Use of supervisory authority to curb risk in banks with commercial real estate lending concentrations: A case study

This paper argues that an observed decline in the share of Federal Reserve regulated banks with high concentrations in commercial real estate (CRE) lending resulted from a regime shift in supervisory emphasis. After plunging subsequent to the Great Recession, the share of banks with high concentrations in CRE lending began to increase in late 2013. However, in 2016, this upward risk trend was broken for banks regulated by the Fed, as the share of Fed regulated banks with high CRE loan concentrations began to fall and has declined ever since. The abatement in the prevalence of high CRE loan concentrations also encompassed positions in relatively risky construction and land development lending. A potential precipitating factor came starting in late 2015, when bank supervisors at the Fed took action designed to improve the resiliency of banks with respect to a potential downturn in CRE markets. The renewed emphasis on CRE concentration risk was motivated largely by perceptions of froth in CRE market valuations. Given that community banks, in terms of balance sheet lending and loan concentrations, have had the greatest exposure to CRE markets, these smaller banks received much of the heightened supervisory attention. We show that starting in early 2016, Fed regulated community banks with high CRE loan concentrations were more likely than before to receive supervisory messages calling for improved management of the risks associated with such concentrations (typically implying the need to increase capital relative to CRE lending). An additional finding is that these supervisory messages were influential in curbing bank risk taking in the form of CRE loan concentrations. We argue that the positive lessons from this episode can provide a template for forward-looking supervision more generally.