraisals on CRE collateral more often, criticizing the  banks’ appraisal review process, and criticizing the appraisals themselves.
Classifications are a major concern for banks primarily because they can  result in reduced earnings. For example, an examiner may determine that  a bank should place a classified loan on nonaccrual—which means the  bank cannot accrue the interest income as earnings. While some bankers  put loans on nonaccrual themselves, a few bank officials with whom we  spoke stated that examiners have been asking bankers to place more loans  on nonaccrual. Classifications also can reduce earnings because they  factor into ALLL, which a bank estimates based on accounting guidance  from the Financial Accounting Standards Board (FASB). As more loans  are classified, more is generally reserved in ALLL to anticipate future  losses from nonperforming loans. In our interviews with bank officials,  some stated that examiners have been requiring additional ALLL and  criticizing the ALLL methodology. In addition, a few bankers noted that  some examiners want ALLL increased based on their peers’ ALLL rather  than the bank’s individual situation.
section_title: Application of CRE-related Guidance
paragraphs: Many bank officials with whom we spoke were concerned that examiners  have been misapplying the 2006 guidance. As we discuss above, the 2006  guidance states that the CRE and ADC concentration levels are not limits,  but some bank officials told us that examiners have been interpreting  them that way. A few bank officials also stated that examiners have not  been calculating CRE concentrations according to the 2006 guidance:  some examiners were including owner-occupied CRE and some were  using the wrong type of capital for the calculation, which inflated the  concentration levels (we also found this in our analysis, described in more  detail below). A few bankers stated that examiners told them they  exceeded the 300 percent concentration threshold for CRE, based on these  faulty calculations, but according to the calculations in the guidance they  actually were under the threshold. Furthermore, a few bank officials also  stated that it was unclear to them what examiners expect in complying  with requirements related to CRE and risk management—for example, on  what is considered to be satisfactory stress testing.
While more bank officials than not noted that examiners’ actions have  been consistent with the letter of the 2009 CRE loan workout guidance, a  few stated that examiners were not always complying with its spirit: to  allow the banks time to work with borrowers until the current CRE  downturn passes. Two bankers with whom we spoke stated that it was  their experience that examiners were particularly stringent in 2008 when  the financial crisis was escalating, but moderated their approach in late  2009, which is around the time that the 2009 CRE loan workout guidance  was issued. An internal review by OCC’s Midsize and Community Banks  Division came to a similar conclusion and noted that examiners have  become more consistent in their CRE loan treatment through internal  discussions, training, and policy communication efforts. A few bank  officials with whom we spoke provided specific suggestions on how to  improve policy guidance—such as clarifying what amount of debt service  coverage is acceptable in a loan workout, how best to conduct global cash  flow analysis, and when new appraisals are needed—but a few others felt  that some form of general regulatory reprieve was needed for community  banks to work through the downturn.
section_title: CAMELS and Capital Requirements
paragraphs: Bank officials we interviewed also stated that their experience with  increased supervisory scrutiny was being reflected in CAMELS ratings and  additional capital requirements. For example, many bank officials thought  the management component rating was more critically assessed now, and  heavily driven by asset quality and other component ratings. A few bank  officials added that they were being rated on deterioration in their  portfolios that was due to the broader economic downturn and problems  in their geographic market that were out of their control. Some bank  officials with whom we spoke stated that examiners have been more  aggressive about requiring additional capital—and two bank officials in  particular stated they thought this was especially the case for banks with  high CRE concentrations.
However, a few bankers thought the additional scrutiny was appropriate,  but should not necessarily be focused on all banks. For example, one  banker stated that if examiners had been applying the guidance stringently  before the crisis that perhaps the banks could have avoided some of the  current problems. A few others also noted that stricter scrutiny was  appropriate given the current CRE market situation and the severity of the  economic downturn. Additionally, a few bank officials stated that the  regulators should focus on the community banks that caused the  problems, rather than subjecting all community banks to such strict  scrutiny.
section_title: Regulators Have Incorporated Lessons Learned from the Financial Crisis into Supervision, Which May Explain Some Bank Officials’ Experiences of Increased Scrutiny
paragraphs: Regulators have been incorporating into their regulatory processes a  number of lessons learned from the financial crisis, including findings  from the agencies’ IGs. Specifically, the IGs of the banking regulators  completed 106 MLRs in 2009 and 2010 for banks that failed during the  recent financial crisis. As noted in a December 2010 report by the FDIC  IG that summarizes certain MLR findings, FDIC determined based on the  MLRs that earlier supervisory action was needed to address banks with  high risk profiles or weak risk-management practices. We also found in  past work that regulators identified a number of weaknesses in  institutions’ risk-management systems before the financial crisis began but  did not always take forceful actions to address them. In addition, the  Financial Crisis Inquiry Commission report notes areas in which  regulators could have been more proactive in using regulatory tools to  address certain risks in the financial system. A number of  nonmanagement regulatory staff in the field offices we visited  acknowledged they could have better followed up on outstanding issues.
In response to lessons learned, regulatory officials stated that they have  been following up more often on matters requiring attention (MRA) and  refocusing their supervisory efforts. For example, OCC’s Midsize and  Community Banks Division issued an MRA Reference Guide that provides  examiners with OCC policy guidance on how to report, follow up on, and  keep records related to MRAs. FDIC in June 2009 also implemented its  “Forward Looking Supervision” program that re-emphasizes reviewing all  aspects of a bank’s risks during the examination process. The program  focuses on helping ensure that (1) CAMELS ratings reflect consideration  of bank management practices without relying solely on a bank’s financial  condition; (2) examiners review risks associated with concentrations and  wholesale funding sources; (3) appropriate capital is maintained; and (4)  examiners follow up on progress related to MRAs and enforcement  actions.
section_title: Although Most Examinations We Reviewed Followed CRE Guidance, a Few Illustrated How Treatment of CRE Concentrations May Be Inconsistent
paragraphs: Based on our analysis of a nonprobability sample of 55 ROEs, examiners’  findings were generally consistent with policy guidance, with some  exceptions. Examiners made statements in ROEs related to the quality of  banks’ loan workouts that were consistent with the 2009 guidance on CRE  loan workouts. ROEs in our sample that comment broadly on banks’ CRE  loan workouts tend to cite areas for improvement (20 of 27). Examiner  concerns include that the bank management or its board could have better  identified, monitored, or tracked problem loan workouts, and therefore  better identified loans that should have been reported as TDRs.  Improvements to managing loan workouts that examiners cited include (1)  reporting on current loan status and related developments (such as  periodic analysis of the borrower’s financial situation); (2) creating and  tracking benchmarks to measure workout progress; (3) providing the  rationale for loan grades related to loan workouts; and (4) updating  collateral values (as appropriate). Almost half of the ROEs in our sample  that raise concerns related to CRE loan workouts (8 of 20) specifically  note concerns about the nature of banks’ loan workouts. For example, in  these cases, examiners most often stated that loans were restructured and  extended on unsustainable terms that either resulted in further asset  quality deterioration, did not adequately assess the borrower’s ability to  repay, or did not follow the 2009 CRE loan workout guidance.
In our sample, most ROEs (44 of 55 sampled) raise concerns about CRE  concentrations and how they are managed. In more than half of those (24  of 44), the concerns are supported by risk-management deficiencies and  explicitly cite the 2006 CRE concentration guidance. Specifically, the  findings include concerns on the bank’s (1) need to update or enhance  internal policies on CRE concentration limits and CRE underwriting  acceptable to the bank; (2) monitoring of CRE concentrations; (3)  management information systems used to track and report various types  of CRE; (4) ability to inform the bank’s board of directors about trends in  CRE concentrations; and (5) the adequacy of stress testing of CRE loans.
However, in 7 instances (of 44), the ROE includes statements that the bank  must reduce its CRE concentrations, but the basis for this requirement  was unclear or appeared inconsistent with the 2006 CRE concentration  guidance. For example:    One ROE states that the bank needed to match its own internal policy on  CRE concentrations to those in the 2006 guidance, and referred to the  concentrations in the guidance as “limits.” Referring to the thresholds in  the 2006 guidance as limits is inconsistent with that guidance.
In two other instances the ROEs state that the bank must reduce its CRE  concentrations—citing them as “excessive” for example—but do not focus  on the bank’s risk-management systems. However, the enforcement  actions for these banks did not require reduced CRE concentrations and  emphasized improvements to risk management. One of these ROEs states  repeatedly that the bank must reduce its CRE concentrations because the  concentrations were too high “in the view of” the regulator. The related  enforcement action did not require reduced CRE concentrations explicitly  but required that the board “refine the concentration risk-management  system” in part by establishing its own limits for certain CRE  concentrations and adhering to them. Differences in message between an  ROE and an enforcement action could be confusing to bank boards and  management as they seek to comply with regulatory requirements for risk  management related to CRE concentrations. Moreover, such confusion  could lead bank officials to misunderstand whether they should focus on  improving their risk-management systems or just reduce their total CRE  concentration numbers.
Another ROE acknowledges that the bank was below the CRE threshold  indicated in the 2006 guidance but states the bank nonetheless should  follow the guidance and assesses in detail the bank’s compliance with it. If  banks are closely assessed on their compliance with the 2006 CRE  guidance, although they have not reached the CRE and ADC thresholds,   bank officials could be unclear on what the trigger is for compliance with  CRE risk-management requirements.
One case in particular provided ambiguous information to the bank about  whether it had the appropriate risk-management systems in place to  manage its CRE concentrations. The ROE requires a bank with a CRE  concentration of about 600 percent of tier 1 capital to address a matter  requiring immediate attention to improve stress testing for its CRE  portfolio. The ROE also states that the bank needed to reduce its CRE  concentrations. However, the ROE states that the bank was in compliance  with the 2006 CRE guidance—which requires robust stress testing for CRE  portfolios when banks reach certain levels of CRE. Requiring a bank to  address a matter requiring immediate attention related to CRE risk  management and noting that the bank must reduce its CRE  concentrations—while also stating that it is complying with the 2006  guidance—could send an unclear message to bank officials about why  they need to reduce CRE concentrations if overall they are complying with  the guidance.
Additionally, we found that out of 47 ROEs that include CRE  concentration information, a number of them did not include CRE  concentration numbers that were calculated according to the 2006 CRE  guidance. For example, some ROEs appear to include owner-occupied  CRE as part of the CRE concentration calculation (14 of 47), although the  2006 CRE guidance specifically excludes this type of CRE. We also found  that 23 of these 47 ROEs include CRE concentrations calculated by using  some combination of tier 1 capital (and sometimes also include a number  simply referred to as a “concentration,” although how it was calculated  was unclear). However, another 24 ROEs specify using either total risk- based capital or equity capital (or also include tier 1 capital), which is  consistent with the 2006 guidance. The effect of calculating these  concentrations differently can be to increase the total CRE concentration  number, which increases the scrutiny placed on the banks’ risk- management systems. Sometimes the difference can be large: one ROE in  our sample that includes both calculations shows a total CRE  concentration of 432 percent when using tier 1 capital and 341 percent  when using total risk-based capital. However, the difference also can be  smaller: one ROE in our sample has a concentration calculated with tier 1  capital at 141 percent; with total risk-based capital it was 133 percent.  While FDIC clarified to its examiners in April 2010 how to calculate CRE  concentrations, other regulators have not done so. Moreover, two of the  FDIC ROEs in our sample that use only tier 1 capital in the calculation  were issued after the April 2010 clarification.
section_title: Regulatory Officials’ Differing Views on the Adequacy of the 2006 CRE Concentration Guidance Could Lead to Inconsistent Treatment of CRE Loans
paragraphs: Senior officials and field examiners have differing views on whether the  2006 CRE guidance is sufficient in addressing CRE concentration risks. We  interviewed about 200 field staff associated with the bank examination  review process at FDIC, the Federal Reserve, and OCC in Atlanta, Boston,  Dallas, and San Francisco. A number of field examiners from all the  agencies stated they did not have the tools to proactively address growing  CRE concentrations when the economy was strong or that some banks  ignored examiners’ concerns on CRE risk management. A number of  examiners also admitted that during strong economic times they could  have been more assertive in asking banks to implement risk-management  changes related to CRE concentrations. When asked whether limits on  CRE concentrations should be considered or whether specific amounts of  capital should be required at certain concentration levels, some examiners  did not think that limits were the answer, but others thought that there  might be some level of concentration that was too high even when  managed well, because a market downturn would expose banks to  significant losses. In addition, some thought that a focus on additional  capital would be sensible given the severe capital shortfalls some banks  with CRE concentrations faced during the financial crisis.
Senior regulatory officials with whom we spoke had differing views on  whether the 2006 guidance was sufficient for examiners to address the  buildup in CRE concentration risks. FDIC senior officials stated that the  current guidance was sufficient for examiners to address risks related to  CRE concentrations and did not think changes were needed. In contrast,  OCC has been reviewing whether particular capital requirements should  be set for banks that have higher CRE concentrations and stated that this  could lead to changes in OCC or interagency guidance. At the Federal  Reserve, senior officials believed that the existing 2006 guidance was  largely sufficient, but noted that efforts to clarify expectations for stress  testing and capital planning were ongoing. The examiners and senior  officials with whom we spoke agreed that determining certain limits on  CRE concentrations, or requiring specific amounts of additional capital for  certain levels of CRE concentrations, would be difficult and require  significant study. Federal Reserve officials also noted that limits or  specific capital requirements would require studies on the potential effect  on credit availability. Examiners exercise significant judgment during  examinations, and different perceptions about the 2006 guidance among  regulators could send mixed signals to examiners—which could affect  how they apply the guidance. In addition, as noted earlier, the regulators’  processes to review and monitor application of examiner guidance and  our review of ROEs identified some inconsistencies. Monitoring and  revising existing controls, such as guidance, is a key component of a  strong internal control system and reflects management’s efforts to  implement findings from quality control processes.
section_title: Multiple Factors Can Affect Banks’ Lending Decisions, Including Regulators’ Actions
subsections: section_title: Capital Requirements Can Affect Lending
paragraphs: Regulators require banks to maintain certain minimum capital  requirements to help ensure the safety and soundness of the banking  system. However, increases in capital requirements can raise the cost of  providing loans, which would lead to higher interest rates for borrowers,  tighter credit terms, or reduced lending. While capital provides an  important cushion against losses for banks, there is a trade-off between  building up this cushion to provide greater protection against unexpected  losses and increasing lending and returns to shareholders. Holding more  capital against each loan means less equity is available to return to  shareholders or back new loans.
Empirical literature generally supports this basic understanding of the  impact of bank capital requirements on lending. For example, researchers  found in one study that bank capital requirements substantially affected  bank loan growth during the last economic downturn. Specifically, in  evaluating bank regulatory agreements in New England, researchers found  that capital requirements significantly affected the lending behavior of  banks. They noted that those banks with “low or no profits and an inability  to obtain new capital at reasonable rates” decreased their assets and  liabilities to meet the higher capital-to-asset ratios required by regulatory  enforcement actions. Using the “capital crunch hypothesis,” the  researchers found that institutions with lower capital ratios had slower  loan growth (or loans shrank more rapidly) to try to satisfy capital  requirements.
section_title: High Concentrations in CRE Can Inhibit Banks’ Ability to Lend, Especially during a Credit Downturn
paragraphs: Banks with capital bases that have been negatively affected by losses in  their CRE portfolios—or those trying to improve their capital ratios or  ALLL to guard against potential losses—may need to reduce lending to  maintain an adequate capital-to-assets ratio on their balance sheets.  Although limited research exists on the impact of CRE loan  concentrations on a bank’s ability to lend, an existing study shows that  high CRE concentrations can limit loan growth during economic  downturns. For example, this study found that banks with high CRE  concentrations before the recent financial crisis made loans to other  sectors of the economy during this crisis at a “significantly slower rate”  than banks that did not have high CRE exposure. In addition, the  researchers found that the higher the bank’s CRE concentration prior to  the crisis, the more its non-CRE lending slowed during the crisis. The  reasons for the contraction of non-CRE lending during the crisis are being  examined. The authors hypothesize that the rise in CRE lending and the  substantially increased delinquencies on these loans “could have inhibited  banks’ willingness or ability to lend to other segments of the economy— particularly when banks’ demand for liquidity and capital was high.” The  authors also cite the possibility that high-CRE banks may have failed at a  greater rate than banks without that level of CRE exposure.
section_title: Limited Research from Past Downturns on the Effect of Examiner Actions on Lending Suggests It Is Minimal
paragraphs: Our assessment of existing studies and interviews with bank officials  found that market factors tend to drive CRE downturns and suggests that  the regulatory effect of examiner actions on such downturns—as  evidenced in studies of the downturn of the 1990s—was minimal. Bankers  we interviewed attributed the CRE downturn to market factors such as  problems in residential real estate that affected the CRE market and the  severity of the broader financial and economic crisis. Although bankers  did not state that regulatory policies were the cause of the CRE downturn,  many noted that examiner actions were exacerbating it and a few stated  banks needed to be given time to work through their troubled assets so  they could continue to lend and support the economy. Other bankers  stated that examiners have been impeding banks’ ability to make new  loans—especially if the bank already had high CRE concentrations. That  said, a few bankers noted that CRE loan demand from creditworthy  borrowers was down significantly, and this was inhibiting loan growth.
There is limited research on the effect of examiner actions on credit  cycles; however, the studies that exist suggest the effects are minimal.  Specifically:  In an analysis of the credit crunch from 1989 to 1992, researchers found  modest support for the hypothesis that increased regulatory “toughness”  occurred and that this affected bank lending. In a comprehensive study  spanning the last financial crisis, three hypotheses were tested regarding  changes in regulatory toughness and its impact on bank lending. The data  provided what the authors call modest support for all three hypotheses  that: (1) toughness increased during the credit crunch from 1989 through  1992, (2) it declined during the boom from 1993 through 1998, and (3)  differences in toughness affected bank lending. During the credit crunch  they studied, the data show no more than 1 percent additional loans  receiving classification or worsening of classification status. During the  boom, the data show a similar change for a decrease in loan  classifications. The authors also reviewed the economic significance of  changes in regulatory “toughness” and found that growth in the number of  classified assets by 1 percent would be predicted to decrease the ratio of  real estate loans to gross total assets by less than 1 percentage point over  the long term, and frequently this impact was projected to be significantly  less than 1 percentage point. Changes in CAMEL ratings were not found to  have a “consistent” impact on future lending behavior, and when there was  an impact, the data show that it was minimal.
Another article specifically focuses on how changes in CAMEL ratings  affected loan growth from the period that spanned 1985–2004. During the  1985–1993 credit crunch, the authors found some evidence that changes in  CAMEL ratings, both the composite and the components, had a significant  impact on loan growth for commercial and industrial loans but a smaller  effect on consumer loans and real estate loans. However, the authors  found minimal evidence that adjustments in CAMEL ratings, including  both composite and component ratings, had any systematic effect on loan  growth during what they define as an economic recovery period (1994– 2004). The researchers also noted that, based on their research, banks may  respond “asymmetrically” to changes in CAMEL ratings. Specifically,  banks may decrease loan growth when their CAMEL ratings are  downgraded, but they do not necessarily increase it when their CAMEL  ratings are upgraded.
These studies suggest examiners’ actions can affect lending, albeit  minimally. However, the research suggests that regulators were more  stringent during the past credit crunch, even holding financial conditions  constant. Therefore, regulators should be aware of how their actions can  affect broader credit markets, and help ensure that their actions do not  contribute to unnecessary procyclical effects: that is, magnification of  economic or financial fluctuations.
section_title: Regulators Are Aware of the Need to Moderate the Potential Procyclical Effects of Regulation
paragraphs: In the aftermath of the recent financial crisis, regulators in the United  States and abroad have been attempting to address the procyclical effects  of their actions. The procyclical effects of regulation may not adequately  discourage overly risky behavior during economic upswings or may inhibit  bank lending during downturns, as banks may need to meet more stringent  requirements during times when it is more difficult to do so. For instance,  if regulators increase capital requirements at the same time that losses  from an economic downturn decrease banks’ capital, banks may be less  able to lend while they seek to rapidly raise additional capital. This can  exacerbate downswings in credit cycles.
Consistent and balanced application of policy guidance in strong and weak  economic times is important to avoiding unnecessary procyclical effects.  Regulatory efforts to better ensure that guidance is applied consistently  during strong and weak economic periods helps to ensure that regulatory  policies do not exacerbate economic upturns or downturns. While  bankers with whom we spoke understood why examiners were looking  more closely at CRE loans given the market’s downturn, a few said the  shift to closer review and attention was a difficult adjustment. Bank  examiners with whom we spoke in the field offices also noted that  problems can be difficult to identify during strong economic times.
Discussions about the procyclicality of regulation have been a central  feature of recent deliberations on revised capital requirements among U.S.  banking regulators and the Basel Committee for Banking Supervision. The  discussions have been seeking to address the procyclical effects of capital  requirements by having banks raise additional capital, commensurate with  risks, during times of economic growth. In December 2010, the Basel  Committee released the framework for Basel III, which includes increased  and higher-quality capital requirements, enhanced risk coverage, the  establishment of a leverage ratio as a “backstop” to the risk-based  requirement, steps to encourage the “build up” of capital that can be used  to absorb losses during “periods of stress,” and the introduction of two  global liquidity standards. As part of the establishment of procedures to  help ensure the consistent global application of this framework, the Basel  Committee has developed standards that will be implemented gradually so  that banks make the shift to higher capital and liquidity standards while  “supporting lending to the economy.”
Federal bank regulators also have acknowledged the importance of  addressing procyclicality in regulatory requirements and have made efforts  in this regard. For example, the Chairman of the Federal Reserve has  stated the importance of regulators acknowledging the significance of  procyclicality and he has noted that both the Basel Committee and the  Financial Stability Forum have worked to address this as it relates to  capital requirements. In addition, FASB has issued accounting guidance  aimed at changes to mark-to-market accounting for assessing asset values  in inactive markets. More recently, in May 2010, FASB released a proposed  Accounting Standards Update, which encompassed proposals on the  impairment of financial assets and suggested implementing a more  forward-looking impairment model. Based on exposure draft comments,  in January 2011 FASB proposed with the International Accounting  Standards Board a common solution on how to account for the  impairment of financial assets and presented the document for public  comment. Efforts such as these seek to address procyclicality concerns  related to capital and accounting requirements, while the potential  procyclical effects of examiners’ application of policy guidance is  something regulators consider in their supervision of banks, according to  regulatory officials with whom we spoke. The recent financial crisis  underscored how important it is for regulators to evenly apply guidance  during strong economic periods, although this was not always the case, as  previously noted. Consistent application of guidance is important to avoid  unduly hampering credit provision throughout the economy.
section_title: Conclusions
paragraphs: CRE still is working through a downturn sparked by the broader financial  crisis, presenting an ongoing challenge to community banks and  regulators. While community banks have been working through the  challenges associated with many years of past growth in CRE  concentrations, CRE portfolios continue to have a significant effect on  community bank balance sheets as loan delinquencies and charge-offs  remain historically high. Community banks continue to seek ways to work  with their borrowers and shore up capital to remain solvent, but the  current economic environment and the expectation that refinancing of  CRE loans will bring a new round of market stress suggest many  community banks may face these challenges for some time. And, because  community banks tend to provide a greater proportion of their loans to  small businesses, the availability of credit to small businesses could be  constrained while community banks work through these difficulties.
Prior to the financial crisis, regulators’ efforts included guidance on CRE  concentrations and risk management, but these efforts were not as robust  as they could have been in addressing CRE risks. Since the financial crisis,  the shift in examination focus and differences in the application of the  CRE concentration guidance has contributed to concerns among  community banks about regulatory stringency. That is, a number of  bankers remain concerned that regulators have become more stringent in  reviewing CRE loans since the crisis, which could be explained partly by  regulators re-emphasizing fundamentals and addressing lessons learned  from the crisis. While we and the regulators have reviewed examiner  application of the CRE guidance and generally found examiners’ actions  were accurate or well-supported, some inaccuracies and inconsistencies  were evident—particularly relating to the 2006 guidance. Regulators have  mixed views about the adequacy of the 2006 guidance. Our findings from  an analysis of ROEs were similar to those of the regulators’ internal  reviews and assessments, which raised questions about the consistency of  policy guidance application. Given these findings, and in light of lessons  learned from the recent financial crisis and CRE market downturn, the  regulators could reassess the adequacy of the guidance. Revising or  supplementing the guidance to provide more details about risk- management practices and examples of when to reduce CRE  concentrations would help both examiners and bankers better understand  how to assess and manage such concentrations. Furthermore,  incorporating CRE-specific analyses into the scope of internal and quality  assurance reviews—at least while CRE issues remain a concern—will help  ensure consistent application of the guidance and produce clearly  articulated support in examination reports for requiring reduced  concentrations. In this way, regulatory management can better ensure that  examination practices related to CRE concentrations and risks will be  carried out consistently from examiner to examiner and across regulators.  Consistent treatment also will make clear to banks what regulatory  expectations are for managing CRE concentration risks.
Given the key role community banks play in business lending, bank  regulators are aware of the potential effects of their actions in  exacerbating the credit cycle. Many factors can affect a bank’s decision to  lend, including regulatory requirements. But if such requirements are too  stringent, they can unduly limit lending. Such limits on lending can have  widespread effects on the economy, as acknowledged in Basel Committee  for Banking Supervision discussions on capital requirements. Although  isolating the impact of bank supervision is difficult, the recent severe cycle  of credit upswings followed by the downturn serves as a useful reminder  of the supervisory balance needed to help ensure the safety and soundness  of the banking system and support economic recovery.
section_title: Recommendations for Executive Action
paragraphs: To improve supervision of CRE-related risks, we recommend that the  Chairman of the Federal Deposit Insurance Corporation, the Chairman of  the Board of Governors of the Federal Reserve System, and the  Comptroller of the Currency:    Enhance and either re-issue or supplement interagency CRE concentration  guidance—based on agreed-upon standards by FDIC, the Federal Reserve,  and OCC—to provide greater clarity and more examples to help banks  comply with CRE concentration and risk-management requirements and  help examiners ensure consistency in their application of the guidance,  especially related to reductions in CRE concentrations and calculation of  CRE concentrations.
After issuing revised or supplemental CRE concentration guidance,  incorporate steps in existing review and quality assurance processes, as  appropriate, to better ensure that the revised guidance is implemented  consistently and that examiners clearly indicate within bank examination  reports the basis for requiring a bank to reduce CRE loan concentrations.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to FDIC, the Federal Reserve, and OCC  for review and comment. All of the agencies provided written comments  that we have reprinted in appendixes III, IV, and V, respectively. The  agencies also provided technical comments, which we considered and  have incorporated as appropriate.
In written comments, the Federal Reserve welcomed our  recommendations to improve CRE concentrations guidance to help banks  and examiners comply with it, and to ensure consistent implementation of  such guidance. The Federal Reserve stated that it intends to work with its  counterparts at the OCC and FDIC to develop and implement  enhancements to CRE concentrations guidance.
In its written comments, the OCC agreed with our conclusions and  recommendations. OCC noted that community banks’ increased CRE  concentrations exposes them to CRE market declines, which may require  more explicit regulatory expectations for the robustness of risk- management systems, stress testing, capital planning, and capital levels  when CRE concentrations increase. OCC also stated that it would discuss  with the other federal banking regulators how to enhance the 2006 CRE  concentrations guidance and would ensure the consistent implementation  of any revised or supplemented guidance.
In written comments, FDIC stated that it has already supplemented the  2006 CRE concentrations and risk-management guidance—citing a 2008  Financial Institution Letter, divisionwide training, and internal reviews. As  noted in our report, the federal banking regulators all have numerous  controls to help ensure examination consistency, such as training and  internal reviews that FDIC highlights in its letter. Nonetheless, our review  of ROEs from all three regulators, and their own internal reviews,  uncovered instances of inconsistency in the treatment of CRE loans and  application of the 2006 CRE guidance—demonstrating that no regulator  was immune from consistency issues. We also noted in our report some  concerns raised by bank examiners and bankers about applying the 2006  guidance, such as whether the current CRE concentration thresholds are  hard limits, how the CRE concentrations should be calculated, and  whether specific amounts of additional capital should be required for  banks with elevated CRE concentrations. Though FDIC provided  clarification on CRE risk management in March 2008 that could contribute  to interagency action on CRE guidance, this guidance does not address all  of the concerns raised more recently by examiners and bankers that we  describe in the report, nor was it developed in conjunction with the other  regulators. Therefore, we continue to believe that our recommendations  on enhanced or clarified CRE concentration guidance—on an interagency  basis that involves the FDIC—would help bankers and examiners better  understand how to comply with CRE risk management requirements and  help ensure the consistent application of such requirements.
FDIC also cited a study by the Bank for International Settlements that  concluded the social benefits of higher bank capital requirements  outweigh the large reductions in economic activity from a banking  collapse. As our report notes, additional capital provides an important  cushion against losses, though this comes at a cost. From our review of  the literature, there is disagreement on the magnitude of such costs on  lending. We added information to the report to clarify this issue, which  includes information on the study cited by FDIC.
We are sending copies of this report to FDIC, the Federal Reserve, OCC,  and other interested parties. The report also is available at no charge on  the GAO Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact A.  Nicole Clowers at (202) 512-8678 or clowersa@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix VI.
section_title: Appendix I: Scope and Methodology
paragraphs: To assess the condition of the commercial real estate (CRE) market and  the implications for community banks, we collected and analyzed the  following data to provide information on overall trends in CRE:    To determine trends in CRE prices, we analyzed monthly data from  Moody’s/REAL Commercial Property Price Index from January 2002  through December 2010. We assessed their reliability for the purposes of  providing a picture of the trends in CRE prices by reviewing  documentation on how the data were collected and reviewed for accuracy.  We determined that the data were sufficiently reliable for the purpose of  determining price trends.
To determine when CRE loans would be up for refinancing and what  percentage of CRE loans were “underwater,” we analyzed data on CRE  loan volume by maturity schedule and underlying collateral value provided  by Trepp, a commercial mortgage analysis firm. To determine the accuracy  of these data, we discussed the data with officials and reviewed  documentation on their data quality processes. We determined that the  data was sufficiently reliable for purposes of determining when CRE loans  were maturing and how many were underwater.
To understand how the condition of the CRE market has affected  community banks, we analyzed call report data from the Federal Deposit  Insurance Corporation (FDIC) for banks with assets of less than $1 billion  to assess (1) CRE loan concentrations as a percent of total loans and  leases, (2) trends in CRE loan concentrations as a percent of total risk- based capital, (3) trends in CRE loans that were noncurrent, and (4) trends  in CRE loans charged off. We assessed changes in the rate of noncurrent  CRE loans and CRE loan charge-offs over time. We also calculated average  CRE concentration rates at community banks from 1996 through 2010 by  taking the aggregate reported total of loans secured by CRE (the sum of  construction and development, nonfarm nonresidential, and multifamily  residential real estate) divided by the reported amount of total risk-based  capital. We conducted similar analyses for commercial banks with assets  more than $1 billion. We assessed the reliability of the call report data by  reviewing the controls in place to help ensure its accuracy and by relying  on past GAO reviews of these data. We determined that they were  sufficiently reliable for the purpose of determining trends in CRE loan  concentrations and performance at community banks.
Reports by the inspectors general of the federal banking regulators  provided additional information on the effect of the CRE market downturn  on community banks. We reviewed all 106 of the material loss reviews  (MLR) issued by the offices of the inspectors general of the Board of  Governors of the Federal Reserve System (Federal Reserve), FDIC, and  U.S. Department of the Treasury (for the Office of the Comptroller of the  Currency, or OCC) from 2009 and 2010. In reviewing the MLRs, we noted  which ones cited concentrations in either overall CRE or acquisition,  development, and construction loans (ADC) as a factor in the bank’s  failure. We also interviewed officials at the Conference of State Bank  Regulators on the findings of their independent review of the MLRs.
Additional reports provided background and information on the overall  condition of CRE markets and their impact on community banks. The  reports we reviewed were culled from research and literature reviews  from academic journals, the Congressional Research Service, the  Congressional Oversight Panel, FDIC, the Federal Reserve, and previous  GAO reports. We also spoke with and reviewed speeches and public  comments from officials at FDIC, the Federal Reserve, and OCC; bank  officials; and academics and a think tank official with expertise on bank  examinations or CRE.
To determine how the banking regulators responded to trends in the CRE  market, we interviewed regulatory and bank officials and reviewed reports  of examination (ROE) from a sample of banks. Our sample selection for  bank interviews and reviews of ROEs started with a data request to FDIC,  the Federal Reserve, and OCC on bank examinations for banks with assets  of less than $1 billion with data elements that included the value of their  CRE loans, recent CAMELS ratings, total risk-based capital, recent  enforcement actions, and other information. We determined that the data  were sufficiently reliable for the purposes of selecting a sample, based on  prior use of these data and interviews with agency officials. We further  refined the sample so that we would have a breadth of banks for  interviews and ROE reviews, based on the state in which they were  located, their CAMELS composite rating, and their regulator. We also  wanted to increase the likelihood that banks we sampled were relevant to  our study; therefore, we selected banks with elevated CRE and ADC  concentrations and those that had a recent bank examination. To achieve  these goals, we selected the sample as follows.
From the bank examination information we received from the regulators,  we selected banks from California, Georgia, Massachusetts, and Texas. We  selected these states because the banks in the first two states have had a  relatively greater share of CRE-related nonperforming loans, and the latter  two states a relatively smaller share of such loans (as measured by the  percentage of CRE loans past due or in nonaccrual). We also wanted to  include states from different regions of the country. To inform the  selection, we conducted an analysis of call report data downloaded from  SNL Financial and held discussions with the federal banking regulators.  We analyzed the following data points for commercial banks with assets of  less than or equal to $1 billion: (1) loans and leases for construction and  land development, multifamily, owner-occupied real estate, other  property, and nonfarm nonresidential; (2) loans 90 days past due for each  of these categories; and (3) loans in nonaccrual status for each of these  categories. We reviewed these commercial banks in each of the 50 states  in relation to these measures and total assets in CRE loan categories, and  arrived at our four states. We reviewed SNL data reliability and  determined that it was sufficient for the purposes of selecting states for  our sample.
We further refined the sample to include only banks that had an  examination conducted after October 2009, to capture those examinations  for which the 2009 CRE loan workout guidance would have applied.
From that subset, we placed banks into four “pools,” with the goal of  speaking with officials from, and reviewing ROEs for, a breadth of  community banks from a range of states in our sample, from all three of  the banking regulators, and with a range of CAMELS ratings.
Pool 1 consisted of banks with good CAMELS composite ratings and  high CRE concentrations. In this group, we included banks with a  CAMELS composite rating of 1 or 2 and a CRE concentration above 300  percent of CRE loans (including owner-occupied) to total capital. By  including owner-occupied loans, we would ensure the largest possible  pool of banks and also identify concerns that such banks might have  about regulatory treatment of their CRE loans.
Pool 2 consisted of banks that generally were in good condition but  also had ADC concentrations. Pool 2 criteria were a CAMELS  composite rating of 2 and both a 300 percent or greater concentration  in overall CRE and a 100 percent or greater concentration in ADC loans  to total capital.
Pool 3 banks were intended to represent banks that were struggling  and that had a higher number of loans classified as loss at the most  recent examination. These had a CAMELS composite rating of 3, an  overall CRE concentration of 300 percent or greater, and a proportion  of loans classified loss to total assets in the 75th percentile and above,  for banks within our sample. This “loss ratio” was calculated by taking  the total assets classified loss for the most recent examination and  dividing them by total assets.
Pool 4 was the most distressed pool of banks and consisted of banks  with CAMELS composite ratings of 4 or 5, a 300 percent or greater  concentration in overall CRE in the 75th percentile or greater for the  banks in our sample, and a loss ratio in the 75th percentile of our  sample, calculated as described above.
Once we selected these pools, we began contacting banks to interview. We  simultaneously began requesting ROEs and some related workpapers from  the federal banking regulators. In that process, we learned that FDIC and  Federal Reserve data included ROEs led by the state banking regulator  (because they share examination responsibilities with state examiners),  and we excluded these from our sample.
The resulting sample from this process is outlined below, broken down by  regulator (table 5), state (table 6), and CAMELS ratings (table 7). OCC- supervised banks represent the greatest number of banks in our sample, in  part because a number of the examinations in our sample for the Federal  Reserve and FDIC were led by the state regulator and were out of the  scope of our review. To avoid overweighting the sample with OCC- supervised banks, we randomly removed some OCC-led bank  examinations for which we had a sufficient number of cases: banks rated 2  in Texas.
To further understand how FDIC, the Federal Reserve, and OCC have  responded to the CRE downturn and its effect on community banks, we  collected and analyzed interagency policy guidance to examiners related  to CRE loan treatment and interagency statements on lending, and also  assessed regulatory efforts to address CRE-related concerns. As part of  this work, we observed examiner training at FFIEC provided to  commissioned examiners, to include a week-long training on CRE and a  day-long training on regulatory updates related to policy guidance on CRE  loans.
To understand banks’ concerns about examiners’ treatment of their CRE  loans and how examiners supported findings related to CRE loans, we  interviewed bank and regulatory officials and analyzed ROEs.
We spoke with community bank officials affiliated with 43 community  banks in a number of states (see table 8). Most of the bank officials with  whom we spoke were located in California, Georgia, and Texas based on  our nonprobability sample. We initiated contact with 62 banks drawn from  this sample and interviewed all of the 21 bank officials who responded to  us. We gained additional bank views by supplementing this sample.  Specifically, we interviewed officials from 22 additional banks that either  testified before Congress on the issue of CRE, were identified to us  through bank associations, or had learned of our work and wanted to talk  to us. When we summarize statements from our interviews with bank  officials throughout this report, we use the term “a few” to refer to 3–10 of  43 banks making the statement; “some” to refer to 11–25 of 43 banks  making the statement; and “many” to refer to 26–43 banks making a  statement. We do not provide specific numbers in the body of the report to  avoid overstating the precision of the results from the nonprobability  sample we used to select bank interviewees.
We interviewed more than 230 regulatory field staff at FDIC, throughout  the Federal Reserve System, and at OCC—along with additional staff at  these regulators’ headquarters—to seek views and information about  recent practices on CRE-specific guidance related to loan workouts and  concentrations, training provided on the guidance, CAMELS ratings,  capital requirements, and liquidity issues. The interviews were conducted  at headquarters offices in Washington, D.C., and by telephone, video  teleconference, and in person at district, regional, and field offices in  California, Colorado, Georgia, Massachusetts, and Texas. We sought to  determine if there were different views or practices related to CRE loan  treatment among regulatory roles or between those in headquarters and  the field offices, and therefore we interviewed staff in a range of roles and  locations. The staff with whom we spoke in field locations included field  examiners, their supervisors, case managers, analysts (at OCC), and senior  management. Examiners were interviewed both in group settings and  individually, and included those who served as examiners-in-charge (EIC)  for ROEs in our sample. Examiners interviewed in group settings were  gathered by the field offices, and based on our request, had a range of  experience (either less than 5 years or more than 5 years, because  examiners are usually commissioned within 5 years). Individual meetings  with EICs were held based on our nonprobability sample. Of the field staff  we interviewed, about 200 were directly involved in drafting or reviewing  ROEs, and about 50 of the 200 were in senior management positions.
We analyzed 55 ROEs based on our nonprobability sample, as described  above, of banks in California, Georgia, Massachusetts, and Texas. We  reviewed how examiners supported statements related to banks’ CRE loan  workouts, concerns about CRE concentrations, and how examiners  calculated CRE concentrations.
To understand the controls the regulators have in place to help ensure  consistent application of policy guidance, we reviewed the examination  report review process at all of the regulators based on regulatory guidance  and interviews with regulatory officials. We also collected, compared, and  analyzed examination review reports and quality assurance processes for  the three regulators to determine what processes were in place to identify  and address inconsistencies among examiners, and what findings had  resulted from these reviews. For FDIC, we reviewed reports conducted by  FDIC’s Internal Control and Review Section for the Atlanta, Dallas, New  York, and San Francisco regions, because these regions covered the states  in our nonprobability sample. For OCC, we reviewed reports from all four  of its districts related to the agency’s quality assurance process that  focused on reviewing the classifications of CRE loans. For the Federal  Reserve, we reviewed a special engagement report from the General  Auditor at the Federal Reserve Bank of Atlanta and a Quality Assurance  memorandum for the Atlanta, Kansas City, Philadelphia, and Richmond  districts. We also discussed with Federal Reserve staff whether other  similar studies existed.
To determine and assess the factors that can affect banks’ lending  decisions and their impact, we reviewed and summarized academic  studies that included analysis of various factors on bank lending. With  assistance from a research librarian, we conducted searches of research  databases and report sources (Congressional Research Service,  Congressional Budget Office, JSTOR, ProQuest, EconLit, Accounting and  Tax Database, and Social Science Search). We also sought and reviewed  studies cited by the American Bankers Association (ABA) and the  Independent Community Bankers of America (ICBA). All studies included  published papers released between 1991 and 2010. Based on our selection  criteria, we determined that six studies were sufficient for our purposes.  Specifically, with the assistance of a senior economist, we analyzed the  methodologies underlying these studies and determined that they were the  most relevant to our study and also had robust controls. Nonetheless, the  research conducted in this area is not exhaustive and focuses primarily on  what occurred during the previous economic downturn of the late 1980s  and early 1990s. However, we did identify one study that examines the role  of CRE and its effect on bank lending in the current financial crisis. To  further demonstrate how loan losses, allowance for loan and lease losses,  and capital requirements can affect lending, we developed an illustrative  example of how loan losses affect capital ratios on a bank’s balance sheet,  with assistance from certified public accountants. To obtain information  on how examiner practices may affect lending, we interviewed bankers,  examiners, and regulatory officials. We also interviewed officials from  ABA, the Conference of State Bank Supervisors, and ICBA.
section_title: Appendix II: ALLL and Loan Loss Impact on Capital
paragraphs: Increases in capital requirements or the allowance for loan and lease loss  (ALLL) can affect a bank’s ability to lend. Figure 6 illustrates relationships  between loan losses, bank balance sheets, and capital requirements under  certain assumptions. In this simplified example, the bank begins with  $1,000 in assets ($1,010 in loans and $10 in ALLL), $900 in liabilities, and  $100 in capital, which equates to a total capital ratio of 10 percent  (calculated by dividing total capital by total assets). In this example the  bank has analyzed the collectibility of its loans and decided to add $20 to  its ALLL in anticipation of loan losses. Provisions for these losses increase  the ALLL, which in turn are charged to the bank’s expenses, reduce  income, and therefore reduce retained earnings that are included as part  of total capital. As a result, the capital ratio falls to 8.2 percent. If the bank  identifies as uncollectible and charges off a $20 loan that it holds as an  asset, given the assumptions in the example, the bank’s total loans and  ALLL would each decline by $20 with no change in capital. If the bank  conducts another analysis of its loan collectibility and decides to add to its  ALLL, then its capital would be further reduced.
For this example, if the bank decides to—or is required to—meet a 10  percent capital ratio after adding to its ALLL to cover estimated future  losses, it would need to raise capital by seeking it from the bank’s owners  or from investors. If the bank cannot raise additional capital because it is  in poor financial condition, or chooses not to because the cost of capital is  prohibitive, then it could, among other options, reduce its assets (perhaps  by selling assets such as other real estate owned) to decrease liabilities or  by paying off borrowings to increase the capital ratio. Reducing assets is  often referred to as “shrinking the balance sheet.” However, banks in  better financial condition may be able to respond differently in the face of  loan losses—they may be able to continue lending without raising  additional capital or can rely on their stronger financial position to secure  new capital.
section_title: Appendix III: Comments from the Federal Deposit Insurance Corporation
section_title: Appendix IV: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix V: Comments from the Office of the Comptroller of the Currency
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: Kay Kuhlman, Assistant Director, and Robert Lee, Analyst-in-Charge,  managed this review. Emily Biskup and Jason Wildhagen also led portions  of the research and made significant contributions throughout the report.
Anna Maria Ortiz and Rudy Chatlos provided methodological assistance  related to our nonprobability sample. Michael Hoffman provided  assistance reviewing the methodologies of our research studies and  assistance on capital-related issues. JoAnna Berry provided assistance in  identifying relevant research literature. Bill Cordrey, Jay Thomas, and  Gary Chupka provided accounting assistance. Paul Thompson provided  legal assistance. Marc Molino developed the report’s graphics. Barbara  Roesmann provided editorial assistance. Jan Bauer, Kimberly Cutright,  Andrea Dawson, Nathan Gottfried, Elizabeth Jimenez, Angela Messenger,  Lauren Nunnally, Michael Pahr, Ellen Ramachandran, Maria Soriano,  Winnie Tsen, Gavin Ugale, and Carrie Watkins held various roles in  verifying our findings.