The increased yield from construction loans can contribute significantly to a bank’s bottom line, but with increased yield comes increased risk. After the Great Recession studies by FDIC and the Office of the Inspector General (OIG) showed that some lending institutions with high construction loan concentrations weathered the recession with no significant decline in overall financial condition. At the same time, though, almost all banks that failed during the recession had significant construction portfolios.
An increase in troubled loans is expected as a result of the pandemic. Lessons from the FDIC and OIG studies could provide useful tips to help mitigate risks. Aggressive growth, high construction loan concentrations, poor risk management practices, ineffective controls and risky decision making were identified as past contributors to the failure of most institutions.
Common weaknesses in risk management and controls included:
- Lack of independent review
- Frequent exceptions
- Ineffective loan monitoring
- Inadequate monitoring of participation loans
Lack of Independent Review
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Construction loans can be lucrative, but proper administration is much more complex than it is for conventional loans. It can be tempting to administer loans based on relationships with the borrower or in anticipation of future business, rather than assuring the quality of an individual loan. A strong market can be forgiving of many such decisions, but as markets turn, the sale or lease of a property may become problematic, values can decline, and borrowers may be unable or unwilling to fulfil commitments. Independent review and oversight of loans was found to result in lower losses.
Though occasional exceptions are not unusual, frequent exceptions to loan requirements can be a strong indication of a troubled project and granting such exceptions can allow problems to go unrecognized. In the OIG study, many lenders were found to have no consistent method for identifying, tracking, and evaluating exceptions. By implementing a tracking system, lenders can evaluate and report the frequency of exceptions requested and/or approved in order to intelligently allocate resources to higher risk projects.
Ineffective Loan Monitoring
OIG found significant weakness in risk management and internal controls in 80% of the failing institutions studied. Examples included in the study show that Directors failed to maintain risk management policies and procedures to support increasing risks during the downturn. This resulted in an inability to assure equity injections, monitor disbursements, track insurance, monitor and clear liens, etc., producing cumulatively catastrophic impacts in the troubled market.
Inadequate Monitoring of Participation Loans
As a result of their study, OIG found that many failed institutions obtained participating interests in construction loans in hopes of increasing yield without the risks of expanding their own operations into construction lending. Unfortunately, in many cases participants relied upon due diligence performed by the lead lender, whose own due diligence was less thorough than one might hope. In subsequent guidance, regulators imposed requirements for institutions purchasing a participating interest in loans to conduct an independent review of the transaction to assure satisfaction of their own lending criteria.
Federal banking regulators have published guidance for examiners evaluating risks associated with pending construction. In addition to the management of programmatic risks such as loan concentrations and loan-to-value ratios, guidance identifies key factors in the management of project-specific risks.
- Pre-loan evaluation of project feasibility
- Rigorous construction loan administration and minimum standards for loan documentation
- Critical evaluation of construction plans, contracts, budgets, and schedule
- Assessment of the borrower’s and contractor’s capabilities
- Careful management of disbursements and monitoring of progress
With an anticipated downturn in construction, now could be the perfect time to revisit policies and procedures.
What are Top Lenders Doing to Manage Risk?
In two weeks, the annual Construction Lender Risk Management Roundtable convenes virtually on March 16 & 17, bringing over 50 construction lending and investing institutions together. It’s a unique forum for construction financiers to benchmark and learn from each other, sharing best practices and perspectives on risk management. If you’re reading this article, it’s probably up your alley so I highly encourage you to get involved.