Walking the Regulatory Road

NOTE TO READERS: Along with Dianne Crocker’s article, Bank Regulators Turn Up the Heat in the November 2016 edition of Scotsman Guide, appeared this important article by Rod Alba, senior VP and senior regulatory counsel for the American Bankers Association mortgage markets division. Alba’s piece sheds light on the increasing regulatory scrutiny banks face, as well as highlighting that “the regulatory system is well down the path of commingling the commercial with the residential worlds.” 

Walking the Regulatory Road

Federal scrutiny of the commercial mortgage market is ramping up

Commercial mortgage professionals have many reasons to feel like they are on a knife’s edge. In addition to the presidential election and uncertainty in interest rate movements, the next few months are expected to bring higher levels of regulatory scrutiny. This tighter legal and regulatory environment is likely to have long-term structural implications for lenders, originators and investors alike. Navigating these new regulations will require skill and knowledge as well as a thorough understanding of the regulations that are coming their way.

For nearly two decades, commercial real estate lenders viewed regulations as a minor impediment to the real work they had to do as originators and financiers of commercial deals. Commercial lenders have been sheltered from the legal storms and reforms that have been pounding and reshaping residential mortgage markets.

The efforts to increase homeownership, the subprime-lending buildup and the real estate bubble bust contributed to a situation in which residential lending became the principal stage of a never-ending play. Policymakers focused almost singularly on home-secured lending, and commercial mortgage lenders and brokers remained relatively unaffected.

This is now changing. The same winds that caused so much regulatory upheaval in residential lending now are hitting commercial lending. Commercial mortgage stakeholders are feeling it and should be on full alert. The regulatory surge is likely to reshape commercial real estate lending fundamentally. There are four main concerns that are shared by almost everyone in the commercial mortgage market.

Prudent risk management

This past year, federal banking agencies issued guidance that warns about the loosening of commercial real estate loan-underwriting standards. The purpose was to remind banks of the need to engage in risk-management practices that are aligned with the volatility of real estate lending cycles.

The guidance focuses on construction and land-development loans and on total commercial real estate loans, providing that elevated loan concentrations in these segments will lead to intensified supervision.

Although the guidance was not intended to serve as a ceiling on bank concentration levels of commercial real estate, institutions are reporting that numerical limits are being applied more strictly. The rigid application of these rules is likely to lead to curtailed lending. Fewer loans will be possible as prudential restrictions intensify. The regulatory agencies recently announced that supervisors would continue their scrutiny of commercial real estate lending throughout the coming year.

High-volatility loans

Under final rules issued by federal regulators, certain loans will carry increased risk weights if deemed to fall under the category of High Volatility Commercial Real Estate (HVCRE). This designation generally applies to acquisition, development and construction loans.

The same winds that caused so much regulatory upheaval
in residential lending now are hitting commercial lending.

Under the recent rules, the higher risk weights will apply unless a transaction fits within certain designated exclusions. Put simply, the more HVCRE loans a bank holds, the less additional lending it can do. The incentive, therefore, is to minimize the “high volatility” label on any portfolio of transactions. The challenge identified by banks is that it is onerous to apply the HVCRE rules, because the definitions are uncertain or indeterminate. The impact on commercial mortgage brokers and borrowers is heightened uncertainty and unpredictability with regard to pricing and the feasibility of any particular transaction.

Third-party lending

This past July, the Federal Deposit Insurance Corp. (FDIC) issued proposed new guidance regarding safety and soundness considerations that FDIC banks must follow when lending through a business relationship with a third party. If an institution engages in significant lending activities through third parties, that institution can expect increased supervisory attention, including but not limited to heightened examinations covering risk and consumer protections, offsite monitoring and possible review of third parties.

Although this guidance is only in proposed form at present, it is clear that there will be a bright light focused on third-party lending arrangements, and the impact and application of this heightened supervision are still unascertainable.

Fair lending

This past February, the Consumer Financial Protection Bureau (CFPB) released policy priorities that articulate the CFPB’s vision of “a small-business lending market where fair-lending laws are enforced and where communities, governmental entities, and creditors have access to the data needed to identify the business and community development needs and opportunities of women-owned, minority-owned and small businesses.”

This CFPB statement may set forth an unobjectionable ideal. The catch, however, is that this apparently gentle statement introduces a full and novel regime of fair-lending scrutiny and enforcement against all commercial lending institutions. It is now evident that regulators will accelerate the application of fair-lending concepts to nonresidential, business-purpose transactions.

There is some uncertainty as to how far they will go, and how they will define, if at all, the newly regulated lending segments. As they advance, however, we should expect the application of a potentially convoluted fair-lending regime to commercial lending. This will be thorny, jumbled and politically sensitive for a long time to come.

•  •  •

Overall, the increase in government controls and regulations are more than theoretical and philosophical. This past May, a bipartisan group of 20 congressmen wrote a letter to the treasury secretary to point out that business lending is fundamentally different from consumer lending, and regulations should not treat them similarly. The lawmakers cautioned the Treasury Department not to make any recommendations that would stifle business credit — particularly for small businesses.

This communication illustrates that the regulatory system is well down the path of commingling the commercial with the residential worlds. Commercial mortgage lenders and brokers should support industry efforts to educate and instruct policymakers on the nature and process of real estate finance. Commercial lenders also should be aware that the impact of these new rules soon will affect them in a direct way.

As federal regulators implement these and similar provisions, and as these rules grow and proliferate, the examination and legal risk associated with these new requirements is likely to result in higher costs, extended processing times, more cumbersome quality-assurance and monitoring practices, and expanded training requirements for all banks — and by extension, their partners.


Rod J. Alba, senior vice president and senior regulatory counsel for the American Bankers Association (ABA) mortgage markets division