Banking Regulators Propose CRE Loan Policy Update, Signal Concerns for Upcoming Business Cycle

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  • Updated statement signals concern from agencies about the impact of slowing economy on CRE lenders and borrowers.
  • Proposed statement affirms that lenders will not be criticized for implementing certain CRE loan workouts and accommodations.
  • Agencies will not adversely classify modified loans that meet certain terms on the grounds of the underlying collateral losing value to less than the loan balance.
  • Before entering into workout agreements, financial institutions should demonstrate prudent risk management and decision-making practices when evaluating a borrower’s ability and willingness to repay.

On August 2, 2022, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA) issued a notice and request for comment on a proposed interagency policy statement on commercial real estate (CRE) loan accommodations and workouts. This proposed statement would expand “Policy Statement on Prudent CRE Loan Accommodations and Workouts” issued in 2009.

According to the FDIC, 98 percent of banks engage in CRE lending, and CRE loans are the largest loan portfolio type for nearly half of all banks. The COVID-19 pandemic placed a strain across a variety of CRE property types, including offices, hospitality, retail and entertainment. As CRE borrowers recover from pandemic-induced cash flow issues, current rising interest rates and inflationary pressures will further stress borrowers. The proposed statement emphasized that “[p]rudent CRE loan accommodations and workouts are often in the best interest of both the financial institution and the borrower.”

Highlights from the Proposed Statement   

The proposed statement applies to federally insured financial institutions engaged in CRE lending. The statement reaffirms two key principles from regulators’ 2009 statement:

  1. Financial institutions that implement prudent CRE loan accommodation and workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts, even if these arrangements result in modified loans that have weaknesses that result in adverse credit classification; and
  2. Modified loans to borrowers who have the ability to repay their debts according to reasonable terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.

For financial institutions which enter loan accommodations or workout agreements with borrowers, the proposed statement emphasizes the importance of a financial institution’s risk management practices regarding these agreements and prudent analysis of a borrower’s ability and willingness to repay.

The proposed statement includes criteria that an agency examiner will use to evaluate whether a bank appropriately handled CRE loan workout risk management. These factors include the borrower’s character and overall financial condition, the nature and degree of protection provided by the cash flow from business operations, and market conditions that may influence repayment prospects.

Key Updates to the 2009 Statement

The proposed statement includes three main changes to the 2009 statement on CRE loans: (1) A new section on short-term loan accommodations; (2) information about changes in accounting principles since 2009; and (3) revisions and additions to examples of CRE loan workouts.

Short-Term Loan Accommodations

Unlike the 2009 statement, the proposed statement encourages financial institutions working with borrowers undergoing financial stress to enter loan accommodations which are “generally short-term or temporary in nature but occur before a loan reaches a workout scenario.” The proposed statement did not include examples of short-term loan accommodations.

Changes in Accounting Standards  

The proposed statement would alter regulatory reporting and accounting considerations to include current expected credit loss references, as required by post-2009 GAAP. It would reflect current troubled debt restricting (TDR) accounting standards for financial institutions, with the plan to eliminate the TDR determination by the end of 2023, in accordance with Financial Accounting Standards Board (FASB) standards.

Historically, TDRs have been subject to more stringent accounting requirements than other restructurings – specifically, any incremental expected loss must be reported upon modification in the allowance for credit losses on the lenders financial statements which often can only be done through a discounted cash flow model. However, in February 2022, the FASB released an update to accounting standards in which it recognized that TDR-specific accounting standards are “unnecessarily complex and no longer provide decision-useful information.” This update, which takes effect by year-end 2023, eliminates TDR accounting requirements and only requires a lender to note whether the modification represents a new loan or a continuation of an existing loan.

Revisions and Additions to Examples of Loan Workouts

Appendix 1 of the proposed statement contained examples of loan workout agreements, for cases such as an office building with declining occupancy. While workout revisions can take many forms, the agencies point to restructuring loan terms and granting additional credit to improve the chances of repayment as items that may be included in a workout agreement. They also emphasize that three criteria should be met for a loan workout take place: the loan must be consistent with sound banking and accounting practices, comply with proper laws and regulations, and improve the prospect for repayment.

Considerations for Banks and Borrowers  

The proposed statement demonstrates the agencies’ sensitivity to the unique challenges facing CRE lenders and borrowers in the post-COVID years, and may indicate growing concern about elevated CRE risk in the upcoming business cycle.

If adopted, the proposed statement will increase supervisory flexibility with respect to CRE loans, but only if lenders follow the agencies’ guidance on prudent risk management practices and sound analysis demonstrating ability to repay.

Financial institutions engaged in CRE lending should evaluate whether they have appropriate risk management practices regarding CRE loan workouts. This could entail updating internal controls, policies and procedures, and regulatory reporting and communication practices.

The agencies requested comment on the proposed statement and a set of five questions.[1] Comments are due by October 3, 2022. 

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[1] Question 1: To what extent does the proposed Statement reflect safe and sound practices currently incorporated in a financial institution’s CRE loan accommodation and workout activities? Should the agencies add, modify, or remove any elements, and, if so, which and why?

Question 2: What additional information, if any, should be included to optimize the guidance for managing CRE loan portfolios during all business cycles and why?

Question 3: Some of the principles discussed in the proposed Statement are appropriate for Commercial & Industrial (C&I) lending secured by personal property or other business assets. Should the agencies further address C&I lending more explicitly, and if so, how?

Question 4: What additional loan workout examples or scenarios should the agencies include or discuss? Are there examples in Appendix 1 of the proposed statement that are not needed, and if so, why not? Should any of the examples in the proposed Statement be revised to better reflect current practices, and if so, how?

Question 5: To what extent do the TDR examples continue to be relevant in 2023 given that ASU 2022-02 eliminates the need for a financial institution to identify and account for a new loan modification as a TDR?

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