By Matt Weiland
Last December, James Nigro, senior vice president and credit risk manager of Provident Bank, attended what he thought was a fairly routine meeting.
“Someone from our finance department came to me and said, ‘By the way, Jim, in the next quarter, we’re going to start reporting something new on the call report called ‘high volatility commercial real estate,’” Nigro recalled. “When I read the call report definition, my first thought was ‘This is going to change the way we make loans.’”
The new high volatility commercial real estate (HVCRE) classification was passed as part of new Basel III capital rules last fall, but reporting requirements went into effect as of March 31 call reports of this year. The new rules state that acquisition, developmental and construction loans that meet certain criteria are classified as HVCRE, and carry a 150 percent capital risk weighting.
“What this required was a lot of education for our lenders and underwriters, coaching them about HVCRE, how it can affect their deal structures, how to potentially avoid this type of classification and the ramifications and cost to the bank if they make loans that are classified HVCRE,” Nigro said. “We also created a resource guide that laid out definitions and key terms of the HVCRE rules, new reporting and tracking procedures, steps that had to be taken to implement them and a form that was used to qualify every potential HVCRE credit.”
Education of Provident’s staff took place almost immediately, with the bank’s commercial real estate lenders receiving the most rigorous training.
“The people in that group are the ones who originate the largest volume and dollar exposure of construction loans within the bank,” said Nigro. “Keep in mind, HVCRE doesn’t just apply to construction; it can apply to interim acquisition loans and land deals, but most of the transactions that might trigger an HVCRE classification would originate in our CRE group.”
More intensive training was also provided for the bank’s commercial underwriting staff. Provident’s other groups, such as middle market, business banking and asset-based lending received remote training on the new classifications so that they were aware of the new rules.
Nigro and his team noticed an immediate impact when they began to track the new HVCRE classification, most noticeably in the way regulators chose to calculate the equity requirements of loans.
“The method the regulators chose to assess project equity isn’t consistent with the way that most bankers structure deals,” said Nigro. “The regulations look at equity as a percentage of the ‘as complete’ appraised value of the project, which a lot of banks don’t use. Typically, we’ll look at LTV and the percentage of the project cost being contributed as upfront capital in the deal. Because of the different factors, some of our deal structures and the ways that we’ve approached underwriting and structuring loans have been tripped up.”
He went on to describe an issue that arose when one of the bank’s borrowers was in the process of acquiring a distressed property to be renovated, repositioned and re-leased. The project’s as-complete appraised value was higher than anticipated, which raised some unanticipated issues. “We had 25 percent cash equity and 55 percent LTV, but the loan still triggered the HVCRE classification because the cash equity contribution was shy of the 15 percent of the as-complete value, as that valuation came in so high,” said Nigro. “We had a deal where we had strong cash equity and a low LTV, and under the new rules, it was being classified as high-risk.”
Provident went ahead with this transaction, despite the fact that it triggered the HVCRE classification.
“We felt very confident in the risk of the deal, so we decided that, rather than penalize the borrower with more equity or re-pricing it, we would bite the bullet,” said Nigro. “We didn’t want to risk renegotiating the deal with the borrower because of a regulatory requirement that’s going to require us to hold a little bit of additional capital.”
Provident’s supply of additional capital also played a part in the decision to green light the transaction.
“We have an advantage due to our excess capital,” said Nigro. “It doesn’t really hurt us as much because we don’t have to commit additional capital that costs us incrementally more money. We already have the capital on our books. Other banks that are not as well-capitalized are going to find it very costly to make HVCRE loans.”
One issue that seems to be taking place throughout the banking industry is that some bankers are unaware of either the new rules, or the impact that they have upon their lending practices.
“I was talking to other banks in mid-February about this, reaching out to them to ask them how they looked at certain types of situations,” said Nigro. “It was interesting that a lot of the banks under $10 billion (in assets) hadn’t even heard about it yet. When I shared with them what I had learned, they had the same reaction as me, which was ‘Holy cow, this is a really big deal.’”
Nigro theorizes that the disconnect in attention might be a result of the new regulations being included in capital language.
“I think most people on the lending side weren’t focused on this because it was part of the capital rules,” he said. “You normally don’t think about capital requirements in terms of how you structure your credits. Another problem that I see is that the definition is very atypical with the way banks lend money. It’s a change of habits, a change in the way you look at transactions and a change in the way you structure your deals.”■
Matt Weiland is marketing coordinator for Ardmore Banking Advisors, specializing in risk management consulting for community banks. He can be reached at firstname.lastname@example.org.