Assessing Loan Portfolio Risk for Mid-Sized Banks? Look to CRE Concentration Ratios (2024)

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News of the FDIC’s takeover of First Republic and the immediate sale to JPMorgan keeps the question of liquidity at the forefront of discussion in the commercial mortgage-backed securities (CMBS) and commercial real estate (CRE) markets. The recent banking stress as a result of the collapse of Silicon Valley Bank, Signature Bank, and now First Republic, has signaled the potential need for more rules and regulations specifically for mid-sized banks.

There are a few metrics that regulators use to evaluate the risk of potential loss of a bank’s portfolio. However, especially in the current environment of fluctuating asset prices in the commercial real estate sector, one metric that can indicate potential risk of stress is the CRE concentration ratio.

Bank CRE Concentration Ratios

The CRE concentration metric measures the extent to which a bank's loan portfolio consists of commercial and multifamily mortgages as well as construction and land loans. Secondly, a bank’s construction concentration ratio focuses on just the proportion of the loan portfolio focused on financing construction and land loans. These two ratios are calculated against a bank’s Tier 1 and Tier 2 equity. Combined, these tiers make up a bank’s total risk capital, which serves as a cushion for the bank to absorb any unexpected losses.

Recent years have seen increased CRE loan origination volumes from banks, with about 58%, or $498 billion of the $862 billion in loan originations in 2022, coming from bank loan originations. Thus, banks have taken on more of the CRE lending burden and must weather its associated risks, especially in the current environment where prevailing trends from the pandemic as well as heightening fears of recession have been resetting market values for commercial real estate properties.

During recessionary periods and downturns in CRE markets, banks with high levels of CRE concentration may face challenges, as they endure significant losses if borrowers are unable to make their scheduled loan payments. Having a high percentage of underlying collateral in CRE exposes a bank’s loan portfolio to property value fluctuations, which can open the door to potential loan losses. Furthermore, in the event of bank deposit declines, CRE loans can also be a liquidity risk since selling loans to raise cash takes more time and generally costs more than selling Treasury bonds or other securities.

Analysis of CRE Concentration by Bank Size

The guidance levels used by regulators for bank stress testing and that we use for this analysis are a 300% concentration ratio for all CRE loans and a 100% concentration ratio for just construction loans.

If a bank's CRE concentration ratio exceeds 300% or if its construction concentration ratio exceeds 100%, it may be subject to increased regulatory scrutiny from its supervisory authority, such as the Federal Reserve or the FDIC. The bank may be required to take actions to reduce its concentration risk, such as limiting its new commercial real estate lending, increasing its capital levels, or implementing more robust risk management practices.

In extreme cases, a bank may be required to take corrective action, such as divesting its commercial real estate loans or reducing its overall size to ensure that it can operate safely and soundly.

In the below table, we display the number of banks that exceeded at least one of the two concentration ratio thresholds as of 4Q 2022, stratified by bank size as measured by total assets. We have also included the relative percentage for each figure, which is calculated against the total number of banks for each corresponding bank size. Additionally, we flag the banks where both the construction concentration ratio and the CRE construction ratio surpass 100% and 300%, respectively. Having both metrics surpass guidance levels serves as an indicator of a higher degree of CRE lending burden and can signal greater potential pockets of risk.

Out of the almost 4,760 banks in Trepp’s Bank Navigator product, 763 banks have either a CRE or construction loan concentration ratio that exceeds the prescribed thresholds of 300% or 100% respectively. 149 banks have both construction concentration and CRE concentration exceeding guidance thresholds. Looking at the various bank sizes, banks with $1 to $10 billion in total assets saw the greatest percentage of almost 30% of banks with at least one concentration ratio that exceeded the threshold. Furthermore, the bank size of $10 to $50 billion saw the highest percentage of almost 6.5% of banks with both concentration ratios exceeding thresholds.

Looking Ahead for Banks in CRE…

Regional bank shares took a hit the first week of May following the collapse of First Republic, with shares of several big regional banks selling off by double-digit amounts. For example, shares of Los Angeles-based PacWest Bancorp (PACW.O), which owns Pacific Western Bank (PacWest), were down by as much as 70% from the prior month’s closing price before recovering roughly one-third of its losses on May 5th. Volatility remains elevated for PacWest’s shares as the stock has had three days with double-digit price swings in the last five trading days. To put PacWest’s price action in perspective, Valley National Bancorp (VLY.O), another regional bank which owns Passaic, NJ-based Valley National Bank, fell roughly 20% on May 1st after the collapse of First Republic and daily price moves over the following 11 days were +/- 6.4%.

However, although shares were down, PacWest’s press release on May 4th tried to reassure investors that deposit flows have been stable, with insured deposits even higher than previous periods, while also noting that they are “continuously review[ing] strategic options.”

In assessing the concentration levels for PacWest, as of Q1 2023, the bank had a 328% CRE concentration ratio and a 126% construction concentration ratio. Both of these ratios exceed the regulatory guidance levels. Also, as of Q1 2023, Valley National Bank had a CRE concentration ratio of 463%, and a construction concentration of 65%, with the CRE concentration metric sharply exceeding the guidance threshold. These regulatory guidance concentration metrics could prove to be helpful in identifying potential risks when it comes to concerns around CRE exposure of these more mid-sized regional banks.

With the contraction in bank liquidity and lending and an increased radar for bank stress testing from regulators due to the recent turmoil, banks with the highest CRE concentrations could see a pull-back on their lending books to allow their debt to roll off. As a result, participants in the CMBS and CRE markets could be seeing lower CRE origination volumes in the coming months and years.

If you are looking for more CRE lending or banking data, insights, and analytics, request a meeting with a Trepp expert today.

Disclaimer: The information provided is based on information generally available to the public from sources believed to be reliable.

Questions? Please contact us atinfo@trepp.comor call 212-754-1010.