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. 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. 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.