June 19, 2012
Authored by: Jonathan Hightower
Many bankers are spending their evenings attempting to work through the very dense and long Joint Notices of Proposed Rulemakings that together propose new capital standards for financial institutions. Even though the proposed Basel III rules would not become effective until January 1, 2013 and the proposed risk-weighting rules would not become effective until January 1, 2015, bankers need to begin to understand how these rules will affect their capital planning now. While the regulatory agencies are busily assuring bankers that the vast majority of financial institutions would have been in compliance if the proposed rules had been effective on March 31, 2012, the rules, as proposed, will certainly change how many financial institutions approach their capital planning and asset mixes.
One facet of the rule that may impact many community banks and their borrowers is the proposed risk-weighting of certain commercial real estate (CRE) loans. While acquisition, development, and construction (ADC) lending has certainly fallen out of favor with regulators and bankers in recent years, many bank boards realize that a part of their long-term success will be a re-entry into this market. Many lenders are very experienced in underwriting ADC loans and have deep relationships with successful real estate developers. While bank boards are more cautious with respect to ADC and CRE lending concentrations, continuing to engage in lending activities that have provided good returns over the long-term still makes sense.
The Notice of Proposed Rulemaking entitled “Regulatory Capital Rules—Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements” will apply to all banking organizations other than bank holding companies with less than $500 million in total consolidated assets. As a part of the new risk-weighting rules, certain higher risk CRE loans will carry a 150% risk-weighting, as opposed to the standard 100% risk-weighting. Those higher risk loans are proposed to be defined as a credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances:
(1) one- to four-family residential property; or
(2) commercial real estate projects in which:
i. the LTV ratio is less than or equal to the applicable maximum LTV ratio in the agencies’ real estate lending standards (generally 65 to 80%);
ii. the borrower has contributed capital in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and
iii. the borrower contributed the amount of capital required under 2(ii) before the bank advances funds and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project (i.e., when permanent financing is obtained).
The proposed rule defines those ADC loans not meeting the criteria above as High Volatility Commercial Real Estate (HVCRE) loans.
The change in the risk-weighting of such loans will obviously affect the amount of leverage a banking organization is able to employ when it makes HVCRE loans. Under the newly proposed capital standards under Basel III, the “well capitalized” definition will require Tier 1 capital to risk-based assets ratio of 8.0%. In other words, for every dollar of Tier 1 capital it maintains, a bank could lend $12.50 for a typical CRE loan (with a 100% risk-weighting) or $8.33 in a HVCRE loan (with a 150% risk-weighting). Obviously, in order to achieve an equivalent return, a bank would need to price a HVCRE loan 50% higher than a “normal” CRE loan.
Given these onerous standards for HVCRE, we expect financial institutions will continue to shy away from loans that fall into the HVCRE category. Under these standards, banks and developers will no longer be able to rely solely on the equity provided by appraisals. We expect these requirements will limit the ability for thinly capitalized developers to obtain financing, which will, in turn, limit development activity. Because of some of the catastrophic consequences of over-development in some markets, the regulatory authorities are likely quite comfortable with that outcome.
Even though the proposed risk-weighting rules, if adopted, would not be effective until 2015, financial institutions need to keep the restrictions in mind as they move forward. Even though most banks would not make a HVCRE loan today, history tells us that many banks would be inclined to re-enter this segment when market conditions improve. Given the impact of the propose risk-weighting rules, that re-entry may never materialize in any substantial fashion.