FAYETTEVILLE,
Ark.
— In response to federal banking regulators’ concern about community banks’
increased participation in commercial real-estate lending, a University
of Arkansas
researcher has developed a system that allows banks to perform stress tests on
their commercial real-estate portfolios.
Tim Yeager, an
associate professor of finance, modeled how large losses within categories of
commercial real-estate loans would affect a bank’s overall losses, earnings and
capital. His spreadsheet-based simulation tracked the effects of significant
losses, or “shocks,” in eight categories, including retail, industry and, most
importantly, construction and land development.
“Nationwide,
commercial real-estate loans at community banks have exploded from 23 percent
of total loans in 1990 to 47 percent in 2005,” said Yeager, who
is also the Arkansas Bankers Association Chair in the Sam M. Walton College of
Business. “It is not surprising, therefore, that bank supervisors have
expressed concern at the growing concentration.”
Yeager
defines community banks as all banks that have less than $5 billion in
inflation-adjusted assets. Officials at various federal regulatory agencies —
Office of the Comptroller of the Currency, the Federal Reserve System and the
Federal Deposit Insurance Corporation — closely monitor lending at all banks to
assess the level of risk associated with loan types, including residential real
estate, consumer loans and commercial loans, in addition to commercial real
estate. Red flags are raised when banks concentrate too much of their lending
in one sector because a downturn in that sector could lead to large bank
losses.
In
2006, regulators representing the above agencies responded to the trend of
community banks’ ever-increasing participation in commercial real-estate
lending by releasing interagency guidance on risk-management practices. The
guidelines stated that banks identified as having significant commercial
real-estate concentration risk should perform portfolio-level stress tests to
quantify the impact of changing economic conditions on assets, earnings and
capital.
To
develop his stress test, Yeager focused on Arkansas’
community banks, many of which, according to criteria established by the
regulatory agencies, would be identified as potentially exposed to commercial
real-estate concentration risk. The researcher first obtained financial data
from banks’ regulatory filings — the so-called “call reports,” which report
commercial real-estate lending in four broad categories: construction and land
development, multifamily, farmland and nonfarm nonresidential.
But
Yeager needed more detailed information, so he designed a survey that
classified commercial real-estate loans into eight categories: apartment,
office, retail, hotel/motel, industrial, mixed, other and construction and land
development. Fifteen Arkansas
community banks form three metropolitan statistical areas —
Fayetteville-Springdale-Rogers, Little Rock/North Little Rock and Jonesboro
— participated in the survey. Yeager used these data and financial information
from two other major databases to create the stress-test model.
Participant
banks had an average of $144.7 million in commercial real-estate loans, of
which 45 percent was in construction and land development. A 20 percent shock —
or rate of loss — to this category relative to the other loan types produced
the largest negative effect due to its dominant proportion of the banks’ loan
portfolios. The 20 percent shock — an extremely rare event, and thus a
worst-case scenario — reduced average capital ratios by 3 percentage points in
the first year. One sample bank’s capital ratio was reduced to 2 percent, which
would prompt regulators to close the bank.
The
capital ratio is a bank’s
equity divided by assets. High capital ratios protect a bank from insolvency
because shareholder equity absorbs the first losses, Yeager said. Currently,
the typical capital ratio for banks is between 7 and 9 percent. A capital ratio
of 2 percent is the threshold that bank regulators use to close a bank.
As a tool for any community bank,
Yeager’s simulation method allows users to “shock” each loan category
separately and provides a five-year forecast of balance-sheet and
income-statement effects. Each category receives an initial shock of 20
percent, and then the model decreases the loss rate over the next three years
until it returns to its pre-shock level in the fifth year. Results of the
simulation estimate the effects of a large and historically remote loss to
banks’ commercial real-estate portfolios.
“To prepare banks and provide the
most useful information, our results are skewed toward a reasonable, worst-case
scenario,” Yeager said.
Prior to his appointment in the Walton College, Yeager was an economist at the Federal
Reserve Bank of St.
Louis.