Regulatory Update: CRE, HVCRE and HVADC
Ardmore Banking Advisors (ABA) regularly monitors new and proposed guidance issued by the bank regulatory agencies, other news and analysis related to the banking industry, and stays in close touch with client banks about what they are hearing from the regulators.
One of the topics we have heard discussed consistently and increasingly by regulators is commercial real estate (CRE). Regulatory issuances and on-site exams have addressed CRE concentrations and the elements of the enhanced risk management framework that regulators expect to be in place if a CRE portfolio is growing rapidly or if it has exceeded the 300% total CRE 100% acquisition, development and construction (ADC) thresholds. Recently clients have reported an even stronger focus by their examiners on banks being expected to maintain strong underwriting discipline and prudent risk management practices in the face of rapidly growing CRE portfolios. We expect that this focus will continue as the economic cycle remains strong.
Earlier this month the regulators issued for comment the proposed guidance aimed at simplifying the capital rules related to higher risk construction/development lending. The following changes are proposed:
- Name change from High Volatility Commercial Real Estate (HVCRE) to High Volatility Acquisition, Development, and Construction (HVADC)
- Reduce the risk weighting for risk based capital analysis on HVADC from 150% to 130%
- Eliminate requirements for minimum cash equity in projects and that the equity must stay in the projects
- Clarify the definition of transactions affected, those exempted from this classification, and what constitutes a “permanent loan”
- HVADC is a credit facility that primarily finances or refinances (note that the terminology “is secured by” is NOT a part of the definition; thus an unsecured loan that passes the purpose test would be classified as an HVADC even without real estate security) as follows:
- The acquisition of vacant or developed land
- The development of land to prepare to erect new structures (including site improvement and demolition of existing structures)
- The construction of buildings or dwellings or other improvements including additions or alterations to existing buildings or dwellings
Loans to finance construction of 1-4 family residential structures, including loans that combine land acquisition, development, and construction, and including lot loans. (Note that 1-4 family homes definition for exclusion from HVADC includes townhouses or row homes, but does not include condominiums or cooperatives (unless they contain less than 5 units))
Facilities financing ADC projects for which the primary purpose is community development as defined by the CRA
Facilities financing the purchase or development of agricultural land
The HVADC designation is not applied to permanent loans, defined as a prudently underwritten loan that has a clearly identified ongoing source of repayment sufficient to service amortizing P&I payments (whether the loan is actually amortizing or not) other than from the sale of the property. Typically an owner occupied construction project would NOT be considered HVADC, provided that the owner has sufficient capacity at origination to repay the loan from ongoing operation
If a loan is structured as construction to perm, once the property is generating sufficient revenue the HVADC treatment can be eliminated
- Note that these changes would only apply to loans originated after the final rule is implemented. Any loans currently considered HVCRE will remain HVCRE and retain their current 150% risk weight.
- Note also that the risk weighting is proposed to be reduced to 130% because the regulators believe that the projects with sufficient equity / low LTV will now be included in HVADC, and thus arguably the overall risk will be lower.
- However, with this inclusion of formerly excluded high equity projects, and as the purpose definition will include other projects that are not specifically secured by the assets being acquired and developed more loans will meet the definition of HVADC.
- While this proposal is thought to simplify the process, the unintended consequences will be a considerable amount of analysis by all banks to determine the specific projects to be included and the risk weighting impact on those assets and risk based capital. It is likely to generate significant discourse from the banking community.
The proposed rulemaking addresses capital-related subjects other than HVCRE as well; the Community Bank Summary from the FDIC website is recommended reading by credit and financial professionals.
If you have any questions on these new regulations, or would like more information on how Ardmore can help your bank address these changes, please contact us today.
Suzanne Storm has been a Senior Consultant for Credit Policy & Risk Management at Ardmore Banking Advisors since 2014. She previously served as Director of Risk Policy for Wachovia, overseeing credit policy, operational risk policy, and corporate risk governance. Following the merger, she was head of Corporate Credit Policy for Wells Fargo and oversaw the integration of lending authorities and credit policy.