Earlier this year, the Federal Reserve released a broad description of criteria for its 2017 “stress test,” which is meant to measure how well the largest U.S. banks would fare in a financial crisis like the one in 2008. This year, the Fed is putting a larger focus on commercial real estate and even banks that aren’t subject to the stress test should take heed.
What are the Fed Stress Tests?
Stress tests are examinations of what would happen if one of the big banks – those with more than $50 billion in assets – ran into trouble. At their core, they are a mathematical projection of what would happen to the bank given certain economic events occurring, such as an increase in unemployment, a drop in the stock market, or a decrease in oil prices. For the examinations, the “students” (banks) are required to submit their tests to the “teacher” (the Fed). Also known as capital plans, the tests are then “graded” a pass or fail by the Fed.
Exposure of Banks that Fail
If they are to succeed at commercial real estate lending, all financial institutions must develop a risk management strategy that includes robust underwriting standards and credit administration practices. Of the 414 banks that failed from January 2008 through December 2011, 85% of them had less than $1 billion in assets, and they were found to have pursued aggressive growth strategies that, when combined with both weak underwriting standards and credit administration practices, led to high commercial real estate concentrations. The result? The banks’ exposure to the sustained economic and real estate downturn that began in 2007 was increased dramatically.
Why Smaller Banks Should Care
In January, the Fed announced it would be reducing the number of lenders who needed to pass the stress test from thirty-three in 2016 to thirteen in 2017. The new rule was intended to remove a significant burden on smaller lenders and put the toughest checks on the biggest banks.
As recent history has shown, however, commercial real estate markets can experience rapid changes. It’s important for any financial institution with commercial real estate loan concentrations to assess the risk posed by the concentration, and to maintain sound risk management practices. Even though the majority of lenders are not subject to the Fed stress tests, they should use them as a useful guide for proper capitalization and loan sector concentrations.
Knowledge is Power
Ultimately, all financial institutions need to stay abreast of current regulations as they apply to commercial real estate lending. A qualified appraisal management company like Oxford can act as an experienced partner to help you sort through and understand the regulations and requirements as they pertain to your commercial lending business. It’s a smart strategic move that helps you minimize risk, reduce losses, and maximize returns on all your commercial real estate transactions.