The Great Recession took a heavy toll on the nation’s banking industry and dramatically reshaped its makeup. A total of 465 banks failed and their assets and deposits redistributed to the country’s remaining 7,176 institutions, fewer than many feared, but still a major and expensive disruption.
It has been well documented that in almost all of the recent bank failures, commercial real estate lending was a major factor in weakening them to the point of collapse.
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Rather than rehash that point, a new federal audit and evaluation took a different view and examined how banks with heavy CRE loan concentrations survived through the recession’s critical years and avoided demise.
The FDIC Office of Inspector General (OIG) completed a study of FDIC-supervised institutions with significant acquisition, development, and construction (ADC) loan concentrations that did not fail during the recent economic downturn.
ADC loans are considered the riskiest type of commercial real estate (CRE) lending. During the recent financial crisis, FDIC analysis shows that failed institutions had concentrations of ADC loans to total assets that were roughly three times the average of concentrations of non-failed institutions.
The objective of the new audit was to identify factors that may have helped banks mitigate the risks historically associated with ADC concentrations during periods of economic stress. The banks the OIG studied had characteristics and ADC loan concentrations similar to those that failed. In general what it found was that the banks that did not fail had a combination of the following six characteristics:
Geographic Location Played a Significant Role in Financial Performance.
For starters, it helped that almost all of them were geographically immune. Most bank officials the OIG interviewed emphasized that the economic decline was not as steep in their marketplace as it was in other areas of the country. Although every region of the country was impacted by the financial crisis to some extent, the economic fallout was not uniform across the country. Bank failures were more concentrated in areas that experienced greater economic distress - including Georgia, Florida, Illinois, and California. Of the banks that survived, the OIG found only one bank that was located in one of the states with the greatest number of failures.
Implemented More Conservative Growth Strategies.
In general, the banks that failed pursued aggressive growth strategies centered in ADC lending, which left those institutions more vulnerable to the economic downturn. While the 436 banks in the OIG study experienced some increasing ADC concentration levels from 2005 through 2007, most of the bankers it spoke with characterized their institution’s risk appetite as being conservative or moderate. Bank officials from one bank explained that the bank was aggressive early but also “got scared” early. In addition bankers stated that once the economy declined, they mitigated the risk associated with their ADC loan concentrations by intentionally reducing their ADC loan portfolio, thus further diversifying their loan portfolio,
Implemented Prudent Risk Management Practices and Limited Speculative Lending, Loan Participations, and Out-of-Area Lending.
Most banks included in the study had stronger loan underwriting practices than failed banks and, consequently, a lower risk profile in general. Generally, bank officials said that speculative loans were originated only on a limited basis before the economic crisis, if at all. Furthermore, in cases where banks did fund speculative ADC loans, bank officials indicated that loans were made to existing borrowers and were tied to strong customer relationships. Most of the banks that survived either did not originate out-of-area loans or did so only on a limited basis to existing customers.
Posted Lower Level of Non-Current Loans and Losses Associated with ADC Loans.
The successful banks in the FDIC study generally experienced a lower level of non-performing loans and losses. For institutions that failed, non-performing ADC loans represented 8% of all nonperforming assets in the first quarter of 2000 and rose to a decade-high of 54% in the third quarter of 2008. For survivor institutions, non-performing ADC loans also rose but not as much - from almost 4% in the first quarter of 2000 to 23% in the third quarter of 2009.
Maintained Stable Capital Levels and Had Access to Additional Capital If Needed.
Of course, capital serves as a buffer between operating losses and insolvency. The more capital a bank has the more losses it can withstand. Losses associated with ADC loans were not as significant for surviving banks compared to the banks that failed. In addition, most bankers commented that their bank’s access to capital was not restricted. If needed, their shareholders or outside investors were willing to invest additional capital.
Relied on Core Deposits and Limited Net Non-Core Funding Dependence.
Examiners have historically categorized core deposits as stable, less-costly deposits obtained from local customers that maintain a relationship with the institution. Brokered deposits are considered potentially volatile, interest-rate-sensitive deposits from customers in search of yield. The FDIC’s research indicates that core deposits may reduce a bank’s probability of failure because they typically provide a bank with a stable and relatively cost-effective source of funds and are a direct indication of a bank’s valuable customer relationships and franchise value.
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