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United States Government Accountability Office: 
GAO: 

Report to the Ranking Member, Committee on Financial Services, House 
of Representatives: 

May 2011: 

Banking Regulation: 

Enhanced Guidance on Commercial Real Estate Risks Needed: 

GAO-11-489: 

GAO Highlights: 

Highlights of GAO-11-489, a report to the Ranking Member, Committee on 
Financial Services, House of Representatives. 

Why GAO Did This Study: 

Since the onset of the financial crisis in 2008, commercial real 
estate (CRE) loan delinquencies have more than doubled. The federal 
banking regulators have issued statements and guidance encouraging 
banks to continue lending to creditworthy borrowers and explaining how 
banks can work with troubled borrowers. However, some banks have 
stated that examiners’ treatment of CRE loans has hampered their 
ability to lend. This report examines, among other issues, (1) how the 
Federal Deposit Insurance Corporation (FDIC), Board of Governors of 
the Federal Reserve System (Federal Reserve), and the Office of the 
Comptroller of the Currency (OCC) responded to trends in CRE markets 
and the controls they have for helping ensure consistent application 
of guidance and (2) the relationships between bank supervision 
practices and lending. GAO reviewed agency guidance, examination 
review procedures, reports of examination, and relevant literature and 
interviewed agency officials, examiners, bank officials, and academics. 

What GAO Found: 

Aware of the potential risks of growing CRE concentrations at 
community banks, federal banking regulators issued guidance on loan 
concentrations and risk management in 2006 and augmented it with 
guidance and statements on meeting credit needs and conducting CRE 
loan workouts from 2008 to 2010. The regulators also conducted 
training on CRE treatment for examiners and internal reviews to help 
ensure compliance with CRE guidance. Nevertheless, a number of banks 
reported that examiners have been applying guidance more stringently 
since the financial crisis and believe that they have been too harsh 
in treatment of CRE loans. Regulators have incorporated lessons 
learned from the crisis into their supervision approach, which may 
help explain banks’ experiences of increased scrutiny. GAO found that 
examiners generally provided support for exam findings on loan 
workouts, but identified some inconsistencies in applying the 2006 CRE 
concentration guidance-—which is similar to what some of the 
regulators uncovered in their internal reviews. Moreover, regulatory 
officials had varying views on the adequacy of the 2006 guidance, and 
some examiners and bankers noted that the guidance lacked clarity on 
how to comply with it. As a result, examiners and bankers may not have 
a common understanding about CRE concentration risks. 

Figure: Average CRE Concentration among Community Banks and Regulatory 
Guidance: 

[Refer to PDF for image: vertical bar graph] 

Year: 1996; 
CRE Concentration: 149.4%. 

Year: 1997; 
CRE Concentration: 156.7%. 

Year: 1998; 
CRE Concentration: 161.3%. 

Year: 1999; 
CRE Concentration: 180.3%. 

Year: 2000; 
CRE Concentration: 192.8%. 

Year: 2001; 
CRE Concentration: 212.4%. 

Year: 2002; 
CRE Concentration: 228.6%. 

Year: 2003; 
CRE Concentration: 244.5%. 

Year: 2004; 
CRE Concentration: 260.9%. 

Year: 2005; 
CRE Concentration: 278.2%. 

Year: 2006; 
CRE Concentration: 286.8%; 
[Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices: 12/12/2006] 

Year: 2007; 
Owner-occupied properties: 76.9%; 
CRE Concentration: 221.4%; 

Year: 2008; 
Owner-occupied properties: 95.8%; 
CRE Concentration: 210.7%; 
[Statement on Meeting the Needs of Creditworthy Borrowers: 11/12/2008] 

Year: 2009; 
Owner-occupied properties: 96.4%; 
CRE Concentration: 197.2%; 
[Policy Statement on Prudent Commercial Real Estate Loan Workouts: 
10/30/2009] 

Year: 2010; 
Owner-occupied properties: 93.4%; 
CRE Concentration: 175.1%; 
[Statement on Meeting the Credit Needs of Creditworthy Small Business 
Borrowers: 2/5/2001] 

Source: GAO analysis of data from FDIC and regulatory guidance. 

[End of figure] 

Although many factors influence banks’ lending decisions, research 
shows that the capital banks hold is a key factor. Capital provides an 
important cushion against losses, but if a bank needs to increase it, 
the cost of raising capital can raise the cost of providing loans. 
High CRE concentrations also can limit a bank’s ability to lend 
because the bank may need to raise capital to mitigate the 
concentration risk during a downturn. Economic research on the effect 
of regulators’ examination practices on banks’ lending decisions is 
limited, but shows that examiners’ increased scrutiny during credit 
downturns can have a small impact on overall lending. Although 
isolating these impacts is difficult, the recent severe cycle of 
credit upswings followed by the downturn provides a useful reminder of 
the balance needed in bank supervision to help ensure the banking 
system can support economic recovery. 

What GAO Recommends: 

Federal banking regulators should enhance or supplement the 2006 CRE 
concentration guidance and take steps to better ensure that such 
guidance is consistently applied. The Federal Reserve and OCC agreed 
with the recommendations. FDIC said that it had implemented strategies 
to supplement the 2006 guidance. 

View [hyperlink, http://www.gao.gov/products/GAO-11-489] or key 
components. For more information, contact A.Nicole Clowers at (202) 
512-8678 or clowersa@gao.gov. 

[End of section] 

Contents: 

Letter: 

Background: 

Deterioration of the CRE Market Negatively Affected Community Banks, 
Which Could Impact Small Business Lending: 

While Regulators Have Taken Steps to Address CRE Concentrations and 
Bank Concerns, Challenges Remain in Consistently Applying Guidance: 

Multiple Factors Can Affect Banks' Lending Decisions, Including 
Regulators' Actions: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Scope and Methodology: 

Appendix II: ALLL and Loan Loss Impact on Capital: 

Appendix III: Comments from the Federal Deposit Insurance Corporation: 

Appendix IV: Comments from the Board of Governors of the Federal 
Reserve System: 

Appendix V: Comments from the Office of the Comptroller of the 
Currency: 

Appendix VI: GAO Contact and Staff Acknowledgments: 

Tables: 

Table 1: Regulatory Overview Information for FDIC, the Federal 
Reserve, and OCC (as of December 31, 2010): 

Table 2: CAMELS Composite Score Definitions: 

Table 3: Regulatory Loan Classification System: 

Table 4: Key CRE Property Types: 

Table 5: Sample Selection by Regulator for ROE Analysis: 

Table 6: Sample Selection by State for ROE Analysis: 

Table 7: Sample Selection by CAMELS Composite Rating for ROE Analysis: 

Table 8: Locations of Banks Whose Officials We Interviewed: 

Figures: 

Figure 1: Trends in Commercial Property Price Index (from 2002 through 
2010): 

Figure 2: Average CRE Concentrations at Community Banks (from 1996 
through 2010): 

Figure 3: Percent of Noncurrent Loans Secured by CRE at Community 
Banks (from 2000 through 2010): 

Figure 4: Average Charge-off Rate for Loans Secured by CRE at 
Community Banks (from 2000 through 2010): 

Figure 5: The Community Bank Examination Review Process at FDIC, the 
Federal Reserve, and OCC: 

Figure 6: Illustration of How ALLL and Loan Losses Can Affect Capital 
Ratios on a Bank's Balance Sheet: 

Abbreviations: 

ABA: American Bankers Association: 

ADC: acquisition, development, and construction: 

ALLL: allowance for loan and lease loss: 

CAMELS: Capital adequacy, Asset quality, Management, Earnings, 
Liquidity, and Sensitivity: 

CLD: construction and land development: 

CMBS: commercial mortgage-backed securities: 

CRE: commercial real estate: 

EIC: examiner-in-charge: 

FASB: Financial Accounting Standards Board: 

FDIC: Federal Deposit Insurance Corporation: 

Federal Reserve: Board of Governors of the Federal Reserve System: 

FFIEC: Federal Financial Institutions Examination Council: 

ICBA: Independent Community Bankers of America: 

IG: inspector general: 

MLR: material loss reviews: 

MRA: matter requiring attention: 

NCUA: National Credit Union Administration: 

OCC: Office of the Comptroller of the Currency: 

OTS: Office of Thrift Supervision: 

ROE: report of examination: 

TDR: troubled debt restructuring: 

[End of section] 

United States Government Accountability Office: 
Washington, DC 20548: 

May 19, 2011: 

The Honorable Barney Frank: 
Ranking Member: 
Committee on Financial Services: 
House of Representatives: 

Dear Mr. Frank: 

The financial crisis, and the economic downturn that followed it, 
largely arose out of problems related to the residential mortgage 
sector, but the commercial real estate (CRE) market also has 
experienced significant setbacks, that in turn, have affected 
community banks.[Footnote 1] More than a third of community bank 
lending is tied to CRE, and delinquencies for such loans have more 
than doubled since 2008. While segments of the CRE market have shown 
some improvement, problems in CRE lending are expected to continue, 
and refinancing such loans could present further challenges to the 
market in coming years. Banks are addressing these problems in many 
ways, including modifying borrowers' loan terms so that they can 
continue to make payments, increasing bank capital and reserves as 
protection against future losses, and, in some cases, reducing 
lending.[Footnote 2] However, reduced lending to creditworthy 
borrowers can exacerbate credit tightening and inhibit economic 
recovery. 

The federal banking regulators have been monitoring the increasing CRE 
concentrations for a number of years and have responded to the current 
CRE downturn and its impact on the banks they supervise. The 
regulators have issued interagency statements and guidance--most 
recently from 2006 through 2010--on managing the risks of CRE 
concentrations, encouraging banks to continue lending to creditworthy 
borrowers, clarifying to banks how examiners will review loans secured 
by CRE, and explaining how banks can work with troubled borrowers. 
[Footnote 3] Regulators have also noted concerns they have about the 
risk-management systems of banks with high CRE concentrations and have 
"classified" more loans (that is, identified loans that pose a risk of 
loss to banks).[Footnote 4] In doing so, examiners have been 
criticized by some in the banking industry for being too harsh in 
their treatment of CRE loans in banks' portfolios, and some argue that 
this has hampered lending more broadly in communities across the 
country. 

In light of these questions about examiners' treatment of CRE loans, 
you asked us to review whether examiners' practices related to CRE 
were consistent with recent regulatory statements and guidance; 
whether regulatory views on regulators' bank ratings, capital, and 
liquidity have changed; and what the potential impact of regulatory 
practices might be on lending by community banks. This report examines 
(1) the condition of the CRE market and the implications for community 
banks; (2) how three federal banking regulators--the Federal Deposit 
Insurance Corporation (FDIC), Board of Governors of the Federal 
Reserve System (Federal Reserve), and the Office of the Comptroller of 
the Currency (OCC)--responded to trends in CRE markets through their 
supervision of community banks and what controls they have to help 
ensure consistent application of policy guidance; and (3) what is 
known about the relationships between bank supervision practices and 
lending. 

To address our objectives related to the condition of the CRE market 
and its implications for community banks, we analyzed data from 1996 
through 2010 (when available) from Moody's/REAL Commercial Property 
Price Index for CRE values and call report data for CRE loan 
concentrations and performance.[Footnote 5] We reviewed CRE-related 
reports from the Congressional Oversight Panel, Congressional Research 
Service, FDIC, Federal Reserve, and academic journals, and conducted 
interviews with bank examiners, regulatory officials, and community 
bankers. We also examined material loss reviews (MLR) conducted by the 
inspectors general (IG) of the bank regulators and previous GAO 
products. To understand how FDIC, the Federal Reserve, and OCC have 
responded to the CRE downturn, we collected and analyzed regulatory 
guidance related to CRE loan treatment and interagency statements on 
lending, and also assessed regulatory efforts to address CRE-related 
concerns.[Footnote 6] As part of this work, we observed training 
provided by the Federal Financial Institutions Examination Council 
(FFIEC) to examiners related to CRE guidance and loan classifications. 
[Footnote 7] 

To understand bank officials' concerns about examiners' treatment of 
CRE loans, we spoke with officials from 43 community banks and 
analyzed 55 bank reports of examination (ROE). For our bank official 
interviews, we contacted 62 banks and spoke with all 21 that responded 
to us based on a nonprobability sample of banks in California, 
Georgia, Massachusetts, and Texas. We chose those states because banks 
in the first two states have had a relatively greater share of CRE-
related nonperforming loans (as measured by the percentage of CRE 
loans past due or on nonaccrual) and banks in the last two a 
relatively smaller share.[Footnote 8] From these states, we selected 
banks that had a federal bank regulator examination after October 
2009; elevated concentrations in CRE; or elevated concentrations in 
acquisition, development, and construction (ADC) loans.[Footnote 9] 
This sampling approach also was used to select the 55 ROEs for 
analysis. Our sample is not designed to be generalizable to all banks, 
but instead provides information on a range of banks working under 
different supervisors, having different conditions, and operating in 
different economic environments. For our bank official interviews, we 
supplemented the sample by interviewing officials from 22 additional 
banks that testified before Congress on the issue of CRE, were 
identified through bank associations, or requested an interview after 
learning about our work. 

To understand examiners' practices and views on certain regulatory 
measures, especially on the CRE loan workout guidance, we spoke with 
regulatory staff at district, regional, and field offices in 
California, Colorado, Georgia, Massachusetts, and Texas, and in 
headquarters at Washington, D.C. We spoke with more than 230 field 
staff in various roles (either directly involved in drafting and 
reviewing ROEs or participating in oversight of the review process)-- 
both in group settings and individually. While not representative of 
the population of examiners and regulatory staff, our interviews with 
examiners and other regulatory staff provide a broad range of views. 
To understand the controls the regulators have in place to help ensure 
consistent application of policy guidance, we collected, compared, and 
analyzed examination review reports and quality assurance processes 
for the three regulators, and also interviewed officials. To 
understand what is known about the relationships between regulators' 
supervision practices, lending, and CRE values, we conducted a 
literature review dating to 1991 and focusing on comprehensive, 
empirical, published research that reviewed such topics and also 
interviewed academics, regulatory officials, and bank officials. 

We conducted this performance audit from May 2010 through May 2011 in 
accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives.[Footnote 10] 

Background: 

As of December 31, 2010, there were 6,364 community banks (commercial 
banks with total assets of $1 billion or less). This represents about 
92 percent of all commercial banks, although only about 10 percent of 
commercial bank assets nationwide. 

Banks in the United States are supervised by one of the following 
three federal regulators: 

* FDIC supervises all FDIC-insured state-chartered banks that are not 
members of the Federal Reserve System. 

* The Federal Reserve supervises commercial banks that are state- 
chartered and members of the Federal Reserve System. 

* OCC supervises federally chartered national banks. 

Table 1 summarizes the regulators' oversight responsibilities for 
community banks. 

Table 1: Regulatory Overview Information for FDIC, the Federal 
Reserve, and OCC (as of December 31, 2010): 

Regulator: Federal Reserve; 
Bank type supervised: State-chartered member banks of Federal Reserve 
System; 
Number of banks supervised: 829; 
Number of community banks (less than $1 billion total assets) 
supervised: 729; 
Total assets under supervision: $1.697 billion; 
Total assets under supervision at banks with less than $1 billion in 
total assets: $167.2 million. 

Regulator: FDIC; 
Bank type supervised: State nonmember banks; 
savings institutions; 
Number of banks supervised: 4,715; 
Number of community banks (less than $1 billion total assets) 
supervised: 4,414; 
Total assets under supervision: $2.259 billion; 
Total assets under supervision at banks with less than $1 billion in 
total assets: $865.4 million. 

Regulator: OCC; 
Bank type supervised: Federally chartered national banks; 
Number of banks supervised: 1,383; 
Number of community banks (less than $1 billion total assets) 
supervised: 1,221; 
Total assets under supervision: $8.432 billion; 
Total assets under supervision at banks with less than $1 billion in 
total assets: $267.7 million. 

Regulator: Total; 
Number of banks supervised: 6,927; 
Number of community banks (less than $1 billion total assets) 
supervised: 6,364; 
Total assets under supervision: $12.388 billion; 
Total assets under supervision at banks with less than $1 billion in 
total assets: $1.300 billion. 

Source: GAO analysis of FDIC call report data. 

[End of table] 

The purpose of federal banking supervision is to help ensure that 
banks throughout the financial system are operating in a safe and 
sound manner, and are complying with banking laws and regulations in 
the provision of financial services. As we have identified in previous 
work, financial regulation more broadly has sought to achieve four 
goals: to (1) ensure adequate consumer protections, (2) ensure the 
integrity and fairness of markets, (3) monitor the safety and 
soundness of institutions, and (4) act to ensure the stability of the 
overall financial system.[Footnote 11] Federal banking regulators use 
a number of tools to achieve these goals. 

* Capital requirements: Regulators require banks to maintain certain 
minimum capital requirements to help ensure the safety and soundness 
of the banking system, and generally expect banks to hold capital 
above these minimums--commensurate with their risks. Capital provides 
an important cushion against losses for banks, and represents the 
amount of money that can cover losses the bank may face related to 
nonpayment of loans and other losses on assets. Capital can be 
measured as total capital or tier 1 capital.[Footnote 12] Regulators 
oversee the capital adequacy of their regulated institutions through 
ongoing monitoring, including on-site examinations and off-site tools. 
When regulators require banks to hold capital above regulatory 
minimums, these requirements may result from an enforcement action 
through an agreement between the regulator and the bank. However, 
requiring banks to hold more capital may reduce the availability of 
bank credit and reduce returns on equity to shareholders. 

* Examinations and ratings: Federal banking laws and regulatory 
guidance require on-site examinations, which serve to evaluate a 
bank's overall risk exposure and its ability to identify and manage 
those risks--especially as they affect a bank's financial health. At 
each full-scope examination, examiners review the bank's risk exposure 
on a number of components using what is known as the CAMELS rating 
system (Capital adequacy, Asset quality, Management, Earnings, 
Liquidity, and Sensitivity to market risk). Evaluations of CAMELS 
components consider the institution's size and sophistication, the 
nature and complexity of its activities, and its risk profile. In 
examinations, a bank is rated for each of the CAMELS components and 
given a composite rating, which generally bears a close relationship 
to the component ratings. However, the composite is not an average of 
the component ratings. The component rating and the composite ratings 
are scored on a scale of 1 (best) to 5 (worst). Regulatory actions 
typically correspond to the composite CAMELS ratings, with the actions 
generally increasing in severity as the ratings become worse. Table 2 
describes the definitions of the composite scores under the Uniform 
Financial Institutions Rating System.[Footnote 13] 

Table 2: CAMELS Composite Score Definitions: 

Composite score: 1; 
Definition: Banks in this group are sound in every respect and 
generally have components rated 1 or 2. These banks are the most 
capable of withstanding changing business conditions. These banks 
exhibit the strongest performance and risk-management practices 
relative to the bank's size, complexity, and risk profile and give no 
cause for regulatory concern. 

Composite score: 2; 
Definition: Banks in this group are fundamentally sound and generally 
should not have component ratings worse than 3. Only moderate 
weaknesses are present and are within the bank's management 
capabilities to correct. Risk-management practices are satisfactory 
and there are no material regulatory concerns. 

Composite score: 3; 
Definition: Banks in this group exhibit some degree of regulatory 
concern in one or more of the component areas. These banks exhibit a 
combination of weaknesses that may range from weak to moderate and 
management may lack the ability or willingness to effectively address 
these weaknesses. These banks are generally less capable of 
withstanding business fluctuations than 1 or 2 rated banks. Risk-
management practices may be less than satisfactory but failure appears 
unlikely. 

Composite score: 4; 
Definition: Banks in this group generally exhibit unsafe and unsound 
practices or conditions. There are serious financial or managerial 
deficiencies that may range from severe to critically deficient. Banks 
in this group are generally not capable of withstanding business 
fluctuations. Risk-management practices generally are unacceptable 
relative to the institution's size, complexity, and risk profile. 
Failure is a distinct possibility if problems are not addressed and 
resolved. 

Composite score: 5; 
Definition: Banks in this group exhibit extremely unsafe and unsound 
practices or conditions; exhibit critically deficient performance; 
often contain inadequate risk-management practices relative to the 
bank's size, complexity, and risk profile; and are the greatest 
regulatory concern. 

Source: Federal Reserve. 

[End of table] 

* Loan classifications: In examinations, examiners review a sample of 
banks' internal ratings of loans to determine the adequacy of credit 
risk administration and identify loans that show undue risk and may be 
uncollectible. As part of this review, examiners determine which loans 
are considered "pass," with no concerns noted, as well as those that 
are special mentioned or "classified"--that is, subject to criticism 
because they are not performing or may not perform in the future. 
There are three classification categories used by the federal banking 
regulators: substandard, doubtful, and loss (see table 3). These loan 
classifications, and the internal ratings that banks produce for all 
of their loans, are incorporated into how each bank calculates its 
allowance for loan and lease loss (ALLL), which is an estimate made 
according to accounting guidance of incurred losses on loans and 
leases.[Footnote 14] Therefore, if additional loans are classified 
substandard or doubtful, this information is included in a bank's 
updated ALLL estimates. If loans are classified loss, they are charged 
off the bank's balance sheet.[Footnote 15] 

Table 3: Regulatory Loan Classification System: 

Classification: Substandard; 
Definition: Loans that are inadequately protected by the current sound 
worth and paying capacity of the obligor or of the collateral pledged, 
if any. Loans so classified must have a well-defined weakness or 
weaknesses that jeopardize the liquidation of the debt. They are 
characterized by the distinct possibility that the bank will sustain 
some loss if the deficiencies are not corrected. 

Classification: Doubtful; 
Definition: Loans that have all the weaknesses inherent in those 
classified substandard with the added characteristic that the 
weaknesses make collection or liquidation in full, on the basis of 
currently known facts, conditions, and values, highly questionable and 
improbable. 

Classification: Loss; 
Definition: Loans that are considered uncollectible and of such little 
value that their continuance as bankable assets is not warranted. This 
classification does not mean that the loan has absolutely no recovery 
or salvage value but rather it is not practical or desirable to defer 
writing off this basically worthless asset even though partial 
recovery may be effected in the future. 

Source: Federal Reserve. 

[End of table] 

The end result of an on-site examination is an ROE that includes the 
CAMELS ratings and other findings on the bank's condition, which is 
provided to the bank's management and board of directors. 

CRE Property Types and Associated Risks: 

CRE encompasses many different property types that present different 
risks. Table 4 describes the key CRE property types. 

Table 4: Key CRE Property Types: 

Property types: Retail; 
Definition: Malls, major retailers, strip malls and small, local 
retail businesses. These properties depend on the cash flow of the 
resident businesses and are closely tied to consumer demand and the 
overall economy. 

Property types: Hotel/tourist; 
Definition: All types of hotel and motel properties. These properties' 
cash flows depend on levels of occupancy and the daily rate charged. 
In addition to being tied to trends in tourism and the overall 
economy, the hotel sector also is vulnerable to fluctuations in local 
economies and conditions. 

Property types: Office buildings; 
Definition: Includes diverse properties in which office occupancy is 
the dominant use. Office properties may be more stable due to their 
longer lease cycles than other CRE property types. 

Property types: Industrial; 
Definition: Warehouses, manufacturing plants, light industrial plants, 
laboratories, and research properties. 

Property types: Multifamily housing and apartments; 
Definition: Buildings with multiple dwelling units for rent. These 
properties, unlike most residential properties, are income generating 
and use the commercial mortgage market for financing. 

Property types: Homebuilders; 
Definition: The development of residential properties and loans to 
businesses that develop residential properties. 

Source: Congressional Oversight Panel (COP). 

Note: This information is from the Congressional Oversight Panel's 
February 10, 2010, report Commercial Real Estate Losses and the Risk 
to Financial Stability. 

[End of table] 

Regulators define CRE loans to include construction loans, loans to 
finance CRE that are not secured by CRE, loans secured by multifamily 
property, and loans secured by nonfarm, nonresidential property in 
which the primary source of repayment derives from the rental income 
associated with the property or the proceeds of the sale, refinancing, 
or permanent financing of the property. CRE loans in which the primary 
source of repayment is not the property itself are called owner- 
occupied loans and can include loans to businesses for working capital 
purposes that use real estate as collateral.[Footnote 16] For example, 
a line of credit for a business's operating expenses might be secured 
in part by commercial property, such as an office. 

Owner-occupied properties generally are considered to carry less risk 
than non-owner-occupied properties because regulators consider them to 
be less sensitive to the condition of the CRE market. In ADC loans, 
also called construction and land development (CLD) loans, generally 
are considered to be the riskiest class of CRE, due to their long 
development times and because they can include properties (such as 
housing developments or retail space in a shopping mall) that are 
built before having firm commitments from buyers or lessees. In 
addition, by the time the construction phase is completed, market 
demand may have fallen, putting downward pressure on sales prices or 
rents--making this type of loan more volatile. In recent years, this 
type of loan also has tended to have a much higher loss volatility 
than loans secured by properties such as multifamily housing and other 
nonfarm, nonresidential commercial properties. 

Banks report on four broad categories of CRE in their quarterly call 
reports: 

* CLD: loans secured by real estate to finance land development and 
construction. This includes new construction, as well as additions and 
alterations on existing properties. 

* Multifamily: loans for residential properties with five or more 
dwelling units, such as apartment buildings. 

* Nonfarm nonresidential: loans secured by real estate for business 
and industrial properties, as well as properties such as hotels, 
churches, hospitals, schools, and charitable organizations. This 
category includes offices, retail, and warehouse space. 

* Loans to finance CRE, construction, and land development (not 
secured by CRE). 

Interagency guidance issued in 2006 on concentrations in CRE and sound 
risk-management practices define CRE loans within these categories to 
include those in which repayment is dependent on the cash flow 
generated from the real estate itself. When evaluating concentrations 
in CRE, examiners are instructed not to include owner-occupied 
properties in which the income or value of the property is not the 
primary source of repayment. 

Deterioration of the CRE Market Negatively Affected Community Banks, 
Which Could Impact Small Business Lending: 

The CRE Market Has Experienced a Significant Downturn: 

CRE as an asset class--and especially properties in the ADC category-- 
is prone to volatility and cyclical behavior, as illustrated in the 
current CRE market downturn. This volatility and cyclical behavior is 
attributed to characteristics such as information-gathering 
difficulties, infrequent transactions, high transaction costs, rigid 
and constrained supply, long construction times, and a two-fold 
reliance on external finance (shorter-term to cover construction, and 
longer-term for the occupancy period).[Footnote 17] Additionally, CRE 
is by nature diverse and localized. For example, shopping centers are 
one type of CRE, but even within this category properties can have 
significant differences depending on design, types of tenants, and 
other factors that can affect their value. Because of these factors, 
the supply of CRE in the marketplace is slow to respond to an increase 
in demand, which drives prices up when investor optimism rises. 
Conversely, the marketplace is slow to respond when the market supply 
of CRE catches up and new construction projects are delivered, 
resulting in oversupply and declining property values. According to 
regulatory officials, the weakness in the ADC sector during this 
crisis was primarily due to residential housing construction, and that 
weakness affected the performance of other areas of CRE (for example, 
failed residential housing developments will affect the ability of 
nearby strip malls to attract and generate rental income from tenants). 

The recent downturn in the CRE markets can be seen in the market 
values for commercial property and the condition of the commercial 
mortgage-backed securities (CMBS) market.[Footnote 18] Market values 
for all major commercial property types have declined significantly. 
As of December 2010, overall CRE market values were down more than 42 
percent from their peak in 2007. This decline followed a rapid 
appreciation in CRE asset values during which CRE values increased by 
more than 85 percent from 2002 to the market's peak in October 2007 
(see figure 1). Overall deterioration in CRE markets can be found in 
the condition of the CMBS market as well. By January 2011, the 
delinquency rate on loans included in CMBS was at a record high, above 
9 percent. As we have reported, overall CMBS issuance slowed severely 
since the CRE downturn started. After peaking in 2007, the CMBS market 
came to a complete halt by the end of 2008.[Footnote 19] 

Figure 1: Trends in Commercial Property Price Index (from 2002 through 
2010): 

[Refer to PDF for image: line graph] 

January 2002: 
Moody’s/REAL Commercial Property Price Index: 1.03382. 

February 2002: 
Moody’s/REAL Commercial Property Price Index: 1.01771. 

March 2002: 
Moody’s/REAL Commercial Property Price Index: 1.01816. 

April 2002: 
Moody’s/REAL Commercial Property Price Index: 1.02342. 

May 2002: 
Moody’s/REAL Commercial Property Price Index: 1.03576. 

June 2002: 
Moody’s/REAL Commercial Property Price Index: 1.0518. 

July 2002: 
Moody’s/REAL Commercial Property Price Index: 1.05786. 

August 2002: 
Moody’s/REAL Commercial Property Price Index: 1.0682. 

September 2002: 
Moody’s/REAL Commercial Property Price Index: 1.08324. 

October 2002: 
Moody’s/REAL Commercial Property Price Index: 1.1045. 

November 2002: 
Moody’s/REAL Commercial Property Price Index: 1.11236. 

December 2002: 
Moody’s/REAL Commercial Property Price Index: 1.12428. 

January 2003: 
Moody’s/REAL Commercial Property Price Index: 1.13584. 

February 2003: 
Moody’s/REAL Commercial Property Price Index: 1.13297. 

March 2003: 
Moody’s/REAL Commercial Property Price Index: 1.12844. 

April 2003: 
Moody’s/REAL Commercial Property Price Index: 1.14627. 

May 2003: 
Moody’s/REAL Commercial Property Price Index: 1.14843. 

June 2003: 
Moody’s/REAL Commercial Property Price Index: 1.14761. 

July 2003: 
Moody’s/REAL Commercial Property Price Index: 1.16016. 

August 2003: 
Moody’s/REAL Commercial Property Price Index: 1.15243. 

September 2003: 
Moody’s/REAL Commercial Property Price Index: 1.16052. 

October 2003: 
Moody’s/REAL Commercial Property Price Index: 1.17424. 

November 2003: 
Moody’s/REAL Commercial Property Price Index: 1.18882. 

December 2003: 
Moody’s/REAL Commercial Property Price Index: 1.20396. 

January 2004: 
Moody’s/REAL Commercial Property Price Index: 1.21075. 

February 2004: 
Moody’s/REAL Commercial Property Price Index: 1.23835. 

March 2004: 
Moody’s/REAL Commercial Property Price Index: 1.26039. 

April 2004: 
Moody’s/REAL Commercial Property Price Index: 1.26914. 

May 2004: 
Moody’s/REAL Commercial Property Price Index: 1.2752. 

June 2004: 
Moody’s/REAL Commercial Property Price Index: 1.27776. 

July 2004: 
Moody’s/REAL Commercial Property Price Index: 1.32175. 

August 2004: 
Moody’s/REAL Commercial Property Price Index: 1.33385. 

September 2004: 
Moody’s/REAL Commercial Property Price Index: 1.34659. 

October 2004: 
Moody’s/REAL Commercial Property Price Index: 1.37283. 

November 2004: 
Moody’s/REAL Commercial Property Price Index: 1.38539. 

December 2004: 
Moody’s/REAL Commercial Property Price Index: 1.4005. 

January 2005: 
Moody’s/REAL Commercial Property Price Index: 1.45451. 

February 2005: 
Moody’s/REAL Commercial Property Price Index: 1.46699. 

March 2005: 
Moody’s/REAL Commercial Property Price Index: 1.5036. 

April 2005: 
Moody’s/REAL Commercial Property Price Index: 1.51287. 

May 2005: 
Moody’s/REAL Commercial Property Price Index: 1.54277. 

June 2005: 
Moody’s/REAL Commercial Property Price Index: 1.56263. 

July 2005: 
Moody’s/REAL Commercial Property Price Index: 1.58314. 

August 2005: 
Moody’s/REAL Commercial Property Price Index: 1.6162. 

September 2005: 
Moody’s/REAL Commercial Property Price Index: 1.62764. 

October 2005: 
Moody’s/REAL Commercial Property Price Index: 1.61632. 

November 2005: 
Moody’s/REAL Commercial Property Price Index: 1.62886. 

December 2005: 
Moody’s/REAL Commercial Property Price Index: 1.60636. 

January 2006: 
Moody’s/REAL Commercial Property Price Index: 1.66567. 

February 2006: 
Moody’s/REAL Commercial Property Price Index: 1.6936. 

March 2006: 
Moody’s/REAL Commercial Property Price Index: 1.69193. 

April 2006: 
Moody’s/REAL Commercial Property Price Index: 1.66103. 

May 2006: 
Moody’s/REAL Commercial Property Price Index: 1.68323. 

June 2006: 
Moody’s/REAL Commercial Property Price Index: 1.70244. 

July 2006: 
Moody’s/REAL Commercial Property Price Index: 1.68103. 

August 2006: 
Moody’s/REAL Commercial Property Price Index: 1.68241. 

September 2006: 
Moody’s/REAL Commercial Property Price Index: 1.68536. 

October 2006: 
Moody’s/REAL Commercial Property Price Index: 1.70515. 

November 2006: 
Moody’s/REAL Commercial Property Price Index: 1.70782. 

December 2006: 
Moody’s/REAL Commercial Property Price Index: 1.74085. 

January 2007: 
Moody’s/REAL Commercial Property Price Index: 1.79245. 

February 2007: 
Moody’s/REAL Commercial Property Price Index: 1.83466. 

March 2007: 
Moody’s/REAL Commercial Property Price Index: 1.85204. 

April 2007: 
Moody’s/REAL Commercial Property Price Index: 1.86369. 

May 2007: 
Moody’s/REAL Commercial Property Price Index: 1.8559. 

June 2007: 
Moody’s/REAL Commercial Property Price Index: 1.87248. 

July 2007: 
Moody’s/REAL Commercial Property Price Index: 1.88175. 

August 2007: 
Moody’s/REAL Commercial Property Price Index: 1.91112. 

September 2007: 
Moody’s/REAL Commercial Property Price Index: 1.88888. 

October 2007: 
Moody’s/REAL Commercial Property Price Index: 1.9187. 

November 2007: 
Moody’s/REAL Commercial Property Price Index: 1.91403. 

December 2007: 
Moody’s/REAL Commercial Property Price Index: 1.88514. 

January 2008: 
Moody’s/REAL Commercial Property Price Index: 1.87311. 

February 2008: 
Moody’s/REAL Commercial Property Price Index: 1.91241. 

March 2008: 
Moody’s/REAL Commercial Property Price Index: 1.86924. 

April 2008: 
Moody’s/REAL Commercial Property Price Index: 1.81227. 

May 2008: 
Moody’s/REAL Commercial Property Price Index: 1.74972. 

June 2008: 
Moody’s/REAL Commercial Property Price Index: 1.69276. 

July 2008: 
Moody’s/REAL Commercial Property Price Index: 1.6996. 

August 2008: 
Moody’s/REAL Commercial Property Price Index: 1.69741. 

September 2008: 
Moody’s/REAL Commercial Property Price Index: 1.73917. 

October 2008: 
Moody’s/REAL Commercial Property Price Index: 1.69764. 

November 2008: 
Moody’s/REAL Commercial Property Price Index: 1.63996. 

December 2008: 
Moody’s/REAL Commercial Property Price Index: 1.60463. 

January 2009: 
Moody’s/REAL Commercial Property Price Index: 1.5158. 

February 2009: 
Moody’s/REAL Commercial Property Price Index: 1.50631. 

March 2009: 
Moody’s/REAL Commercial Property Price Index: 1.48072. 

April 2009: 
Moody’s/REAL Commercial Property Price Index: 1.35309. 

May 2009: 
Moody’s/REAL Commercial Property Price Index: 1.25044. 

June 2009: 
Moody’s/REAL Commercial Property Price Index: 1.23816. 

July 2009: 
Moody’s/REAL Commercial Property Price Index: 1.1756. 

August 2009: 
Moody’s/REAL Commercial Property Price Index: 1.14061. 

September 2009: 
Moody’s/REAL Commercial Property Price Index: 1.09609. 

October 2009: 
Moody’s/REAL Commercial Property Price Index: 1.07981. 

November 2009: 
Moody’s/REAL Commercial Property Price Index: 1.09104. 

December 2009: 
Moody’s/REAL Commercial Property Price Index: 1.13577. 

January 2010: 
Moody’s/REAL Commercial Property Price Index: 1.14733. 

February 2010: 
Moody’s/REAL Commercial Property Price Index: 1.11698. 

March 2010: 
Moody’s/REAL Commercial Property Price Index: 1.11161. 

April 2010: 
Moody’s/REAL Commercial Property Price Index: 1.13095. 

May 2010: 
Moody’s/REAL Commercial Property Price Index: 1.17219. 

June 2010: 
Moody’s/REAL Commercial Property Price Index: 1.12515. 

July 2010: 
Moody’s/REAL Commercial Property Price Index: 1.08984. 

August 2010: 
Moody’s/REAL Commercial Property Price Index: 1.05371. 

September 2010: 
Moody’s/REAL Commercial Property Price Index: 1.09947. 

October 2010: 
Moody’s/REAL Commercial Property Price Index: 1.11413. 

November 2010: 
Moody’s/REAL Commercial Property Price Index: 1.12124. 

December 2010: 
Moody’s/REAL Commercial Property Price Index: 1.11158. 

Source: Moody’s/REAL Commercial Property Price Index. 

[End of figure] 

Although CRE market price deterioration appears to have leveled off 
recently, vacancies at many properties remain high and signs of a 
market recovery have been uneven in different areas of the country. 
High-value properties in markets such as New York, Washington, San 
Francisco, and Boston have performed well more recently.[Footnote 20] 
But low rental rates and high vacancies indicate that demand for 
office, retail, multifamily housing, and warehouse space remains 
relatively weak.[Footnote 21] Furthermore, although CRE markets 
nationally have experienced a downturn, some regions have experienced 
more distress than others. For example, the CRE markets in the South, 
Midwest, and West have experienced greater stress and deterioration 
than the East.[Footnote 22] These areas that have experienced greater 
CRE market stress also have experienced more bank failures, according 
to FDIC data. 

The Decline of the CRE Market Has Adversely Affected Community Banks: 

Community banks increasingly have moved toward providing CRE loans 
more than other kinds of loan products, in part because of competitive 
pressures. During the last decade, large banks and other financial 
institutions increased their market share for consumer loans, credit 
cards, and residential mortgages. As a result, community banks shifted 
their focus to CRE lending. Some market observers argue that community 
banks' focus on CRE lending, and, therefore, the long-term trend of 
increased CRE concentrations, came about because community banks 
generally know their local CRE markets better than larger banks and 
are well-positioned to gather location-specific information for CRE 
properties. 

The increased exposure of community banks to CRE loans has been 
pronounced over the last 10-15 years. While CRE collateral backed 
about 30 percent of total loans and leases at community banks in 2000, 
a decade later that rate increased to more than 43 percent. 
Concentrations have been less pronounced at larger banks, which tend 
to rely less heavily on CRE lending. Since 2000, CRE as a percent of 
total loans and leases has ranged from about 15 percent to about 21 
percent at commercial banks with more than $1 billion in total assets. 

Community banks also have come to hold large concentrations of CRE 
loans in comparison to their total capital. The average CRE 
concentration at community banks as a percentage of total risk-based 
capital increased from about 168 percent in 1996-2000 to about 289 
percent in 2005-2010 (see figure 2). 

Figure 2: Average CRE Concentrations at Community Banks (from 1996 
through 2010): 

[Refer to PDF for image: vertical bar graph] 

Year: 1996; 
CRE Concentration: 149.4%. 

Year: 1997; 
CRE Concentration: 156.7%. 

Year: 1998; 
CRE Concentration: 161.3%. 

Year: 1999; 
CRE Concentration: 180.3%. 

Year: 2000; 
CRE Concentration: 192.8%. 

Year: 2001; 
CRE Concentration: 212.4%. 

Year: 2002; 
CRE Concentration: 228.6%. 

Year: 2003; 
CRE Concentration: 244.5%. 

Year: 2004; 
CRE Concentration: 260.9%. 

Year: 2005; 
CRE Concentration: 278.2%. 

Year: 2006; 
CRE Concentration: 286.8%. 

Year: 2007; 
Owner-occupied properties: 76.9%; 
CRE Concentration: 221.4%; 

Year: 2008; 
Owner-occupied properties: 95.8%; 
CRE Concentration: 210.7%. 

Year: 2009; 
Owner-occupied properties: 96.4%; 
CRE Concentration: 197.2%. 

Year: 2010; 
Owner-occupied properties: 93.4%; 
CRE Concentration: 175.1%. 

Quarterly data for 2008-2010: 

2008: Q1; 
Owner-occupied properties: 89%; 
CRE Concentration: 211.7%. 

2008: Q2; 
Owner-occupied properties: 91.2%; 
CRE Concentration: 211.2%. 

2008: Q3; 
Owner-occupied properties: 93.8%; 
CRE Concentration: 210.3%. 

2008: Q4; 
Owner-occupied properties: 97%; 
CRE Concentration: 209.4%. 

2009: Q1; 
Owner-occupied properties: 97.5%; 
CRE Concentration: 202.7%. 

2009: Q2; 
Owner-occupied properties: 99.1%; 
CRE Concentration: 200.5%. 

2009: Q3; 
Owner-occupied properties: 99.6%; 
CRE Concentration: 194.1%. 

2009: Q4; 
Owner-occupied properties: 102.2%; 
CRE Concentration: 191.4%. 

2010: Q1; 
Owner-occupied properties: 101.6%; 
CRE Concentration: 184%. 

2010: Q2; 
Owner-occupied properties: 101.3%; 
CRE Concentration: 177%. 

2010: Q3; 
Owner-occupied properties: 99.8%; 
CRE Concentration: 171.3%. 

2010: Q4; 
Owner-occupied properties: 100.5%; 
CRE Concentration: 168%. 

Source: GAO analysis of data from FDIC. 

Note: The CRE concentrations represented in this graphic include loans 
secured by owner-occupied CRE. Call report data did not begin 
specifying whether CRE was owner-occupied until 2007. 

[End of figure] 

Increased exposure to CRE has made community banks vulnerable to the 
decline of this market. According to FDIC, nearly 30 percent of 
community banks have concentrations of CRE to total capital above 300 
percent, the concentration threshold established in the 2006 
interagency guidance on CRE, above which regulators review banks' risk-
management controls more closely. This means that nearly a third of 
community banks are exposing three times their total capital to risks 
related to their CRE loans. As noted by a Bank for International 
Settlements report on bank lending and commercial property cycles, 
declining property prices increase the proportion of nonperforming 
loans, lead to a deterioration in banks' balance sheets, and weaken 
banks' capital bases.[Footnote 23] In particular, the decline in CRE 
values has contributed to more noncurrent CRE loans, charge-offs, and 
bank failures. 

* Noncurrent CRE loans have increased. From the first quarter of 2008 
through the fourth quarter of 2010, the percent of CRE loans at 
community banks that were noncurrent increased from 2.2 to 5.3 
percent, well above the average rate of 0.9 percent from 2000 through 
2007. The average from 2000 through 2010 is 1.94 percent. However, the 
data show that the volume of noncurrent CRE loans has begun to level 
off (see figure 3). 

Figure 3: Percent of Noncurrent Loans Secured by CRE at Community 
Banks (from 2000 through 2010): 

[Refer to PDF for image: 2 vertical bar graphs] 

Annual average (2000-2010): 

Average, 2000-2010: 1.94%. 

Year: 2000; 
Average: 0.68%. 

Year: 2001; 
Average: 0.92%. 

Year: 2002; 
Average: 0.9%. 

Year: 2003; 
Average: 0.83%. 

Year: 2004; 
Average: 0.63%. 

Year: 2005; 
Average: 0.57%. 

Year: 2006; 
Average: 0.72%. 

Year: 2007; 
Average: 1.65%. 

Year: 2008; 
Average: 3.68%. 

Year: 2009; 
Average: 5.39%. 

Year: 2010; 
Average: 5.32%. 

Quarterly average (2008-2010): 

2008: Q1; 
Average: 2.22%. 

2008: Q2; 
Average: 2.63%. 

2008: Q3; 
Average: 3.02%. 

2008: Q4; 
Average: 3.68%. 

2009: Q1; 
Average: 4.24%. 

2009: Q2; 
Average: 4.79%. 

2009: Q3; 
Average: 5.17%. 

2009: Q4; 
Average: 5.39%. 

2010: Q1; 
Average: 5.54%. 

2010: Q2; 
Average: 5.4%. 

2010: Q3; 
Average: 5.37%. 

2010: Q4; 
Average: 5.32%. 

Source: GAO analysis of data from FDIC. 

[End of figure] 

* CRE loan charge-offs increased. From the end of 2007 through the end 
of 2010, the percent of CRE loans that had to be charged off at 
community banks rose from 0.19 to 1.34 percent. From 2000 through 
2007, the average charge off rate of CRE loans at community banks was 
0.09 percent, and from 2000 through 2010 it was 0.39 percent (see 
figure 4). Charge-offs and expected losses that may arise from 
increases in noncurrent CRE loans have put stress on banks' capital 
and ALLL. 

Figure 4: Average Charge-off Rate for Loans Secured by CRE at 
Community Banks (from 2000 through 2010): 

[Refer to PDF for image: vertical bar graph] 

Average: 0.39%. 

Year: 2000; 
Percentage: 0.04%. 

Year: 2001; 
Percentage: 0.09%. 

Year: 2002; 
Percentage: 0.11%. 

Year: 2003; 
Percentage: 0.1%. 

Year: 2004; 
Percentage: 0.07%. 

Year: 2005; 
Percentage: 0.04%. 

Year: 2006; 
Percentage: 0.05%. 

Year: 2007; 
Percentage: 0.19%. 

Year: 2008; 
Percentage: 0.74%. 

Year: 2009; 
Percentage: 1.51%. 

Year: 2010; 
Percentage: 1.34%. 

Source: GAO analysis of data from FDIC. 

[End of figure] 

* Increased bank failures linked to high CRE and ADC concentrations. 
Many bank failures are associated with high CRE and ADC 
concentrations. In 2009 and 2010, 102 of 106 of the MLRs issued by the 
IGs of the banking regulators cited high CRE concentrations, and 92 of 
106 specifically cited ADC loans in particular as a contributing 
factor in bank failures. In the 106 MLRs, 76 of the banks reviewed 
were community banks.[Footnote 24] For example, the MLR for one failed 
bank--which contains findings similar to many other MLRs we reviewed--
states that the rapid growth of its CRE portfolio "increased the 
institution's exposure to a sustained downturn in the real estate 
market and reduced its ability to absorb losses due to unforeseen 
events." 

Depressed CRE Markets Could Reduce Small Business Lending: 

CRE market value declines could reduce overall small business lending 
by community banks. As we previously reported, community banks tend to 
have a larger portion of small-business related loans compared with 
larger banks.[Footnote 25] Because CRE can be used as collateral for 
small business loans, diminished CRE values also can negatively affect 
credit availability to small businesses. Specifically, when the value 
of collateral declines, the amount of financing a bank is willing to 
lend against that collateral typically declines as well. Conversely, 
increases in collateral values lower the premium on external financing-
-improving credit availability for borrowers, boosting demand for real 
estate assets, and driving up prices. Therefore, falling property 
prices can generate a cycle of declining CRE values because they can 
accompany reduced credit. A report by the Bank for International 
Settlements notes that falling CRE prices decrease the value of 
collateral held by banks and, therefore, can give rise to significant 
losses by these banks and ultimately contract the supply of credit. 
[Footnote 26] 

The problem of CRE loan refinancing may exacerbate the negative CRE 
trends and limit lending to small businesses. CRE loans usually are 
written for 3-10 years, with a 20-30 year amortization schedule and a 
balloon payment at the end. Instead of making the large balloon 
payment, the borrower typically will sell the property or refinance 
the loan at the end of the term. Small businesses that are looking to 
refinance a loan against a property that has lost a significant amount 
of market value may have to put up more equity. Alternatively, such 
borrowers might default on the loan, or the bank could work with the 
borrower to restructure the loan and avoid default. Trepp LLC, a 
commercial mortgage analysis firm, estimates that about $1.7 trillion 
in CRE mortgages will mature between 2011 and 2015, with about half of 
that held at banks. Moreover, Trepp estimates that approximately 60 
percent of CRE debt maturing in 2011 is "underwater"--meaning the 
value of the loan exceeds the value of the underlying collateral. Due 
to price declines and stricter bank underwriting standards compared to 
when these loans were originated, those mortgages will be difficult to 
refinance. 

Results from the Federal Reserve's Senior Loan Officer Opinion Survey 
have suggested that new CRE borrowers have faced tighter credit 
conditions, due to banks tightening their underwriting standards in 
response to the downturn. The January 2011 survey found that 10.6 
percent of respondents reported easing credit standards over the 
previous 3 months, compared to 10.5 percent who reported tightening 
them. However, this is a positive development from past results that 
showed severe tightening.[Footnote 27] The trend of tighter credit 
standards suggests that borrowers who previously were considered 
creditworthy might not meet banks' higher standards. 

While Regulators Have Taken Steps to Address CRE Concentrations and 
Bank Concerns, Challenges Remain in Consistently Applying Guidance: 

The regulators have been aware for some time of the risk-management 
challenges related to growing CRE concentrations at community banks 
and have taken steps to address these challenges. The regulators, for 
example, issued guidance to banks on managing CRE concentration risks, 
conducted training on CRE treatment, and conducted internal reviews to 
better ensure examiner compliance with CRE guidance. Even with the 
training and reviews, a number of bank officials we interviewed stated 
that regulators have applied guidance rigidly since the financial 
crisis and have been too harsh in classifying loans and improperly 
applying the 2006 CRE guidance, among other issues. Regulators have 
been incorporating lessons from the financial crisis in their 
supervisory practices, which in part may explain bank officials' 
experience of increased stringency in supervision. Based on our review 
of a nonprobability sample of 55 bank examinations, examiners' 
findings were consistent with CRE loan workout guidance, although in 
some instances examiners did not clearly support requirements for 
reduced CRE concentrations and did not calculate CRE concentrations 
according to concentration and risk-management guidance. Additionally, 
senior regulatory officials and examiners have differing views on the 
adequacy of the 2006 guidance, which may affect how consistently the 
guidance is applied. 

Federal Banking Regulators Addressed CRE Issues before and after the 
Financial Crisis by Issuing Guidance on CRE Concentrations and Loan 
Workouts: 

The regulators began to address CRE concerns before the financial 
crisis. Beginning in the early 2000s, the agencies reviewed CRE 
concentrations and risk-management systems across banks. For example, 
an OCC review found potential for improvement in banks' risk-
management processes for CRE concentrations, including the sufficiency 
of stress testing. The regulators issued draft guidance in January 
2006 on CRE concentrations and risk management, based in part on the 
trends they had observed in CRE concentrations and risks.[Footnote 28] 
The draft guidance elicited considerable feedback from bank 
representatives, many of whom stated it would curtail their CRE 
lending, impose arbitrary limits on CRE concentrations, and require 
additional capital without explicitly stating how much would be 
required. The regulators revised the guidance based on the feedback 
received. Issued in final form in December 2006, the interagency 
guidance provides levels of CRE concentrations that will result in 
additional regulatory attention on risk-management systems: (1) 300 
percent of CRE loans to total capital, (2) increases of 50 percent or 
more in CRE loans during the prior 36 months, and (3) 100 percent of 
CLD (or ADC) loans to total capital. In determining the concentration 
ratio, owner-occupied CRE is removed.[Footnote 29] The guidance also 
states that the concentration numbers are not limits, but rather 
indicate when banks will receive closer scrutiny of risk-management 
systems and capital adequacy. Such thresholds are not intended to be a 
"safe harbor"--that is, banks with lower concentrations may still 
receive scrutiny of their CRE loans in examinations--and banks that 
exhibit other risk factors can receive criticisms on their CRE 
concentrations.[Footnote 30] 

In October 2009, after the start of the financial crisis and the 
widespread deterioration in CRE loan performance, regulators issued 
interagency guidance on CRE loan workouts.[Footnote 31] According to 
the regulators, the guidance was issued to (1) help ensure consistent 
CRE loan and workout treatment among the regulators, (2) update and re-
assert previous guidance, (3) inform banks of examiner expectations, 
and (4) ensure that supervisory practices do not inadvertently curtail 
the availability of credit to sound borrowers. Officials told us that 
the guidance was not intended as forbearance, but to encourage prudent 
loan workouts. While the 2009 guidance was similar to that issued in 
1991 and 1993, regulatory officials noted that it includes updates for 
changes in accounting (for example, related to ALLL), information on 
risk management for CRE loan workouts, and numerous examples to assist 
banks and examiners in interpreting the guidance. The examples provide 
scenarios for different CRE loan classification outcomes and whether 
loans should be considered troubled debt restructurings (TDR), among 
other issues.[Footnote 32] Bankers with whom we spoke stated that the 
examples were helpful in understanding how to apply the guidance. 
Examiners told us that the examples have helped to resolve differences 
of opinion with bankers on how to treat certain CRE-related loans. In 
addition to the 2009 CRE loan workout guidance, the regulators issued 
statements on lending to creditworthy borrowers and creditworthy small 
business borrowers to encourage prudent lending among banks and 
balanced supervision among examiners. 

Regulators Rely on a Variety of Processes to Help Ensure Examinations 
of CRE Portfolios Are Consistent and Appropriate, and Some Processes 
Have Identified Inconsistencies: 

Federal banking regulators help ensure consistency among examinations, 
and appropriate application of guidance, primarily through the ROE 
review process--but also through training, internal reviews, quality 
assurance processes, and processes for obtaining input from banks. 
Such processes reflect federal internal control standards, which 
provide reasonable assurance that management directives are carried 
out. The federal government standards for internal control state that 
managers should have controls in place to compare actual performance 
to planned or expected results over time throughout the organization 
and analyze significant differences.[Footnote 33] All of the 
regulators' processes were used in some form to implement CRE guidance 
and ensure consistent treatment of CRE loans. Some of the internal 
review processes have identified inconsistencies in the application of 
CRE guidance. 

ROE Review Process: 

The regulators' examination drafting and review process is iterative, 
with multiple levels of internal review. According to regulatory 
staff, this design helps ensure consistent application of guidance and 
treatment of banks. Figure 5 illustrates the examination process of 
the federal banking regulators. The process and the staff involved 
vary slightly for each regulator and based on a bank's CAMELS rating. 

Figure 5: The Community Bank Examination Review Process at FDIC, the 
Federal Reserve, and OCC: 

[Refer to PDF for image: illustrated table] 

Conducts bank safety and soundness examination, including reviewing 
loans and compliance with laws and regulatory guidance: 
FDIC examination team; 
Participates in the examination and assembles the draft ROE for 
further review based on the findings of the examination team: 
EIC; 
Reviews the draft ROE, answers questions from, or poses questions to 
the EIC related to the examination: 
Case manager/field supervisor/supervisory examiner; 
Reviews the draft ROE for support of findings and consistency: 
Case manager/field supervisor/supervisory examiner; 
Management review and signature[A]: 
Field Supervisor/Supervisory Examiner (1)(2); 
Headquarters involvement: None; 
Management review and signature[A]: 
Assistant Regional Director (3); Deputy Regional Director/Regional 
Director (4)(5); 
Headquarters involvement: Risk Management and Applications Section
conducts a post-examination review after receiving the ROE and the
Problem Bank Memorandum (for banks rated 4 and 5, and certain banks 
rated 3). 

Conducts bank safety and soundness examination, including reviewing 
loans and compliance with laws and regulatory guidance: 
OCC examination team; 
Participates in the examination and assembles the draft ROE for 
further review based on the findings of the examination team: 
EIC or portfolio manager; 
Reviews the draft ROE, answers questions from, or poses questions to 
the EIC related to the examination: [Empty]; 
Reviews the draft ROE for support of findings and consistency: 
Analyst (working closely with an Assistant Deputy Comptroller); 
Management review and signature[A]: 
Assistant Deputy Comptroller (1)(2); 
Headquarters involvement: None; 
Management review and signature[A]: 
District Supervisory Review Committee: Chaired by the District Deputy 
Comptroller and consisting of Assistant Deputy Comptrollers, 
attorneys, analysts, and problem bank specialists (3)(4)(5); 
Headquarters involvement: 
Deputy Comptroller for Special Supervision (for problem banks assigned
to the national office). 

Conducts bank safety and soundness examination, including reviewing 
loans and compliance with laws and regulatory guidance: 
Federal Reserve examination team; 
Participates in the examination and assembles the draft ROE for 
further review based on the findings of the examination team: 
EIC; 
Reviews the draft ROE, answers questions from, or poses questions to 
the EIC related to the examination: 
Team leader; 
Reviews the draft ROE for support of findings and consistency: 
Case manager/examining manager/examining officer; 
Management review and signature[A]: 
Assistant Vice-President (1)(2); 
Headquarters involvement: None; 
Management review and signature[A]: 
Assistant Vice-President or Vice President (3); 
Headquarters involvement: 
Post-examination review at the Federal Reserve Board for some banks 
rated 3; 
Management review and signature[A]: 
Vice President or Senior Vice President (4)(5); 
Headquarters involvement: 
Review at the Federal Reserve Board. 

Source: GAO. 

(#) CAMELS composite rating. 

[A] Signature authority may vary based on regional delegations of 
authority. 

[End of figure] 

For all examinations, a team of examiners will conduct on-site work, 
led by an examiner-in-charge (EIC), who drafts the ROE. Other staff 
and management also discuss findings with the examination team and 
review the examination report. The case manager in particular helps 
ensure consistency. Case managers review draft ROEs for consistency 
and adequate support of findings for a portfolio of banks. The analyst 
function at OCC serves a similar role: reviewing many ROEs, although 
not assigned to a specific portfolio of banks. While case managers and 
senior management generally do not review loan classification details, 
they review loan classification writeups in ROEs for accuracy and 
support for CAMELS ratings in a broad range of ROEs. According to 
Federal Reserve officials, case managers and senior management hold 
discussions with the examination teams as examination findings are 
being finalized, to ensure that they are appropriate. Therefore, these 
roles help ensure consistent application of guidance among various 
examiners. In certain instances, the regulators' headquarters offices 
in Washington, D.C., may participate to help ensure consistent 
implementation of policy guidance. 

Training: 

Regulators also provide training on new guidance to help ensure 
consistent application. All the agencies offered multiple training 
opportunities or conference calls on the 2006 CRE concentration and 
the 2009 CRE loan workout guidance. For the 2009 CRE loan workout 
guidance, Federal Reserve and FDIC headquarters staff visited field 
offices, and all regulators hosted conference calls with examiners to 
better ensure that the field examiners were implementing it as 
intended. Some field offices also included these CRE topics in their 
own training and team meetings.[Footnote 34] 

Internal Audits and Quality Assurance Processes: 

Regulators also have internal reviews and quality assurance processes 
to help promote consistency, including consistent application of the 
CRE guidance. Regulators' internal reviews include comprehensive 
audits that recur periodically, and real-time and post-ROE quality 
processes.[Footnote 35] Some of these reviews identified 
inconsistencies or other needed improvements related to examiner 
treatment of CRE loans. For example: 

* For certain FDIC regions, reviews found that examiners could have 
better documented findings on CRE concentrations or could have 
provided earlier or harsher criticism of CRE concentrations, and the 
regional office could have better monitored CRE concentrations among 
the banks it supervised. According to an FDIC official, the regions 
already have addressed some of these findings.[Footnote 36] 

* Certain districts of the Federal Reserve System reviewed 
implementation of the 2006 CRE concentration guidance and found 
instances of inconsistency.[Footnote 37] The reports concluded that 
the guidance could have clarified expectations for how examiners 
should review banks' compliance with CRE-related risk-management 
practices and noted that a common, mandatory process for reviewing 
banks' compliance with the 2006 guidance would have resulted in better 
documentation and consistency. In particular, these reviews found that 
examination workpapers sometimes lacked sufficient documentation to 
determine if the examiner adequately assessed compliance with the 
guidance, particularly related to CRE portfolio-level stress testing. 
According to Federal Reserve officials, Washington staff also 
coordinated separate reviews related to implementation of the 2006 
guidance, which resulted in internal clarifications of the appraisal 
review process, ALLL assessment guidance, examiner training sessions 
on the use of interest reserves and TDRs, and contributions to the 
2009 loan workout guidance. 

* According to a San Francisco Federal Reserve Bank official, the San 
Francisco Federal Reserve Bank implemented a "look back" process in 
June 2010 in which a senior official reviews the sufficiency of 
support for downgraded CRE loans for all issued ROEs--in response to 
criticism that examiners were being too harsh and curtailing credit. 
Of 11 CRE loan downgrades reviewed in the third and fourth quarter of 
2010, this official stated that 2 should not have been 
downgraded.[Footnote 38] Specifically, according to this official, the 
loans initially were considered collateral dependent, but after closer 
review the official determined that the borrowers had some capacity to 
repay, so the loans should have been classified but not yet charged 
off. In these two cases, the loan downgrades were reviewed and changed 
before the ROEs were finalized and were consistent with the bank's 
internal loan ratings. According to this official, the findings from 
this quality process will be used to improve the accuracy of CRE loan 
classification. 

* Similarly, all OCC districts instituted a real-time review process 
in which experienced staff reviewed the accuracy of CRE loan 
classifications--before the ROE is finalized.[Footnote 39] For 
example, OCC's central district in January 2009 reported that 95 
percent of examiners' ratings decisions on CRE loans, and 99 percent 
of their accrual decisions, were determined to be accurate. Among 
those classifications that were corrected, 3 percent were downgraded 
and 2 percent were upgraded. Based on these findings, the district 
concluded that the vast majority of examiner loan classifications were 
accurate but recommended more training to address the discrepancies. 
The western district's quality assurance process concluded that 4 
percent of risk ratings were incorrect.[Footnote 40] 

Processes for Obtaining Bank Feedback: 

Regulators also use surveys to gather information on how to improve 
the examination process and understand the impact of policies on the 
banking industry.[Footnote 41] For example, the regulators issued an 
interagency survey for examinations conducted between May 31 and July 
9, 2010. According to an FDIC analysis of the resulting data, more 
than 97 percent of respondents stated that the 2009 CRE loan workout 
guidance has been helpful. In addition, nearly 88 percent of banks 
stated that no specific guidance was inhibiting them from working with 
troubled borrowers. Among the remaining 12 percent, just over three- 
quarters of them raised concerns about accounting-related guidance and 
reporting of TDRs. Based on this information, regulatory officials 
from FDIC, the Federal Reserve, and OCC believe that the 2009 CRE loan 
workout guidance has been helpful. 

Comments provided to regulatory officials during the examination 
process and through the formal appeals process provide information 
about banks' concerns on ratings and whether regulatory guidance has 
been applied consistently. According to bank and regulatory officials 
with whom we spoke, when bank officials have raised concerns, they 
tend to first approach the examination team. Bank officials also can 
contact the ombudsman offices at the regulators to seek confidential 
assistance.[Footnote 42] In addition to these avenues, banks formally 
can appeal regulatory decisions. Although bankers have multiple 
options for raising concerns about regulatory actions, our interviews 
with bank officials found that some were cautious about raising issues 
because of potential repercussions from regulatory officials.[Footnote 
43] In contrast, other bank officials stated that they do contact 
regulatory officials when warranted, although a few raised concerns 
about the time and expense of pursuing formal appeals. Regulatory 
officials told us that many bank officials regularly reach out to 
them, and a few officials also noted that they provide information to 
bank officials about the ombudsman and the appeals process--should 
banks want to raise concerns.[Footnote 44] 

Banks' Concerns about Examiner Treatment of CRE Loans Highlight 
Challenges in Addressing CRE Downturn: 

Interviews with officials from 43 banks in different parts of the 
country identified multiple concerns with examiner treatment of CRE 
loans and related issues.[Footnote 45] Many bank officials' 
overarching concern was that examiners have been applying guidance 
more stringently than before the financial crisis--a shift that a few 
bankers commented was a difficult adjustment. 

Loan Classifications and Effect on Earnings: 

Some bank officials we interviewed expressed concerns with examiner- 
required loan classifications. From the perspective of a few bank 
officials we interviewed, a loan is performing when the borrower 
continues to pay and should not be classified. However, according to 
regulatory guidance and statements of regulatory officials, such a 
loan may be classified if identified weaknesses suggest a reduction in 
the borrower's capacity to repay that in turn could lead to future 
nonpayment. According to bankers and examiners with whom we spoke, 
"global cash flow" analysis always has been part of reviewing loans, 
but in the current economic downturn examiners have been focusing more 
closely on analysis and documentation of borrowers' and guarantors' 
global cash flows. The purpose of such analysis is to determine 
whether they have sufficient income and liquid assets to support loan 
payments. In some cases, such analysis shows that a borrower is unable 
to pay the loan, even if the borrower is currently paying. For 
example, the borrower's income and other debt obligations, when 
reviewed as a whole, could show that the borrower's debt obligations 
exceed income, which raises questions about whether the borrower will 
continue paying on the loan in the future. 

The renewed focus on global cash flow analysis, in part, led many bank 
officials to conclude that examiners were classifying loans based 
either on collateral value or because the bank lacked updated 
financial statements. Regulatory field staff acknowledged that global 
cash flow analysis can be difficult to conduct because borrowers 
sometimes do not provide banks with updated financial statements. 
However, regulatory officials told us that examiners do not classify 
loans solely because of a lack of financial statements, but a lack of 
such statements combined with other weaknesses could provide 
sufficient support for classifying a loan. If the borrower lacks the 
ability to repay, the loan then could be considered "collateral 
dependent." Such loans are classified based on the value of the 
property, and tend to rely on values established in appraisals. 
According to some bank officials we interviewed, examiners have been 
more critical of recent appraisals. For example, these officials 
stated that examiners have been requiring appraisals on CRE collateral 
more often, criticizing the banks' appraisal review process, and 
criticizing the appraisals themselves. 

Classifications are a major concern for banks primarily because they 
can result in reduced earnings. For example, an examiner may determine 
that a bank should place a classified loan on nonaccrual--which means 
the bank cannot accrue the interest income as earnings. While some 
bankers put loans on nonaccrual themselves, a few bank officials with 
whom we spoke stated that examiners have been asking bankers to place 
more loans on nonaccrual. Classifications also can reduce earnings 
because they factor into ALLL, which a bank estimates based on 
accounting guidance from the Financial Accounting Standards Board 
(FASB).[Footnote 46] As more loans are classified, more is generally 
reserved in ALLL to anticipate future losses from nonperforming loans. 
[Footnote 47] In our interviews with bank officials, some stated that 
examiners have been requiring additional ALLL and criticizing the ALLL 
methodology. In addition, a few bankers noted that some examiners want 
ALLL increased based on their peers' ALLL rather than the bank's 
individual situation. 

Application of CRE-related Guidance: 

Many bank officials with whom we spoke were concerned that examiners 
have been misapplying the 2006 guidance. As we discuss above, the 2006 
guidance states that the CRE and ADC concentration levels are not 
limits, but some bank officials told us that examiners have been 
interpreting them that way. A few bank officials also stated that 
examiners have not been calculating CRE concentrations according to 
the 2006 guidance: some examiners were including owner-occupied CRE 
and some were using the wrong type of capital for the calculation, 
which inflated the concentration levels (we also found this in our 
analysis, described in more detail below).[Footnote 48] A few bankers 
stated that examiners told them they exceeded the 300 percent 
concentration threshold for CRE, based on these faulty calculations, 
but according to the calculations in the guidance they actually were 
under the threshold. Furthermore, a few bank officials also stated 
that it was unclear to them what examiners expect in complying with 
requirements related to CRE and risk management--for example, on what 
is considered to be satisfactory stress testing. 

While more bank officials than not noted that examiners' actions have 
been consistent with the letter of the 2009 CRE loan workout guidance, 
a few stated that examiners were not always complying with its spirit: 
to allow the banks time to work with borrowers until the current CRE 
downturn passes. Two bankers with whom we spoke stated that it was 
their experience that examiners were particularly stringent in 2008 
when the financial crisis was escalating, but moderated their approach 
in late 2009, which is around the time that the 2009 CRE loan workout 
guidance was issued. An internal review by OCC's Midsize and Community 
Banks Division came to a similar conclusion and noted that examiners 
have become more consistent in their CRE loan treatment through 
internal discussions, training, and policy communication efforts. A 
few bank officials with whom we spoke provided specific suggestions on 
how to improve policy guidance--such as clarifying what amount of debt 
service coverage is acceptable in a loan workout, how best to conduct 
global cash flow analysis, and when new appraisals are needed--but a 
few others felt that some form of general regulatory reprieve was 
needed for community banks to work through the downturn. 

CAMELS and Capital Requirements: 

Bank officials we interviewed also stated that their experience with 
increased supervisory scrutiny was being reflected in CAMELS ratings 
and additional capital requirements. For example, many bank officials 
thought the management component rating was more critically assessed 
now, and heavily driven by asset quality and other component ratings. 
A few bank officials added that they were being rated on deterioration 
in their portfolios that was due to the broader economic downturn and 
problems in their geographic market that were out of their control. 
Some bank officials with whom we spoke stated that examiners have been 
more aggressive about requiring additional capital--and two bank 
officials in particular stated they thought this was especially the 
case for banks with high CRE concentrations. 

However, a few bankers thought the additional scrutiny was 
appropriate, but should not necessarily be focused on all banks. For 
example, one banker stated that if examiners had been applying the 
guidance stringently before the crisis that perhaps the banks could 
have avoided some of the current problems. A few others also noted 
that stricter scrutiny was appropriate given the current CRE market 
situation and the severity of the economic downturn. Additionally, a 
few bank officials stated that the regulators should focus on the 
community banks that caused the problems, rather than subjecting all 
community banks to such strict scrutiny. 

Regulators Have Incorporated Lessons Learned from the Financial Crisis 
into Supervision, Which May Explain Some Bank Officials' Experiences 
of Increased Scrutiny: 

Regulators have been incorporating into their regulatory processes a 
number of lessons learned from the financial crisis, including 
findings from the agencies' IGs. Specifically, the IGs of the banking 
regulators completed 106 MLRs in 2009 and 2010 for banks that failed 
during the recent financial crisis.[Footnote 49] As noted in a 
December 2010 report by the FDIC IG that summarizes certain MLR 
findings, FDIC determined based on the MLRs that earlier supervisory 
action was needed to address banks with high risk profiles or weak 
risk-management practices. We also found in past work that regulators 
identified a number of weaknesses in institutions' risk-management 
systems before the financial crisis began but did not always take 
forceful actions to address them.[Footnote 50] In addition, the 
Financial Crisis Inquiry Commission report notes areas in which 
regulators could have been more proactive in using regulatory tools to 
address certain risks in the financial system.[Footnote 51] A number 
of nonmanagement regulatory staff in the field offices we visited 
acknowledged they could have better followed up on outstanding issues. 

In response to lessons learned, regulatory officials stated that they 
have been following up more often on matters requiring attention (MRA) 
and refocusing their supervisory efforts. For example, OCC's Midsize 
and Community Banks Division issued an MRA Reference Guide that 
provides examiners with OCC policy guidance on how to report, follow 
up on, and keep records related to MRAs. FDIC in June 2009 also 
implemented its "Forward Looking Supervision" program that re- 
emphasizes reviewing all aspects of a bank's risks during the 
examination process. The program focuses on helping ensure that (1) 
CAMELS ratings reflect consideration of bank management practices 
without relying solely on a bank's financial condition; (2) examiners 
review risks associated with concentrations and wholesale funding 
sources; (3) appropriate capital is maintained; and (4) examiners 
follow up on progress related to MRAs and enforcement actions. 

Although Most Examinations We Reviewed Followed CRE Guidance, a Few 
Illustrated How Treatment of CRE Concentrations May Be Inconsistent: 

Based on our analysis of a nonprobability sample of 55 ROEs, 
examiners' findings were generally consistent with policy guidance, 
with some exceptions. Examiners made statements in ROEs related to the 
quality of banks' loan workouts that were consistent with the 2009 
guidance on CRE loan workouts.[Footnote 52] ROEs in our sample that 
comment broadly on banks' CRE loan workouts tend to cite areas for 
improvement (20 of 27). Examiner concerns include that the bank 
management or its board could have better identified, monitored, or 
tracked problem loan workouts, and therefore better identified loans 
that should have been reported as TDRs. Improvements to managing loan 
workouts that examiners cited include (1) reporting on current loan 
status and related developments (such as periodic analysis of the 
borrower's financial situation); (2) creating and tracking benchmarks 
to measure workout progress; (3) providing the rationale for loan 
grades related to loan workouts; and (4) updating collateral values 
(as appropriate). Almost half of the ROEs in our sample that raise 
concerns related to CRE loan workouts (8 of 20) specifically note 
concerns about the nature of banks' loan workouts. For example, in 
these cases, examiners most often stated that loans were restructured 
and extended on unsustainable terms that either resulted in further 
asset quality deterioration, did not adequately assess the borrower's 
ability to repay, or did not follow the 2009 CRE loan workout guidance. 

In our sample, most ROEs (44 of 55 sampled) raise concerns about CRE 
concentrations and how they are managed. In more than half of those 
(24 of 44), the concerns are supported by risk-management deficiencies 
and explicitly cite the 2006 CRE concentration guidance. Specifically, 
the findings include concerns on the bank's (1) need to update or 
enhance internal policies on CRE concentration limits and CRE 
underwriting acceptable to the bank; (2) monitoring of CRE 
concentrations; (3) management information systems used to track and 
report various types of CRE; (4) ability to inform the bank's board of 
directors about trends in CRE concentrations; and (5) the adequacy of 
stress testing of CRE loans. 

However, in 7 instances (of 44), the ROE includes statements that the 
bank must reduce its CRE concentrations, but the basis for this 
requirement was unclear or appeared inconsistent with the 2006 CRE 
concentration guidance.[Footnote 53] For example: 

* One ROE states that the bank needed to match its own internal policy 
on CRE concentrations to those in the 2006 guidance, and referred to 
the concentrations in the guidance as "limits." Referring to the 
thresholds in the 2006 guidance as limits is inconsistent with that 
guidance. 

* In two other instances the ROEs state that the bank must reduce its 
CRE concentrations--citing them as "excessive" for example--but do not 
focus on the bank's risk-management systems. However, the enforcement 
actions for these banks did not require reduced CRE concentrations and 
emphasized improvements to risk management. One of these ROEs states 
repeatedly that the bank must reduce its CRE concentrations because 
the concentrations were too high "in the view of" the regulator. The 
related enforcement action did not require reduced CRE concentrations 
explicitly but required that the board "refine the concentration risk- 
management system" in part by establishing its own limits for certain 
CRE concentrations and adhering to them.[Footnote 54] Differences in 
message between an ROE and an enforcement action could be confusing to 
bank boards and management as they seek to comply with regulatory 
requirements for risk management related to CRE concentrations. 
Moreover, such confusion could lead bank officials to misunderstand 
whether they should focus on improving their risk-management systems 
or just reduce their total CRE concentration numbers. 

* Another ROE acknowledges that the bank was below the CRE threshold 
indicated in the 2006 guidance but states the bank nonetheless should 
follow the guidance and assesses in detail the bank's compliance with 
it. If banks are closely assessed on their compliance with the 2006 
CRE guidance, although they have not reached the CRE and ADC 
thresholds, 

* bank officials could be unclear on what the trigger is for 
compliance with CRE risk-management requirements. 

* One case in particular provided ambiguous information to the bank 
about whether it had the appropriate risk-management systems in place 
to manage its CRE concentrations. The ROE requires a bank with a CRE 
concentration of about 600 percent of tier 1 capital to address a 
matter requiring immediate attention to improve stress testing for its 
CRE portfolio. The ROE also states that the bank needed to reduce its 
CRE concentrations. However, the ROE states that the bank was in 
compliance with the 2006 CRE guidance--which requires robust stress 
testing for CRE portfolios when banks reach certain levels of CRE. 
Requiring a bank to address a matter requiring immediate attention 
related to CRE risk management and noting that the bank must reduce 
its CRE concentrations--while also stating that it is complying with 
the 2006 guidance--could send an unclear message to bank officials 
about why they need to reduce CRE concentrations if overall they are 
complying with the guidance. 

Additionally, we found that out of 47 ROEs that include CRE 
concentration information, a number of them did not include CRE 
concentration numbers that were calculated according to the 2006 CRE 
guidance. For example, some ROEs appear to include owner-occupied CRE 
as part of the CRE concentration calculation (14 of 47), although the 
2006 CRE guidance specifically excludes this type of CRE. We also 
found that 23 of these 47 ROEs include CRE concentrations calculated 
by using some combination of tier 1 capital (and sometimes also 
include a number simply referred to as a "concentration," although how 
it was calculated was unclear). However, another 24 ROEs specify using 
either total risk-based capital or equity capital (or also include 
tier 1 capital), which is consistent with the 2006 guidance.[Footnote 
55] The effect of calculating these concentrations differently can be 
to increase the total CRE concentration number, which increases the 
scrutiny placed on the banks' risk-management systems. Sometimes the 
difference can be large: one ROE in our sample that includes both 
calculations shows a total CRE concentration of 432 percent when using 
tier 1 capital and 341 percent when using total risk-based capital. 
However, the difference also can be smaller: one ROE in our sample has 
a concentration calculated with tier 1 capital at 141 percent; with 
total risk-based capital it was 133 percent. While FDIC clarified to 
its examiners in April 2010 how to calculate CRE concentrations, other 
regulators have not done so. Moreover, two of the FDIC ROEs in our 
sample that use only tier 1 capital in the calculation were issued 
after the April 2010 clarification. 

Regulatory Officials' Differing Views on the Adequacy of the 2006 CRE 
Concentration Guidance Could Lead to Inconsistent Treatment of CRE 
Loans: 

Senior officials and field examiners have differing views on whether 
the 2006 CRE guidance is sufficient in addressing CRE concentration 
risks. We interviewed about 200 field staff associated with the bank 
examination review process at FDIC, the Federal Reserve, and OCC in 
Atlanta, Boston, Dallas, and San Francisco.[Footnote 56] A number of 
field examiners from all the agencies stated they did not have the 
tools to proactively address growing CRE concentrations when the 
economy was strong or that some banks ignored examiners' concerns on 
CRE risk management. A number of examiners also admitted that during 
strong economic times they could have been more assertive in asking 
banks to implement risk-management changes related to CRE 
concentrations. When asked whether limits on CRE concentrations should 
be considered or whether specific amounts of capital should be 
required at certain concentration levels, some examiners did not think 
that limits were the answer, but others thought that there might be 
some level of concentration that was too high even when managed well, 
because a market downturn would expose banks to significant losses. In 
addition, some thought that a focus on additional capital would be 
sensible given the severe capital shortfalls some banks with CRE 
concentrations faced during the financial crisis. 

Senior regulatory officials with whom we spoke had differing views on 
whether the 2006 guidance was sufficient for examiners to address the 
buildup in CRE concentration risks. FDIC senior officials stated that 
the current guidance was sufficient for examiners to address risks 
related to CRE concentrations and did not think changes were needed. 
In contrast, OCC has been reviewing whether particular capital 
requirements should be set for banks that have higher CRE 
concentrations and stated that this could lead to changes in OCC or 
interagency guidance. At the Federal Reserve, senior officials 
believed that the existing 2006 guidance was largely sufficient, but 
noted that efforts to clarify expectations for stress testing and 
capital planning were ongoing. The examiners and senior officials with 
whom we spoke agreed that determining certain limits on CRE 
concentrations, or requiring specific amounts of additional capital 
for certain levels of CRE concentrations, would be difficult and 
require significant study. Federal Reserve officials also noted that 
limits or specific capital requirements would require studies on the 
potential effect on credit availability. Examiners exercise 
significant judgment during examinations, and different perceptions 
about the 2006 guidance among regulators could send mixed signals to 
examiners--which could affect how they apply the guidance. In 
addition, as noted earlier, the regulators' processes to review and 
monitor application of examiner guidance and our review of ROEs 
identified some inconsistencies. Monitoring and revising existing 
controls, such as guidance, is a key component of a strong internal 
control system and reflects management's efforts to implement findings 
from quality control processes. 

Multiple Factors Can Affect Banks' Lending Decisions, Including 
Regulators' Actions: 

Capital Requirements Can Affect Lending: 

Regulators require banks to maintain certain minimum capital 
requirements to help ensure the safety and soundness of the banking 
system. However, increases in capital requirements can raise the cost 
of providing loans, which would lead to higher interest rates for 
borrowers, tighter credit terms, or reduced lending. While capital 
provides an important cushion against losses for banks, there is a 
trade-off between building up this cushion to provide greater 
protection against unexpected losses and increasing lending and 
returns to shareholders. Holding more capital against each loan means 
less equity is available to return to shareholders or back new 
loans.[Footnote 57] 

Empirical literature generally supports this basic understanding of 
the impact of bank capital requirements on lending. For example, 
researchers found in one study that bank capital requirements 
substantially affected bank loan growth during the last economic 
downturn. Specifically, in evaluating bank regulatory agreements in 
New England, researchers found that capital requirements significantly 
affected the lending behavior of banks. They noted that those banks 
with "low or no profits and an inability to obtain new capital at 
reasonable rates" decreased their assets and liabilities to meet the 
higher capital-to-asset ratios required by regulatory enforcement 
actions.[Footnote 58] Using the "capital crunch hypothesis," the 
researchers found that institutions with lower capital ratios had 
slower loan growth (or loans shrank more rapidly) to try to satisfy 
capital requirements.[Footnote 59] 

High Concentrations in CRE Can Inhibit Banks' Ability to Lend, 
Especially during a Credit Downturn: 

Banks with capital bases that have been negatively affected by losses 
in their CRE portfolios--or those trying to improve their capital 
ratios or ALLL to guard against potential losses--may need to reduce 
lending to maintain an adequate capital-to-assets ratio on their 
balance sheets. Although limited research exists on the impact of CRE 
loan concentrations on a bank's ability to lend, an existing study 
shows that high CRE concentrations can limit loan growth during 
economic downturns. For example, this study found that banks with high 
CRE concentrations before the recent financial crisis made loans to 
other sectors of the economy during this crisis at a "significantly 
slower rate" than banks that did not have high CRE exposure.[Footnote 
60] In addition, the researchers found that the higher the bank's CRE 
concentration prior to the crisis, the more its non-CRE lending slowed 
during the crisis. The reasons for the contraction of non-CRE lending 
during the crisis are being examined. The authors hypothesize that the 
rise in CRE lending and the substantially increased delinquencies on 
these loans "could have inhibited banks' willingness or ability to 
lend to other segments of the economy--particularly when banks' demand 
for liquidity and capital was high." The authors also cite the 
possibility that high-CRE banks may have failed at a greater rate than 
banks without that level of CRE exposure. 

Limited Research from Past Downturns on the Effect of Examiner Actions 
on Lending Suggests It Is Minimal: 

Our assessment of existing studies and interviews with bank officials 
found that market factors tend to drive CRE downturns and suggests 
that the regulatory effect of examiner actions on such downturns--as 
evidenced in studies of the downturn of the 1990s--was minimal. 
Bankers we interviewed attributed the CRE downturn to market factors 
such as problems in residential real estate that affected the CRE 
market and the severity of the broader financial and economic crisis. 
Although bankers did not state that regulatory policies were the cause 
of the CRE downturn, many noted that examiner actions were 
exacerbating it and a few stated banks needed to be given time to work 
through their troubled assets so they could continue to lend and 
support the economy. Other bankers stated that examiners have been 
impeding banks' ability to make new loans--especially if the bank 
already had high CRE concentrations. That said, a few bankers noted 
that CRE loan demand from creditworthy borrowers was down 
significantly, and this was inhibiting loan growth. 

There is limited research on the effect of examiner actions on credit 
cycles; however, the studies that exist suggest the effects are 
minimal. Specifically: 

* In an analysis of the credit crunch from 1989 to 1992, researchers 
found modest support for the hypothesis that increased regulatory 
"toughness" occurred and that this affected bank lending. In a 
comprehensive study spanning the last financial crisis, three 
hypotheses were tested regarding changes in regulatory toughness and 
its impact on bank lending.[Footnote 61] The data provided what the 
authors call modest support for all three hypotheses that: (1) 
toughness increased during the credit crunch from 1989 through 1992, 
(2) it declined during the boom from 1993 through 1998, and (3) 
differences in toughness affected bank lending. During the credit 
crunch they studied, the data show no more than 1 percent additional 
loans receiving classification or worsening of classification status. 
During the boom, the data show a similar change for a decrease in loan 
classifications. The authors also reviewed the economic significance 
of changes in regulatory "toughness" and found that growth in the 
number of classified assets by 1 percent would be predicted to 
decrease the ratio of real estate loans to gross total assets by less 
than 1 percentage point over the long term, and frequently this impact 
was projected to be significantly less than 1 percentage point. 
Changes in CAMEL ratings were not found to have a "consistent" impact 
on future lending behavior, and when there was an impact, the data 
show that it was minimal.[Footnote 62] 

* Another article specifically focuses on how changes in CAMEL ratings 
affected loan growth from the period that spanned 1985-2004.[Footnote 
63] During the 1985-1993 credit crunch, the authors found some 
evidence that changes in CAMEL ratings, both the composite and the 
components, had a significant impact on loan growth for commercial and 
industrial loans but a smaller effect on consumer loans and real 
estate loans.[Footnote 64] However, the authors found minimal evidence 
that adjustments in CAMEL ratings, including both composite and 
component ratings, had any systematic effect on loan growth during 
what they define as an economic recovery period (1994-2004). The 
researchers also noted that, based on their research, banks may 
respond "asymmetrically" to changes in CAMEL ratings. Specifically, 
banks may decrease loan growth when their CAMEL ratings are 
downgraded, but they do not necessarily increase it when their CAMEL 
ratings are upgraded. 

* These studies suggest examiners' actions can affect lending, albeit 
minimally. However, the research suggests that regulators were more 
stringent during the past credit crunch, even holding financial 
conditions constant. Therefore, regulators should be aware of how 
their actions can affect broader credit markets, and help ensure that 
their actions do not contribute to unnecessary procyclical effects: 
that is, magnification of economic or financial fluctuations. 

Regulators Are Aware of the Need to Moderate the Potential Procyclical 
Effects of Regulation: 

In the aftermath of the recent financial crisis, regulators in the 
United States and abroad have been attempting to address the 
procyclical effects of their actions. The procyclical effects of 
regulation may not adequately discourage overly risky behavior during 
economic upswings or may inhibit bank lending during downturns, as 
banks may need to meet more stringent requirements during times when 
it is more difficult to do so. For instance, if regulators increase 
capital requirements at the same time that losses from an economic 
downturn decrease banks' capital, banks may be less able to lend while 
they seek to rapidly raise additional capital. This can exacerbate 
downswings in credit cycles. 

Consistent and balanced application of policy guidance in strong and 
weak economic times is important to avoiding unnecessary procyclical 
effects. Regulatory efforts to better ensure that guidance is applied 
consistently during strong and weak economic periods helps to ensure 
that regulatory policies do not exacerbate economic upturns or 
downturns.[Footnote 65] While bankers with whom we spoke understood 
why examiners were looking more closely at CRE loans given the 
market's downturn, a few said the shift to closer review and attention 
was a difficult adjustment. Bank examiners with whom we spoke in the 
field offices also noted that problems can be difficult to identify 
during strong economic times. 

Discussions about the procyclicality of regulation have been a central 
feature of recent deliberations on revised capital requirements among 
U.S. banking regulators and the Basel Committee for Banking 
Supervision. The discussions have been seeking to address the 
procyclical effects of capital requirements by having banks raise 
additional capital, commensurate with risks, during times of economic 
growth. In December 2010, the Basel Committee released the framework 
for Basel III, which includes increased and higher-quality capital 
requirements, enhanced risk coverage, the establishment of a leverage 
ratio as a "backstop" to the risk-based requirement, steps to 
encourage the "build up" of capital that can be used to absorb losses 
during "periods of stress," and the introduction of two global 
liquidity standards. As part of the establishment of procedures to 
help ensure the consistent global application of this framework, the 
Basel Committee has developed standards that will be implemented 
gradually so that banks make the shift to higher capital and liquidity 
standards while "supporting lending to the economy."[Footnote 66] 

Federal bank regulators also have acknowledged the importance of 
addressing procyclicality in regulatory requirements and have made 
efforts in this regard. For example, the Chairman of the Federal 
Reserve has stated the importance of regulators acknowledging the 
significance of procyclicality and he has noted that both the Basel 
Committee and the Financial Stability Forum have worked to address 
this as it relates to capital requirements. In addition, FASB has 
issued accounting guidance aimed at changes to mark-to-market 
accounting for assessing asset values in inactive markets. More 
recently, in May 2010, FASB released a proposed Accounting Standards 
Update, which encompassed proposals on the impairment of financial 
assets and suggested implementing a more forward-looking impairment 
model.[Footnote 67] Based on exposure draft comments, in January 2011 
FASB proposed with the International Accounting Standards Board a 
common solution on how to account for the impairment of financial 
assets and presented the document for public comment. Efforts such as 
these seek to address procyclicality concerns related to capital and 
accounting requirements, while the potential procyclical effects of 
examiners' application of policy guidance is something regulators 
consider in their supervision of banks, according to regulatory 
officials with whom we spoke. The recent financial crisis underscored 
how important it is for regulators to evenly apply guidance during 
strong economic periods, although this was not always the case, as 
previously noted. Consistent application of guidance is important to 
avoid unduly hampering credit provision throughout the economy. 

Conclusions: 

CRE still is working through a downturn sparked by the broader 
financial crisis, presenting an ongoing challenge to community banks 
and regulators. While community banks have been working through the 
challenges associated with many years of past growth in CRE 
concentrations, CRE portfolios continue to have a significant effect 
on community bank balance sheets as loan delinquencies and charge-offs 
remain historically high. Community banks continue to seek ways to 
work with their borrowers and shore up capital to remain solvent, but 
the current economic environment and the expectation that refinancing 
of CRE loans will bring a new round of market stress suggest many 
community banks may face these challenges for some time. And, because 
community banks tend to provide a greater proportion of their loans to 
small businesses, the availability of credit to small businesses could 
be constrained while community banks work through these difficulties. 

Prior to the financial crisis, regulators' efforts included guidance 
on CRE concentrations and risk management, but these efforts were not 
as robust as they could have been in addressing CRE risks. Since the 
financial crisis, the shift in examination focus and differences in 
the application of the CRE concentration guidance has contributed to 
concerns among community banks about regulatory stringency. That is, a 
number of bankers remain concerned that regulators have become more 
stringent in reviewing CRE loans since the crisis, which could be 
explained partly by regulators re-emphasizing fundamentals and 
addressing lessons learned from the crisis. While we and the 
regulators have reviewed examiner application of the CRE guidance and 
generally found examiners' actions were accurate or well-supported, 
some inaccuracies and inconsistencies were evident--particularly 
relating to the 2006 guidance. Regulators have mixed views about the 
adequacy of the 2006 guidance. Our findings from an analysis of ROEs 
were similar to those of the regulators' internal reviews and 
assessments, which raised questions about the consistency of policy 
guidance application. Given these findings, and in light of lessons 
learned from the recent financial crisis and CRE market downturn, the 
regulators could reassess the adequacy of the guidance. Revising or 
supplementing the guidance to provide more details about risk-
management practices and examples of when to reduce CRE concentrations 
would help both examiners and bankers better understand how to assess 
and manage such concentrations. Furthermore, incorporating CRE-
specific analyses into the scope of internal and quality assurance 
reviews--at least while CRE issues remain a concern--will help ensure 
consistent application of the guidance and produce clearly articulated 
support in examination reports for requiring reduced concentrations. 
In this way, regulatory management can better ensure that examination 
practices related to CRE concentrations and risks will be carried out 
consistently from examiner to examiner and across regulators. 
Consistent treatment also will make clear to banks what regulatory 
expectations are for managing CRE concentration risks. 

Given the key role community banks play in business lending, bank 
regulators are aware of the potential effects of their actions in 
exacerbating the credit cycle. Many factors can affect a bank's 
decision to lend, including regulatory requirements. But if such 
requirements are too stringent, they can unduly limit lending. Such 
limits on lending can have widespread effects on the economy, as 
acknowledged in Basel Committee for Banking Supervision discussions on 
capital requirements. Although isolating the impact of bank 
supervision is difficult, the recent severe cycle of credit upswings 
followed by the downturn serves as a useful reminder of the 
supervisory balance needed to help ensure the safety and soundness of 
the banking system and support economic recovery. 

Recommendations for Executive Action: 

To improve supervision of CRE-related risks, we recommend that the 
Chairman of the Federal Deposit Insurance Corporation, the Chairman of 
the Board of Governors of the Federal Reserve System, and the 
Comptroller of the Currency: 

* Enhance and either re-issue or supplement interagency CRE 
concentration guidance--based on agreed-upon standards by FDIC, the 
Federal Reserve, and OCC--to provide greater clarity and more examples 
to help banks comply with CRE concentration and risk-management 
requirements and help examiners ensure consistency in their 
application of the guidance, especially related to reductions in CRE 
concentrations and calculation of CRE concentrations. 

* After issuing revised or supplemental CRE concentration guidance, 
incorporate steps in existing review and quality assurance processes, 
as appropriate, to better ensure that the revised guidance is 
implemented consistently and that examiners clearly indicate within 
bank examination reports the basis for requiring a bank to reduce CRE 
loan concentrations. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to FDIC, the Federal Reserve, and 
OCC for review and comment. All of the agencies provided written 
comments that we have reprinted in appendixes III, IV, and V, 
respectively. The agencies also provided technical comments, which we 
considered and have incorporated as appropriate. 

In written comments, the Federal Reserve welcomed our recommendations 
to improve CRE concentrations guidance to help banks and examiners 
comply with it, and to ensure consistent implementation of such 
guidance. The Federal Reserve stated that it intends to work with its 
counterparts at the OCC and FDIC to develop and implement enhancements 
to CRE concentrations guidance. 

In its written comments, the OCC agreed with our conclusions and 
recommendations. OCC noted that community banks' increased CRE 
concentrations exposes them to CRE market declines, which may require 
more explicit regulatory expectations for the robustness of risk- 
management systems, stress testing, capital planning, and capital 
levels when CRE concentrations increase. OCC also stated that it would 
discuss with the other federal banking regulators how to enhance the 
2006 CRE concentrations guidance and would ensure the consistent 
implementation of any revised or supplemented guidance. 

In written comments, FDIC stated that it has already supplemented the 
2006 CRE concentrations and risk-management guidance--citing a 2008 
Financial Institution Letter, divisionwide training, and internal 
reviews. As noted in our report, the federal banking regulators all 
have numerous controls to help ensure examination consistency, such as 
training and internal reviews that FDIC highlights in its letter. 
Nonetheless, our review of ROEs from all three regulators, and their 
own internal reviews, uncovered instances of inconsistency in the 
treatment of CRE loans and application of the 2006 CRE guidance-- 
demonstrating that no regulator was immune from consistency issues. We 
also noted in our report some concerns raised by bank examiners and 
bankers about applying the 2006 guidance, such as whether the current 
CRE concentration thresholds are hard limits, how the CRE 
concentrations should be calculated, and whether specific amounts of 
additional capital should be required for banks with elevated CRE 
concentrations. Though FDIC provided clarification on CRE risk 
management in March 2008 that could contribute to interagency action 
on CRE guidance, this guidance does not address all of the concerns 
raised more recently by examiners and bankers that we describe in the 
report, nor was it developed in conjunction with the other regulators. 
Therefore, we continue to believe that our recommendations on enhanced 
or clarified CRE concentration guidance--on an interagency basis that 
involves the FDIC--would help bankers and examiners better understand 
how to comply with CRE risk management requirements and help ensure 
the consistent application of such requirements. 

FDIC also cited a study by the Bank for International Settlements that 
concluded the social benefits of higher bank capital requirements 
outweigh the large reductions in economic activity from a banking 
collapse. As our report notes, additional capital provides an 
important cushion against losses, though this comes at a cost. From 
our review of the literature, there is disagreement on the magnitude 
of such costs on lending. We added information to the report to 
clarify this issue, which includes information on the study cited by 
FDIC. 

We are sending copies of this report to FDIC, the Federal Reserve, 
OCC, and other interested parties. The report also is available at no 
charge on the GAO Web site at [hyperlink, http://www.gao.gov]. 

If you or your staffs have any questions about this report, please 
contact A. Nicole Clowers at (202) 512-8678 or clowersa@gao.gov. 
Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this report. GAO staff who 
made major contributions to this report are listed in appendix VI. 

Sincerely yours, 

Signed by: 

A. Nicole Clowers: 
Acting Director Financial Markets and Community Investment: 

[End of section] 

Appendix I: Scope and Methodology: 

To assess the condition of the commercial real estate (CRE) market and 
the implications for community banks, we collected and analyzed the 
following data to provide information on overall trends in CRE: 

* To determine trends in CRE prices, we analyzed monthly data from 
Moody's/REAL Commercial Property Price Index from January 2002 through 
December 2010. We assessed their reliability for the purposes of 
providing a picture of the trends in CRE prices by reviewing 
documentation on how the data were collected and reviewed for 
accuracy. We determined that the data were sufficiently reliable for 
the purpose of determining price trends. 

* To determine when CRE loans would be up for refinancing and what 
percentage of CRE loans were "underwater," we analyzed data on CRE 
loan volume by maturity schedule and underlying collateral value 
provided by Trepp, a commercial mortgage analysis firm. To determine 
the accuracy of these data, we discussed the data with officials and 
reviewed documentation on their data quality processes. We determined 
that the data was sufficiently reliable for purposes of determining 
when CRE loans were maturing and how many were underwater. 

To understand how the condition of the CRE market has affected 
community banks, we analyzed call report data from the Federal Deposit 
Insurance Corporation (FDIC) for banks with assets of less than $1 
billion to assess (1) CRE loan concentrations as a percent of total 
loans and leases, (2) trends in CRE loan concentrations as a percent 
of total risk-based capital, (3) trends in CRE loans that were 
noncurrent, and (4) trends in CRE loans charged off. We assessed 
changes in the rate of noncurrent CRE loans and CRE loan charge-offs 
over time. We also calculated average CRE concentration rates at 
community banks from 1996 through 2010 by taking the aggregate 
reported total of loans secured by CRE (the sum of construction and 
development, nonfarm nonresidential, and multifamily residential real 
estate) divided by the reported amount of total risk-based capital. We 
conducted similar analyses for commercial banks with assets more than 
$1 billion. We assessed the reliability of the call report data by 
reviewing the controls in place to help ensure its accuracy and by 
relying on past GAO reviews of these data. We determined that they 
were sufficiently reliable for the purpose of determining trends in 
CRE loan concentrations and performance at community banks. 

Reports by the inspectors general of the federal banking regulators 
provided additional information on the effect of the CRE market 
downturn on community banks. We reviewed all 106 of the material loss 
reviews (MLR) issued by the offices of the inspectors general of the 
Board of Governors of the Federal Reserve System (Federal Reserve), 
FDIC, and U.S. Department of the Treasury (for the Office of the 
Comptroller of the Currency, or OCC) from 2009 and 2010. In reviewing 
the MLRs, we noted which ones cited concentrations in either overall 
CRE or acquisition, development, and construction loans (ADC) as a 
factor in the bank's failure. We also interviewed officials at the 
Conference of State Bank Regulators on the findings of their 
independent review of the MLRs. 

Additional reports provided background and information on the overall 
condition of CRE markets and their impact on community banks. The 
reports we reviewed were culled from research and literature reviews 
from academic journals, the Congressional Research Service, the 
Congressional Oversight Panel, FDIC, the Federal Reserve, and previous 
GAO reports. We also spoke with and reviewed speeches and public 
comments from officials at FDIC, the Federal Reserve, and OCC; bank 
officials; and academics and a think tank official with expertise on 
bank examinations or CRE. 

To determine how the banking regulators responded to trends in the CRE 
market, we interviewed regulatory and bank officials and reviewed 
reports of examination (ROE) from a sample of banks.[Footnote 68] Our 
sample selection for bank interviews and reviews of ROEs started with 
a data request to FDIC, the Federal Reserve, and OCC on bank 
examinations for banks with assets of less than $1 billion with data 
elements that included the value of their CRE loans, recent CAMELS 
ratings, total risk-based capital, recent enforcement actions, and 
other information.[Footnote 69] We determined that the data were 
sufficiently reliable for the purposes of selecting a sample, based on 
prior use of these data and interviews with agency officials. We 
further refined the sample so that we would have a breadth of banks 
for interviews and ROE reviews, based on the state in which they were 
located, their CAMELS composite rating, and their regulator. We also 
wanted to increase the likelihood that banks we sampled were relevant 
to our study; therefore, we selected banks with elevated CRE and ADC 
concentrations and those that had a recent bank examination. To 
achieve these goals, we selected the sample as follows. 

* From the bank examination information we received from the 
regulators, we selected banks from California, Georgia, Massachusetts, 
and Texas. We selected these states because the banks in the first two 
states have had a relatively greater share of CRE-related 
nonperforming loans, and the latter two states a relatively smaller 
share of such loans (as measured by the percentage of CRE loans past 
due or in nonaccrual).[Footnote 70] We also wanted to include states 
from different regions of the country. To inform the selection, we 
conducted an analysis of call report data downloaded from SNL 
Financial and held discussions with the federal banking regulators. We 
analyzed the following data points for commercial banks with assets of 
less than or equal to $1 billion: (1) loans and leases for 
construction and land development, multifamily, owner-occupied real 
estate, other property, and nonfarm nonresidential; (2) loans 90 days 
past due for each of these categories; and (3) loans in nonaccrual 
status for each of these categories. We reviewed these commercial 
banks in each of the 50 states in relation to these measures and total 
assets in CRE loan categories, and arrived at our four states. We 
reviewed SNL data reliability and determined that it was sufficient 
for the purposes of selecting states for our sample. 

* We further refined the sample to include only banks that had an 
examination conducted after October 2009, to capture those 
examinations for which the 2009 CRE loan workout guidance would have 
applied.[Footnote 71] 

* From that subset, we placed banks into four "pools," with the goal 
of speaking with officials from, and reviewing ROEs for, a breadth of 
community banks from a range of states in our sample, from all three 
of the banking regulators, and with a range of CAMELS ratings. 

- Pool 1 consisted of banks with good CAMELS composite ratings and 
high CRE concentrations. In this group, we included banks with a 
CAMELS composite rating of 1 or 2 and a CRE concentration above 300 
percent of CRE loans (including owner-occupied) to total capital. By 
including owner-occupied loans, we would ensure the largest possible 
pool of banks and also identify concerns that such banks might have 
about regulatory treatment of their CRE loans. 

- Pool 2 consisted of banks that generally were in good condition but 
also had ADC concentrations. Pool 2 criteria were a CAMELS composite 
rating of 2 and both a 300 percent or greater concentration in overall 
CRE and a 100 percent or greater concentration in ADC loans to total 
capital. 

- Pool 3 banks were intended to represent banks that were struggling 
and that had a higher number of loans classified as loss at the most 
recent examination. These had a CAMELS composite rating of 3, an 
overall CRE concentration of 300 percent or greater, and a proportion 
of loans classified loss to total assets in the 75th percentile and 
above, for banks within our sample. This "loss ratio" was calculated 
by taking the total assets classified loss for the most recent 
examination and dividing them by total assets. 

- Pool 4 was the most distressed pool of banks and consisted of banks 
with CAMELS composite ratings of 4 or 5, a 300 percent or greater 
concentration in overall CRE in the 75th percentile or greater for the 
banks in our sample, and a loss ratio in the 75th percentile of our 
sample, calculated as described above. 

* Once we selected these pools, we began contacting banks to 
interview. We simultaneously began requesting ROEs and some related 
workpapers from the federal banking regulators. In that process, we 
learned that FDIC and Federal Reserve data included ROEs led by the 
state banking regulator (because they share examination 
responsibilities with state examiners), and we excluded these from our 
sample. 

The resulting sample from this process is outlined below, broken down 
by regulator (table 5), state (table 6), and CAMELS ratings (table 7). 
OCC-supervised banks represent the greatest number of banks in our 
sample, in part because a number of the examinations in our sample for 
the Federal Reserve and FDIC were led by the state regulator and were 
out of the scope of our review. To avoid overweighting the sample with 
OCC-supervised banks, we randomly removed some OCC-led bank 
examinations for which we had a sufficient number of cases: banks 
rated 2 in Texas. 

Table 5: Sample Selection by Regulator for ROE Analysis: 

Agency: FDIC; 
Number: 21; 
Percent of total: 38%. 

Agency: Federal Reserve; 
Number: 12; 
Percent of total: 22%. 

Agency: OCC; 
Number: 22; 
Percent of total: 40%. 

Agency: Total; 
Number: 55; 
Percent of total: 100%. 

Source: GAO. 

[End of table] 

Table 6: Sample Selection by State for ROE Analysis: 

State: California; 
Number: 16; 
Percent of total: 29%. 

State: Massachusetts; 
Number: 5; 
Percent of total: 9%. 

State: Georgia; 
Number: 12; 
Percent of total: 22%. 

State: Texas; 
Number: 22; 
Percent of total: 40%. 

State: Total; 
Number: 55; 
Percent of total: 100%. 

State: Total for Massachusetts plus Texas (fewer CRE problems); 
Number: 27; 
Percent of total: 49%. 

State: Total for California plus Georgia (more CRE problems); 
Number: 28; 
Percent of total: 51%. 

Source: GAO. 

[End of table] 

Table 7: Sample Selection by CAMELS Composite Rating for ROE Analysis: 

CAMELS composite rating: CAMELS 1; 
Number: 4; 
Percent of total: 7%. 

CAMELS composite rating: CAMELS 2; 
Number: 24; 
Percent of total: 44%. 

CAMELS composite rating: CAMELS 3; 
Number: 14; 
Percent of total: 25%. 

CAMELS composite rating: CAMELS 4; 
Number: 3; 
Percent of total: 5%. 

CAMELS composite rating: CAMELS 5; 
Number: 10; 
Percent of total: 18%. 

CAMELS composite rating: Total; 
Number: 55; 
Percent of total: 100%. 

CAMELS composite rating: Total 1 and 2 rated; 
Number: 28; 
Percent of total: 51%. 

CAMELS composite rating: Total 3 rated; 
Number: 14; 
Percent of total: 26%. 

CAMELS composite rating: Total 4 and 5 rated; 
Number: 13; 
Percent of total: 24%. 

Source: GAO. 

[End of table] 

To further understand how FDIC, the Federal Reserve, and OCC have 
responded to the CRE downturn and its effect on community banks, we 
collected and analyzed interagency policy guidance to examiners 
related to CRE loan treatment and interagency statements on lending, 
and also assessed regulatory efforts to address CRE-related concerns. 
As part of this work, we observed examiner training at FFIEC provided 
to commissioned examiners, to include a week-long training on CRE and 
a day-long training on regulatory updates related to policy guidance 
on CRE loans. 

To understand banks' concerns about examiners' treatment of their CRE 
loans and how examiners supported findings related to CRE loans, we 
interviewed bank and regulatory officials and analyzed ROEs. 

* We spoke with community bank officials affiliated with 43 community 
banks in a number of states (see table 8). Most of the bank officials 
with whom we spoke were located in California, Georgia, and Texas 
based on our nonprobability sample. We initiated contact with 62 banks 
drawn from this sample and interviewed all of the 21 bank officials 
who responded to us. We gained additional bank views by supplementing 
this sample. Specifically, we interviewed officials from 22 additional 
banks that either testified before Congress on the issue of CRE, were 
identified to us through bank associations, or had learned of our work 
and wanted to talk to us. When we summarize statements from our 
interviews with bank officials throughout this report, we use the term 
"a few" to refer to 3-10 of 43 banks making the statement; "some" to 
refer to 11-25 of 43 banks making the statement; and "many" to refer 
to 26-43 banks making a statement. We do not provide specific numbers 
in the body of the report to avoid overstating the precision of the 
results from the nonprobability sample we used to select bank 
interviewees. 

Table 8: Locations of Banks Whose Officials We Interviewed: 

State: California; 
Banks: 12. 

State: Florida; 
Banks: 4. 

State: Georgia; 
Banks: 5. 

State: Illinois; 
Banks: 2. 

State: Kansas; 
Banks: 1. 

State: Massachusetts; 
Banks: 1. 

State: Maryland; 
Banks: 2. 

State: Michigan; 
Banks: 1. 

State: North Carolina; 
Banks: 1. 

State: New Jersey; 
Banks: 1. 

State: New Mexico; 
Banks: 1. 

State: Ohio; 
Banks: 1. 

State: Oklahoma; 
Banks: 1. 

State: South Carolina; 
Banks: 1. 

State: Texas; 
Banks: 8. 

State: Wisconsin; 
Banks: 1. 

Source: GAO. 

[End of table] 

* We interviewed more than 230 regulatory field staff at FDIC, 
throughout the Federal Reserve System, and at OCC--along with 
additional staff at these regulators' headquarters--to seek views and 
information about recent practices on CRE-specific guidance related to 
loan workouts and concentrations, training provided on the guidance, 
CAMELS ratings, capital requirements, and liquidity issues. The 
interviews were conducted at headquarters offices in Washington, D.C., 
and by telephone, video teleconference, and in person at district, 
regional, and field offices in California, Colorado, Georgia, 
Massachusetts, and Texas. We sought to determine if there were 
different views or practices related to CRE loan treatment among 
regulatory roles or between those in headquarters and the field 
offices, and therefore we interviewed staff in a range of roles and 
locations. The staff with whom we spoke in field locations included 
field examiners, their supervisors, case managers, analysts (at OCC), 
and senior management. Examiners were interviewed both in group 
settings and individually, and included those who served as examiners- 
in-charge (EIC) for ROEs in our sample. Examiners interviewed in group 
settings were gathered by the field offices, and based on our request, 
had a range of experience (either less than 5 years or more than 5 
years, because examiners are usually commissioned within 5 years). 
Individual meetings with EICs were held based on our nonprobability 
sample. Of the field staff we interviewed, about 200 were directly 
involved in drafting or reviewing ROEs, and about 50 of the 200 were 
in senior management positions. 

* We analyzed 55 ROEs based on our nonprobability sample, as described 
above, of banks in California, Georgia, Massachusetts, and Texas. We 
reviewed how examiners supported statements related to banks' CRE loan 
workouts, concerns about CRE concentrations, and how examiners 
calculated CRE concentrations. 

To understand the controls the regulators have in place to help ensure 
consistent application of policy guidance, we reviewed the examination 
report review process at all of the regulators based on regulatory 
guidance and interviews with regulatory officials. We also collected, 
compared, and analyzed examination review reports and quality 
assurance processes for the three regulators to determine what 
processes were in place to identify and address inconsistencies among 
examiners, and what findings had resulted from these reviews. For 
FDIC, we reviewed reports conducted by FDIC's Internal Control and 
Review Section for the Atlanta, Dallas, New York, and San Francisco 
regions, because these regions covered the states in our 
nonprobability sample. For OCC, we reviewed reports from all four of 
its districts related to the agency's quality assurance process that 
focused on reviewing the classifications of CRE loans. For the Federal 
Reserve, we reviewed a special engagement report from the General 
Auditor at the Federal Reserve Bank of Atlanta and a Quality Assurance 
memorandum for the Atlanta, Kansas City, Philadelphia, and Richmond 
districts. We also discussed with Federal Reserve staff whether other 
similar studies existed. 

To determine and assess the factors that can affect banks' lending 
decisions and their impact, we reviewed and summarized academic 
studies that included analysis of various factors on bank lending. 
With assistance from a research librarian, we conducted searches of 
research databases and report sources (Congressional Research Service, 
Congressional Budget Office, JSTOR, ProQuest, EconLit, Accounting and 
Tax Database, and Social Science Search). We also sought and reviewed 
studies cited by the American Bankers Association (ABA) and the 
Independent Community Bankers of America (ICBA). All studies included 
published papers released between 1991 and 2010. Based on our 
selection criteria, we determined that six studies were sufficient for 
our purposes. Specifically, with the assistance of a senior economist, 
we analyzed the methodologies underlying these studies and determined 
that they were the most relevant to our study and also had robust 
controls. Nonetheless, the research conducted in this area is not 
exhaustive and focuses primarily on what occurred during the previous 
economic downturn of the late 1980s and early 1990s. However, we did 
identify one study that examines the role of CRE and its effect on 
bank lending in the current financial crisis. To further demonstrate 
how loan losses, allowance for loan and lease losses, and capital 
requirements can affect lending, we developed an illustrative example 
of how loan losses affect capital ratios on a bank's balance sheet, 
with assistance from certified public accountants. To obtain 
information on how examiner practices may affect lending, we 
interviewed bankers, examiners, and regulatory officials. We also 
interviewed officials from ABA, the Conference of State Bank 
Supervisors, and ICBA. 

[End of section] 

Appendix II: ALLL and Loan Loss Impact on Capital: 

Increases in capital requirements or the allowance for loan and lease 
loss (ALLL) can affect a bank's ability to lend. Figure 6 illustrates 
relationships between loan losses, bank balance sheets, and capital 
requirements under certain assumptions. In this simplified example, 
the bank begins with $1,000 in assets ($1,010 in loans and $10 in 
ALLL), $900 in liabilities, and $100 in capital, which equates to a 
total capital ratio of 10 percent (calculated by dividing total 
capital by total assets).[Footnote 72] In this example the bank has 
analyzed the collectibility of its loans and decided to add $20 to its 
ALLL in anticipation of loan losses. Provisions for these losses 
increase the ALLL, which in turn are charged to the bank's expenses, 
reduce income, and therefore reduce retained earnings that are 
included as part of total capital. As a result, the capital ratio 
falls to 8.2 percent. If the bank identifies as uncollectible and 
charges off a $20 loan that it holds as an asset, given the 
assumptions in the example, the bank's total loans and ALLL would each 
decline by $20 with no change in capital. If the bank conducts another 
analysis of its loan collectibility and decides to add to its ALLL, 
then its capital would be further reduced. 

Figure 6: Illustration of How ALLL and Loan Losses Can Affect Capital 
Ratios on a Bank's Balance Sheet: 

[Refer to PDF for image: illustration] 

Capital ratio = capital/assets: 

Original with 1 percent allowance for loss: 
Bank provides $10 for estimated loan losses in the ALLL, or 1% of its 
loans held on balance sheet. 

Loans: $1,010; 
allowance: -$10; 
Assets: $1,000. 

Liabilities: $900; 
Capital: $100; 
capital ratio: 10%. 

Revised with 3 percent allowance for loss: 
After analyzing loan collectibility, bank raises ALLL to 3% of loans in
anticipation of greater losses. The increase in the ALLL (a charge to
expenses that reduces the retained earnings portion of capital) causes 
net assets and the capital ratio to decline. 

Loans: $1,010; 
allowance: -$30; 
Assets: $980. 

Liabilities: $900; 
Capital: $80; 
capital ratio: 8.2%. 

Revised with charge-off of $20 loan: 
The bank charges off a $20 loan, identified as uncollectible in the 
ALLL, bringing ALLL to $10. 

Loans: $990; 
allowance: -$10; 
Assets: $980. 

Liabilities: $900; 
Capital: $80; 
capital ratio: 8.2%. 

Revised ALLL: 
Bank analyzes loans for collectibility and raises the ALLL to $20 as a 
result of greater estimated loan losses. The $10 increase in the ALLL 
is charged to expenses, which reduces capital. 

Loans: $990; 
allowance: -$20; 
Assets: $970. 

Liabilities: $900; 
Capital: $70; 
capital ratio: 7.2%. 

Source: GAO. 

[End of figure] 

For this example, if the bank decides to--or is required to--meet a 10 
percent capital ratio after adding to its ALLL to cover estimated 
future losses, it would need to raise capital by seeking it from the 
bank's owners or from investors. If the bank cannot raise additional 
capital because it is in poor financial condition, or chooses not to 
because the cost of capital is prohibitive, then it could, among other 
options, reduce its assets (perhaps by selling assets such as other 
real estate owned) to decrease liabilities or by paying off borrowings 
to increase the capital ratio. Reducing assets is often referred to as 
"shrinking the balance sheet." However, banks in better financial 
condition may be able to respond differently in the face of loan 
losses--they may be able to continue lending without raising 
additional capital or can rely on their stronger financial position to 
secure new capital. 

[End of section] 

Appendix III: Comments from the Federal Deposit Insurance Corporation: 

FDIC: 
Federal Deposit Insurance Corporation: 
Division of Risk Management Supervision: 
550 I7th Street NW: 
Washington, D.C. 20429-9990:	 

May 10,	2011: 

Mr. Richard J. Hillman: 
Managing Director: 
Financial Markets and Community Investment: 
United States Government Accountability Office: 
411 G Street N.W. 
Washington, D.C. 20548: 

Dear Mr. Hillman: 

The Federal Deposit Insurance Corporation (FDIC) reviewed the GAO 
report "Banking Regulation: Enhanced Guidance on Commercial Real 
Estate Risks Needed" (GA0-11-489). The FDIC agrees with the GAO's 
conclusion that examiners applied the 2006 Commercial Real
Estate (CRE) concentration guidance[Footnote 1] (Guidance) 
appropriately and their supervisory responses were accurate and well 
supported. The FDIC also agrees with the GAO's conclusion that the 
federal banking regulators have incorporated lessons learned from the 
crisis into their supervisory approach. 

The GAO recommended the federal banking regulators enhance or 
supplement the Guidance and take steps to better ensure the enhanced 
or additional guidance is applied consistently. While the severity of 
the financial crisis exposed areas for regulatory focus, especially 
with respect to the concentration of risk in CRE or other markets, the 
FDIC has implemented additional supplemental supervisory strategies 
that we believe supplement the existing Guidance. 

The Guidance provides a robust process for bankers and examiners to 
assess and monitor CRE portfolio risk and ensure banks are following 
safe-and-sound lending practices. In 2008, the FDIC supplemented the 
Guidance with a Financial Institution Letter (FIL), Managing
Commercial Real Estate (CRE) Concentrations in a Challenging 
Environment, as it was apparent that significant risks were emerging 
in CRE lending, particularly in the Acquisition Development and 
Construction (ADC) sector. This FIL emphasized to financial 
institutions the importance of CRE credit risk management, using 
available loan workout resources, maintaining appropriate capital and 
Allowance for Loan and Lease Losses levels, updating collateral 
valuations, and making prudent CRE and ADC loans available in local 
markets. 

Furthermore, since the beginning of the economic crisis, the FDIC 
applied a constructive and proactive approach to enhancing our 
supervision program. The Division of Risk Management Supervision 
conducted division-wide training during the first quarter 2010 to 
emphasize the analysis of risk management practices, which focused on 
analyzing CRE portfolio risk, and implementation of appropriate and 
timely corrective action. The FDIC follows a comprehensive quality 
assurance and internal review program to ensure examiners consistently 
apply policies and guidance, including those applicable to CRE loan 
concentrations. 

The GAO's report cites the research of a pair of authors to suggest 
that while higher bank capital requirements increase a bank's ability 
to absorb losses, they also constrain its ability to lend.
Other studies by academic economists and the Bank for International 
Settlements (BIS) have concluded that the effect of higher bank 
capital requirements on banks' cost of capital and on borrowing costs 
are modest. The BIS study concluded that the social cost of higher 
bank capital requirements is far outweighed by the benefits in terms 
of avoiding the large reductions in economic activity associated with 
a banking collapse. 

Thank you for the opportunity to review and comment on this Report. 

Sincerely, 

Signed by: 

Sandra L. Thompson: 
Director: 

Footnote: 

[1] Federal Deposit Insurance Corporation, Office of the Comptroller 
of the Currency, and Board of Governors of the Federal Reserve System 
joint Guidance on Concentrations in Commercial Real Estate Lending, 
Sound Risk Management Practices, Federal Register December 12, 2006, 
Volume 71, Number 238, 74580-74588. 

[End of section] 

Appendix IV: Comments from the Board of Governors of the Federal 
Reserve System: 

Board Of Governors of the Federal Reserve System: 
Division of Banking Supervision and Regulation: 
Washington, DC 20551: 

May 6, 2011: 

Ms. A. Nicole Clowers: 
Director, Financial Markets and Community Investment: 
U.S. Government Accountability Office: 
Washington, DC 20548: 

Dear Ms. Clowers: 

Thank you for the opportunity to comment on the GAO's draft report 
entitled Banking Regulation: Enhanced Guidance on Commercial Real 
Estate Risks Needed. As the draft report acknowledges, the banking 
agencies have taken a number of steps to encourage consistency and 
balance in the implementation of Commercial Real Estate (CRE) guidance 
by field examiners. These include extensive training for examiners, 
issuance of clarifications and additional guidance, report-of-
examination review processes, and follow-up on questions and concerns 
raised by bankers. We note that the report deemed these efforts to 
provide reasonable assurance that the guidance was being carried out 
as directed, and that the GAO found—in most cases reviewed—that 
examiners were appropriately applying CRE guidance and supporting 
their findings in reports of examination. 

Nevertheless, we note that the GAO found instances of inconsistency in 
the application of the guidance by all of the agencies, and that it 
recognized additional work would help to enhance consistency. We note 
that the report cites some specific suggestions from examiners and 
bankers on where existing guidance could be enhanced or clarified. In 
this regard, we welcome the report's two recommendations: (1) to 
enhance CRE concentration guidance to help banks comply with CRE 
concentration and risk management requirements and help examiners 
ensure greater consistency in application of the guidance, and (2) 
once enhancements are in place, to take steps within review-and-
quality-assurance procedures to ensure the enhanced guidance is 
adhered to consistently. We concur that such initiatives would improve 
implementation of CRE concentration standards by the agencies, and we 
intend to work with our colleagues at the FDIC and OCC to develop and 
implement such agreed-upon enhancements. 

Sincerely, 

Signed by: 

Patrick M. Parkinson: 
Director: 

[End of section] 

Appendix V: Comments from the Office of the Comptroller of the 
Currency: 

Comptroller of the Currency: 
Administrator of National Banks: 
Washington, DC 20219: 

April 28, 2011: 

Ms. A. Nicole Clowers: 
Acting Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Ms. Clowers: 

We have received and reviewed your draft report titled "Banking 
Regulation: Enhanced Guidance on Commercial Real Estate Risks Needed." 
Your report responds to a Congressional request for a review of 
examiners' practices related to commercial real estate (CRE); 
regulators' views on bank ratings, capital and liquidity; and the 
impact of regulatory practices on lending by community banks. 

You found that: (1) deterioration of the CRE market negatively 
affected community banks, which could impact small business lending; 
(2) while regulators have taken steps to address CRE concentrations 
and bank concerns, challenges remain in consistently applying 
guidance; and (3) multiple factors can affect banks' lending 
decisions, and regulators' actions may affect lending. You further 
note that high concentrations in CRE exposures can inhibit banks' 
ability to lend, especially during a credit downturn, and that 
existing studies and interviews with bank officials suggest that 
market factors drive CRE downturns and that the regulatory effect of 
examiner actions on such downturns was minimal. 

You recommend that the federal banking regulators enhance or 
supplement the 2006 CRE concentration guidance and take steps to 
better ensure that the enhanced or additional guidance is consistently 
applied. 

We agree with your conclusions and recommendations. We will discuss 
with the other federal banking regulators areas where we believe the 
2006 guidance could be enhanced or supplemented to address issues that 
have arisen in the application of that guidance. As your report notes, 
increased exposure to CRE has made community banks vulnerable to 
declines in this market and has been a prevalent factor in recent bank 
failures. Given these facts, the OCC believes there may be a need to 
provide more clear and explicit expectations that as concentrations 
increase, so must the level and robustness of risk management systems, 
stress testing, capital planning, and capital levels. Through our 
existing review and quality assurance processes, we will ensure that 
any revised guidance is implemented consistently and that examination 
conclusions are well-supported. 

We appreciate the opportunity to comment on the draft report. 

Sincerely, 

Signed by: 

John Walsh: 
Acting Comptroller of the Currency: 

[End of section] 

Appendix VI: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

A. Nicole Clowers, Acting Director (202) 512-8678 or ClowersA@gao.gov: 

Staff Acknowledgments: 

Kay Kuhlman, Assistant Director, and Robert Lee, Analyst-in-Charge, 
managed this review. Emily Biskup and Jason Wildhagen also led 
portions of the research and made significant contributions throughout 
the report. 

Anna Maria Ortiz and Rudy Chatlos provided methodological assistance 
related to our nonprobability sample. Michael Hoffman provided 
assistance reviewing the methodologies of our research studies and 
assistance on capital-related issues. JoAnna Berry provided assistance 
in identifying relevant research literature. Bill Cordrey, Jay Thomas, 
and Gary Chupka provided accounting assistance. Paul Thompson provided 
legal assistance. Marc Molino developed the report's graphics. Barbara 
Roesmann provided editorial assistance. Jan Bauer, Kimberly Cutright, 
Andrea Dawson, Nathan Gottfried, Elizabeth Jimenez, Angela Messenger, 
Lauren Nunnally, Michael Pahr, Ellen Ramachandran, Maria Soriano, 
Winnie Tsen, Gavin Ugale, and Carrie Watkins held various roles in 
verifying our findings. 

[End of section] 

Footnotes: 

[1] Throughout this report we define community banks as banks 
regulated by a federal banking regulator that have $1 billion or less 
in total assets. Commercial real estate includes rental apartment 
buildings, industrial properties, office buildings, hotels, healthcare-
related properties, and retail properties such as shopping malls, 
strip malls, and freestanding outlets. 

[2] Capital generally is defined as a firm's long-term source of 
funding, contributed largely by a firm's equity stockholders and its 
own returns in the form of retained earnings. One important function 
of capital is to absorb losses. 

[3] The interagency statements and guidance they issued from 2006 
through 2010 are: OCC, Federal Reserve, and FDIC, Concentrations in 
Commercial Real Estate Lending, Sound Risk Management Practices, 71 
Fed. Reg. 74580 (Dec. 12, 2006); FDIC, Federal Reserve, OCC, and the 
Office of Thrift Supervision (OTS), Interagency Statement on Meeting 
the Needs of Creditworthy Borrowers (Nov. 12, 2008); FDIC, Federal 
Reserve, OCC, OTS, the National Credit Union Administration (NCUA), 
and the Federal Financial Institutions Examination Council (FFIEC) 
State Liaison Committee, Policy Statement on Prudent Commercial Real 
Estate Loan Workouts (Oct. 30, 2009) (see for example, Federal Reserve 
SR 09-07 and FDIC FIL-61-2009); and FDIC, Federal Reserve, OCC, OTS, 
NCUA, and the Conference of State Bank Regulators, Interagency 
Statement on Meeting the Credit Needs of Creditworthy Small Business 
Borrowers (Feb. 12, 2010). 

[4] Bank examiners review how banks internally classify their loans 
and assign their own classification to a sample of loans reviewed 
during an examination. The categories for classification are 
substandard, doubtful, and loss. Having higher amounts of classified 
loans can lead to required increases in reserves for future losses on 
such loans. For more details, see the background section of this 
report. 

[5] All banks that FDIC insures submit quarterly Call Reports, which 
contain a variety of financial information about a bank's condition 
and income. 

[6] FDIC, the Federal Reserve, and OCC supervise community banks that 
hold the greatest amount of CRE loans. We did not include OTS or NCUA 
in our analysis because their institutions hold a relatively small 
amount of total loans in CRE loans. 

[7] FFIEC was established on March 10, 1979, to prescribe uniform 
principles, standards, and report forms for the federal examination of 
financial institutions by FDIC, the Federal Reserve, OCC, NCUA, and 
OTS. 

[8] For this analysis, we considered a loan past due after 90 days. 
Nonaccrual treatment of a loan indicates that the loan is not likely 
to recover full principal and interest, and therefore the bank cannot 
recognize the interest it may receive on the loan as income. According 
to FFIEC call report instructions, generally an asset is to be 
reported as being in nonaccrual status if: (1) it is maintained on a 
cash basis because of deterioration in the financial condition of the 
borrower, (2) payment in full of principal or interest is not 
expected, or (3) principal or interest has been in default for a 
period of 90 days or more unless the asset is both well secured and in 
the process of collection. 

[9] Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices sets thresholds for CRE and ADC concentrations, 
and requires banks to have certain risk-management systems in place to 
address high concentrations. ADC is considered a risky form of CRE, as 
it includes loans for constructing and developing commercial real 
estate projects. We discuss the types of CRE loans and their risks in 
greater detail in the background section of this report. 

[10] See appendix I for additional details on our scope and 
methodology. 

[11] See GAO, Financial Regulation: A Framework for Crafting and 
Assessing Proposals to Modernize the Outdated U.S. Financial 
Regulatory System, [hyperlink, http://www.gao.gov/products/GAO-09-216] 
(Washington, D.C.: Jan. 8, 2009). 

[12] Total capital consists of the sum of tier 1 and tier 2 capital. 
Tier 1 capital consists primarily of tangible equity. Tier 2 capital 
includes subordinated debt, a portion of loan loss reserves, and 
certain other instruments. 

[13] These CAMELS definitions are shared among the federal bank 
regulators; we have excerpted them from the Federal Reserve's 
Commercial Bank Examination Manual. 

[14] The regulatory definition of ALLL is the "general valuation 
allowances that have been established through charges against earnings 
to absorb losses on loans and lease financing receivables." 12 CFR 
325.2. 

[15] A charge-off occurs when a bank recognizes that a particular 
asset or loan will not be collectible and must be written off. This 
loss is removed from the reserve, or ALLL (which is replenished from 
income). 

[16] These definitions are from Concentrations in Commercial Real 
Estate Lending, Sound Risk Management Practices. 

[17] For more information, see E. Philip Davis and Haibin Zhu, "Bank 
Lending and Commercial Property Cycles: Some Cross-Country Evidence," 
Journal for International Money and Finance 30, no. 1 (2010). 

[18] Securitization is a process in which financial assets (such as 
loans) are brought together into interest-bearing securities that are 
sold to investors. CMBS are backed by mortgages for CRE, such as 
apartment and office buildings, industrial properties, hotels, and 
retail properties. CMBS are sensitive to underlying CRE prices and the 
cash flow generated from the properties backing the mortgages. 

[19] GAO, Troubled Asset Relief Program: Treasury Needs to Strengthen 
Its Decision-Making Process on the Term Asset-Backed Securities Loan 
Facility, [hyperlink, http://www.gao.gov/products/GAO-10-25], 
(Washington, D.C.: Feb. 5, 2010). 

[20] Sam Chandan, Real Capital Analytics, "Commercial Real Estate and 
Capital Markets Outlook," presentation at FFIEC's Supervisory Updates 
and Emerging Issues conference in Washington, D.C., on October 20, 
2010. 

[21] Mortgage Bankers Association, Commercial Real Estate/Multifamily 
Finance Quarterly Databook: Third Quarter 2010 (Washington, D.C.: Dec. 
21, 2010). 

[22] Moody's Investors Service, "U.S. CMBS: Moody's CMBS Delinquency 
Tracker" (New York: Feb. 14, 2011). 

[23] See E. Philip Davis and Haibin Zhu, "Bank Lending and Commercial 
Property Cycles." 

[24] Although there are 106 MLR reports, they address findings on 109 
banks. 

[25] GAO, Troubled Asset Relief Program: Status of Programs and 
Implementation of GAO Recommendations, [hyperlink, 
http://www.gao.gov/products/GAO-11-74] (Washington, D.C.: January 
2011). 

[26] Bank for International Settlements, "Cycles and the Financial 
System," in 71st Annual Report (2001): 126. 

[27] In 2008, the average net portion of the quarterly survey's 
respondents who said that they were tightening standards for CRE loans 
was 81.7 percent. This trend of tightening underwriting standards 
continued in 2009 and 2010, although at a decreased rate. The average 
net portion of the quarterly survey's respondents in 2009 who reported 
tightening standards for CRE loans was 56.4 percent, decreasing to an 
average of 12.2 percent in 2010. 

[28] Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices, Proposed Guidance, 71 Fed. Reg. 2302 (Jan. 13, 
2006). 

[29] 71 Fed. Reg. 74580 (Dec. 12, 2006). The guidance focuses on CRE 
loans that are sensitive to conditions in the general CRE market, such 
as market demand, changes in vacancy rates, and other factors. Based 
on the approach in the guidance, CRE primarily consists of loans 
secured by land and development construction, multifamily property, 
and nonfarm nonresidential property (where the primary source of 
repayment is derived from rental income associated with the property 
or the proceeds of the sale, refinancing, or permanent financing of 
the property). Also included are loans to real estate investment 
trusts and unsecured loans to developers. Excluded from this 
definition are loans secured by nonfarm nonresidential properties 
where the primary source of repayment is the cash flow from the 
ongoing operations and activities conducted by the party that owns the 
property. 

[30] 71 Fed. Reg. at 74584, 74587. 

[31] Policy Statement on Prudent Commercial Real Estate Loan Workouts 
(Oct. 30, 2009). 

[32] The 2009 CRE loan workout guidance states the following about 
identifying a TDR: "a restructured loan is considered a TDR when the 
institution, for economic or legal reasons related to a borrower's 
financial difficulties, grants a concession to the borrower in 
modifying or renewing a loan that the institution would not otherwise 
consider. To make this determination, the lender assesses whether (a) 
the borrower is experiencing financial difficulties, and (b) the 
lender has granted a concession." 

[33] GAO, Standards for Internal Control in the Federal Government, 
[hyperlink, http://www.gao.gov/products/GAO/AIMD-00.21.3.1] 
(Washington, D.C.: November 1999). 

[34] FFIEC, working with FDIC officials, also introduced a course on 
CRE loan workouts to supplement existing courses on CRE for 
commissioned examiners across the banking regulators. Examiners 
typically are commissioned after they complete professional training 
and pass tests to measure their proficiency. FFIEC courses are geared 
toward commissioned examiners from the federal banking regulators and 
some state regulators. 

[35] For example, FDIC headquarters conducts periodic reviews of its 
regions. The reviews can focus on issues such as the region's 
timeliness, effectiveness, risk assessment, communication, and systems 
and also may focus on particular risk areas identified in a region. At 
the Federal Reserve, the Federal Reserve Board and Reserve Banks 
conduct a number of internal reviews. First, the Federal Reserve Board 
reviews certain operations of the Reserve Banks, including risk-
focused reviews of each supervision department about every 3 years. 
Second, each Reserve Bank has a General Auditor who conducts audits of 
the Supervision and Regulation function about every 3 years. The 
audits tend to focus on processes and controls. Third, the Reserve 
Banks have a Quality Assurance function that conducts periodic reviews 
on whether Supervision and Regulation is executing its 
responsibilities according to Federal Reserve Board policy guidance. 

[36] Of FDIC's six regions, we reviewed the most recent FDIC internal 
review reports for four (Atlanta, Dallas, New York, and San Francisco). 

[37] The Federal Reserve districts that conducted this review are 
Atlanta, Kansas City, Philadelphia, and Richmond. 

[38] This official clarified that the sample of loans was small 
because he only reviewed downgraded CRE loans, and the volume of 
downgraded loans in recent ROEs was small. 

[39] As part of this process, the districts categorized banks based on 
their CRE-related risks and reviewed CRE loan classifications for 
banks that presented the greatest risks. In some cases, this process 
resulted in changes to loan classifications before the ROE was 
finalized. We reviewed the reports that all of OCC's districts 
produced from their quality assurance processes. 

[40] OCC could not provide comparable quantitative results for the 
southern or northeastern districts. 

[41] Each survey is used for different purposes. For example, FDIC 
issues a survey after safety and soundness examinations to seek input 
from banks to improve the efficiency and effectiveness of the 
examination process. Other surveys are issued to respond to specific 
information needs, as discussed above. 

[42] The ombudsman offices provide confidentiality, as required by 
law, and must follow up on any concerns that banks have about 
potential retaliation from the issues that they have raised with the 
ombudsman, as detailed in the Riegle Community Development and 
Regulatory Improvement Act of 1994, Pub. L. No. 103-325 § 309(d), 12 
U.S.C. § 4806(d). 

[43] Throughout the report, we avoid providing specific numbers of 
bank officials making certain statements to avoid overstating the 
precision of the results from the nonprobability sample we selected. 
For information on how we use the terms "a few," "some," and "many," 
see appendix I. 

[44] In addition, FDIC in March 2011 sent out a reminder to banks 
about the ways they can contact regulatory officials, and encouraged 
them to discuss examination concerns. FDIC Financial Institution 
Letter FL-13-2011, March 1, 2011. 

[45] For more details on how we identified these banks for interviews, 
see appendix I. Because we selected a nonprobability sample, these 
banks' views are not representative of all banks in the country. 

[46] The amount of allowance that a bank provisions in anticipation of 
potential losses is determined by calculations performed under two 
accounting standards, Accounting Standards Codification (ASC) 450, 
Contingencies (formerly FAS 5) and ASC 310-40 (formerly FAS 114). 
Under ASC 450, segments of the loan portfolio are evaluated on the 
basis of risk factors such as historical losses, delinquencies and 
nonaccruals, and concentrations of credit, among other factors. A 
determination on expected loss rates is made for each loan segment 
based on the relevant risk factors. Under ASC 310-40, a bank must 
identify for individual review loans that have been determined to be 
impaired. The bank should provision for the difference between the 
book value and the determined market value. The sum of the ASC 450 and 
310-40 calculations is the total ALLL. 

[47] For additional details on how loan classifications and increased 
provisions for loan losses affect ALLL, see appendix II. 

[48] Specifically, bankers told us that some examiners were using tier 
1 capital plus ALLL as the denominator for calculating the 
concentration, rather than total capital as described in the guidance. 

[49] The IGs for FDIC, the Federal Reserve, and Treasury (for OCC and 
OTS) are required to perform an MLR to determine the cause of bank 
failures that result in a material loss to the Deposit Insurance Fund 
and assess the quality of regulatory supervision preceding the 
failure. See 12 U.S.C. § 1831o(k). Before the Dodd-Frank Wall Street 
Reform and Consumer Protection Act of 2010, the IGs were required to 
conduct these reviews when the Deposit Insurance Fund experienced a 
loss exceeding the greater of $25 million or 2 percent of the bank's 
assets at the time of FDIC assistance. In the act, Congress amended 
the provision by increasing the MLR threshold so that it is based on 
estimated losses exceeding specified amounts. Under the act, IGs are 
required to conduct MLRs when losses to the Deposit Insurance Fund 
exceed $200 million during the period from January 1, 2010, to 
December 31, 2011. This threshold decreases over time to $50 million 
on or after January 2014. The act also requires the IGs to review all 
other losses incurred by the Deposit Insurance Fund to determine (a) 
the grounds identified by the bank's regulator for appointing FDIC as 
receiver and (b) whether any unusual circumstances exist that might 
warrant an in-depth review of the loss. Pub. L. No. 111-203 § 987. 

[50] For additional details, see GAO, Financial Regulation: Review of 
Regulators' Oversight of Risk-management Systems at a Limited Number 
of Large, Complex Financial Institutions, [hyperlink, 
http://www.gao.gov/products/GAO-09-499T] (Washington, D.C.: Mar. 18, 
2009). 

[51] The findings of the Financial Crisis Inquiry Commission mirror 
some MLR findings in stating that leading up to the financial crisis, 
regulators had tools at their disposal to address growing risks in the 
financial system but did not always choose to use them. For example, 
regulators' bank ratings continued to reflect that they were safe and 
sound, and regulators downgraded ratings only immediately before the 
banks failed. The report also includes testimony from the Federal 
Reserve's former director of Banking Supervision and Regulation that 
prior to the financial crisis, regulatory intervention before a bank 
showed poor financial performance could have been considered "overly 
intrusive" or "heavy-handed." See Financial Crisis Inquiry Commission, 
The Financial Crisis Inquiry Report: Final Report of the National 
Commission on the Causes of the Financial and Economic Crisis in the 
United States (Washington, D.C.: January 2011). 

[52] For more information on our nonprobability sampling of banks for 
interviews and ROE analysis, see appendix I. 

[53] Of the 7 ROEs, 1 was conducted by the Federal Reserve (of 12 
Federal Reserve examinations we reviewed); 3 by OCC (of 22 OCC 
examinations), and 3 by FDIC (of 21 FDIC examinations). Two were for 
banks in California, one in Georgia, and four in Texas. Note that the 
sample we selected cannot be extrapolated to the universe of 
examinations and, therefore, cannot be used to draw conclusions about 
potential differences among regulators or among banks in certain 
states. 

[54] In two other ROEs, the examination states that the bank must 
reduce CRE concentrations and the enforcement action also requires at 
least consideration that concentrations be reduced--although the 
enforcement action also emphasizes the need for improvements to the 
bank's risk-management systems. 

[55] Specifically, 10 ROEs use only tier 1 capital or tier 1 capital 
plus ALLL. Another 13 use tier 1 and also provide concentrations as a 
percent of "capital," but the ROEs are unclear on the form of capital. 
Thirteen ROEs use total risk-based capital, equity capital, or capital 
alone. Eleven ROEs use total risk-based capital with tier 1 capital 
plus ALLL. Eight ROEs either do not provide a concentration or do not 
clearly articulate how it was calculated. 

[56] For more details on whom we interviewed, see appendix I. The 
views of this particular group of examiners and officials cannot be 
generalized to the population of all examiners or officials. 

[57] For additional details on the potential impact of capital and 
ALLL on a bank's ability to lend, see appendix II. 

[58] Joe Peek and Eric S. Rosengren, "Bank Regulatory Agreements in 
New England," New England Economic Review (May/June 1995): 1-2. 

[59] Joe Peek and Eric S. Rosengren, "The Capital Crunch in New 
England," New England Economic Review (May/June 1992): 9. 

[60] During the crisis, the average estimated growth rate of non-CRE 
loans at low-and mid-CRE banks was "positive and around 1 percent." 
However, during the crisis banks with high CRE concentrations 
decreased non-CRE lending "on average, by 0.5 percentage points per 
quarter." These changes led to a "nearly $82 billion cumulative 
increase in non-CRE loans at low-and mid-CRE banks…and about a $15 
billion decline in non-CRE loans at high-CRE banks." "Low-CRE banks 
and mid-CRE banks" are based on the ratio of CRE loans to total assets 
right before the onset of the crisis (second quarter of 2007). The 
bank holding companies were categorized into three groups: high-CRE 
banks (top 30 percent), mid-CRE banks (30 to 69 percent), and low-CRE 
banks (bottom 30 percent). Sumit Agarwal, Hesna Genay, and Robert 
McMenamin (Federal Reserve Bank of Chicago), "Why Aren't Banks Lending 
More? The Role of Commercial Real Estate," Chicago Fed Letter 281 
(2010): 1-4. This paper measures changes in loan growth based on 
changes in total loan assets measured in bank call reports. As we 
previously have reported, this approach is limited because reductions 
in total loan balances can be explained by charge-offs and loan 
payoffs and do not therefore provide an ideal measure of new loan 
originations. For more information, see GAO, Troubled Asset Relief 
Program: Treasury's Framework for Deciding to Extend TARP Was 
Sufficient, but Could Be Strengthened for Future Decisions, GAO-10-531 
(Washington, D.C.: June 30, 2010). 

[61] In this article, supervisory "toughness" refers to "treating 
banks of a given financial condition more harshly than in previous 
years." Allen N. Berger, Margaret K. Kyle, and Joseph M. Scalise, "Did 
U.S. Bank Supervisors Get Tougher during the Credit Crunch? Did They 
Get Easier during the Banking Boom? Did It Matter to Bank Lending?" 
National Bureau of Economic Research Working Paper Series 7689 
(Cambridge, Mass.: 2000): 1. 

[62] We use "CAMEL" in this instance, because that is the term the 
authors used in the article. See Berger, Kyle, and Scalise, "Did U.S. 
Bank Supervisors Get Tougher during the Credit Crunch?" 

[63] We use "CAMEL" in these instances, because that is the term the 
authors used in the article. Timothy J. Curry, Gary S. Fissel, and 
Carlos D. Ramirez, "The Impact of Bank Supervision on Loan Growth," 
North American Journal of Economics and Finance 19 (2008): 113-134. 

[64] The tables on pp. 125-130 report aggregate loan growth 
regressions for three loan categories: commercial and industrial loans 
(C & I), consumer loans, and real estate loans over two distinct 
periods: 1985-1993 (first period) and 1994-2004 (second period). 
Explanatory variables included: (a) first and second lagged dependent 
variables (loan growth); (b) changes in CAMEL rating (first and second 
lags); (c) changes in SCOR rating (first and second lag); (d) state 
output growth (first and second lags). As a group, the tables show a 
consistent set of results; in all tables (composite CAMEL ratings and 
components) downgrades are associated with a decline in C&I lending in 
the first period, but not in the second. In virtually all regressions, 
the estimated coefficient ranges from about -0.4 to about -0.8 in the 
short run and the long run. The same is not true, for the most part, 
for consumer lending or real estate lending. Curry, Fissel, and 
Ramirez, "The Impact of Bank Supervision on Loan Growth." 

[65] A recent memorandum attached to a report from FDIC's IG suggests 
this when stating that one of FDIC's primary challenges will be to 
continue its Forward Looking Supervision program even into the next 
economic recovery period. For the report itself, see FDIC, Office of 
Inspector General, Follow-up Audit of FDIC Supervision Program 
Enhancements, MLR-11-010 (Arlington, Va.: Dec. 23, 2010). 

[66] Discussions on capital requirements among banks and regulators 
recognize that capital requirements can impact lending--although there 
is disagreement on the magnitude of that impact. For example, 
according to an analysis by the Bank for International Settlements, a 
4 percentage point increase in the risk-based capital ratio would 
increase loan interest rates by 60 basis points. In contrast, the 
Institute for International Finance estimates that a 4 percentage 
point increase in the risk-based capital ratio would increase loan 
interest rates by 136 basis points. Therefore, it appears that capital 
requirements can affect lending, but the severity of such impacts is 
not completely settled. See Basel Committee on Banking Supervision, An 
Assessment of the Long-term Economic Impact of Stronger Capital and 
Liquidity Requirements (Basel, Switzerland: August 2010) and two 
reports from the Institute of International Finance: Interim Report on 
the Cumulative Impact on the Global Economy of Proposed Changes in the 
Banking Regulatory Framework (Washington, D.C.: June 2010) and The Net 
Cumulative Economic Impact of Banking Sector Regulation: Some New 
Perspectives (Washington, D.C.: October 2010). 

[67] FASB, "Accounting for Financial Instruments and Revisions to the 
Accounting for Derivative Instruments and Hedging Activities," 
proposed accounting standards update issued on May 26, 2010. 

[68] FDIC, the Federal Reserve, and OCC supervise community banks that 
hold the most amount of CRE loans. We did not include Office of Thrift 
Supervision or National Credit Union Administration in our analysis 
because their institutions hold a relatively small amount of their 
total loans in CRE loans. 

[69] CAMELS encompass Capital adequacy, Asset quality, Management, 
Earnings, Liquidity, and Sensitivity to market risk. As discussed 
earlier in this report, in examinations a bank is rated for each of 
the CAMELS components and given a composite rating, which generally 
bears a close relationship to the component ratings. However, the 
composite is not an average of the component ratings. The component 
rating and the composite ratings are scored on a scale of 1 (best) to 
5 (worst). 

[70] For this analysis, we considered a loan past due after 90 days. 
Nonaccrual treatment of a loan indicates that the loan is not likely 
to recover full principal and interest, and therefore the bank cannot 
recognize the interest it may receive on the loan as income. According 
to call report instructions from the Federal Financial Institutions 
Examination Council (FFIEC), generally an asset is to be reported as 
being in nonaccrual status if: (1) it is maintained on a cash basis 
because of deterioration in the financial condition of the borrower, 
(2) payment in full of principal or interest is not expected, or (3) 
principal or interest has been in default for a period of 90 days or 
more unless the asset is both well secured and in the process of 
collection. 

[71] One ROE in our sample was completed before the guidance was 
issued in its final form, but it refers to the 2009 guidance, and 
therefore we included it because it was relevant to our work. 

[72] This example is simplified to clarify the relationships between 
assets and capital. 

[End of section] 

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