It is only natural for community banks to have loan concentrations that result from the market(s) they serve and the markets they pursue. In today’s times, a high commercial real estate (CRE) concentration is often the result of community banks pursuing opportunity in the market. Consequently, interagency guidance on CRE concentration risk management, released in 2006, helps institutions pursue CRE lending with safety and soundness.
The guidance provides seven sound risk management practices that banks should maintain, including board and management oversight, portfolio management, portfolio stress testing and sensitivity analysis and a credit risk review function, among others. It also set criteria to identify those institutions with significant CRE concentration risk. As noted in the interagency guidance, institutions approaching or exceeding the one or both of the following criteria may be subject to further supervisory analysis:
• Total reported loans for construction, land development, and other land loans represent 100 percent or more of the institution's total risk-based capital.
• Total commercial real estate loans, as defined in the guidance, represent 300 percent or more of the institution's total risk-based capital, and the outstanding balance of the institution's commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 months (or 36-month period).
Despite this guidance, many banks continue to maintain concentrations exceeding the expected levels. A recent article on Banking Exchange by Daniel Rothstein highlighted the continued need for community banks to diversify their portfolios and steps for execution of this task. Rothstein often sees banks diversify by simply adding “buckets” to their portfolios – i.e. additional commercial and industrial (C&I) or consumer loans. But by adding these new categories, is that true diversification?
Rothstein says the main benefit of diversification is more predictable performance overall. “To achieve this, it is important to construct a portfolio with loan asset classes that are not highly correlated.” Adding additional buckets may not help banks weather a future downturn if all buckets suffer an interrelated decline.