A Quick Overview and a Note on Construction Lending

On June 16, 2015, the FDIC issued a notice of proposed rulemaking to revise its calculations for deposit insurance assessments for banks with under $10 billion in assets (excluding de novo banks and foreign branches).  The rules would go into effect the quarter after they are finalized but by their terms would not be applicable until after the designated reserve ratio of the Deposit Insurance Fund reaches 1.15%.

At almost 150 pages, there are many facets to the proposed rule that must be carefully analyzed.  At the outset, we give credit to the FDIC for attempting to fine tune deposit insurance assessments beyond the blunt instrument that they have always been.  We have long held the position that the FDIC should adopt more careful underwriting procedures, similar to private insurers, in order to better serve its function in the industry.

Under the proposal, a number of factors are used in a model to calculate a bank’s deposit insurance assessment rates:  CAMELS ratings, Leverage Ratio, net income, non-performing loan ratios, OREO Ratios, core deposit ratios, one year asset growth (excluding growth through M&A, thankfully), and a loan mix index.  All of these factors are intended to predict a bank’s risk of future failure, and all are worthy of discussion.
Putting aside our overall hesitancy to fully support faceless numerical models to draw important conclusions (anyone remember subprime lending?), we were initially drawn to the proposed implementation of the “loan mix index” as a factor for calculating deposit insurance assessment rates.  As we have previously discussed,construction lenders have recently been disadvantaged by the new HVCRE rules under the Basel III capital standards.  Once again, construction loans are the focus of regulatory scorn.

The loan mix index component of the assessment model requires a bank to calculate each of its loan categories as a percentage of assets and then multiply each category by a standardized historical charge-off rate percentage provided by the FDIC.  These products are then aggregated to derive the loan mix index, and the higher the index, the worse the factor is for the bank’s assessment calculation.  As you might have guessed, construction and development loans are assigned the highest/worst historical charge-off percentage at 4.50%.  The next highest category is commercial and industrial loans at 1.60%.

The historical charge-off rates are based upon almost fifteen years of historical data, but the recent economic downturn weighs heavily in the rates due to the fact that the results were weighted by the number of failures that occurred in each year.  While we can’t argue with the numbers per se, we all know that there are lies, damn lies, and statistics.  We take issue with applying to every bank under $10 billion in assets an industry-wide historical charge-off rate to any given category of loans.  Clearly, not every loan in a given category is the same, and not every bank has the same expertise in underwriting and managing each category of loans.

Some of the most successful banks in the country with under $10 billion in assets make construction and development loans with great frequency and in relatively large amounts.  In visiting with many of them, we have observed that these loans are being extended with careful, and in some cases proprietary, underwriting criteria to ensure that the institution is getting an appropriate risk-adjusted return on the credits.  In many cases, the bankers are focused on lessons learned during the financial crisis to ensure as best they can that those mistakes are not repeated.  While the market seems to be continuing to loosen, we have observed that underwriting requirements on these loans are generally much more conservative than they were prior to the crisis and that the credits are being monitored much more carefully than they were prior to the crisis.  Therefore, it makes little sense to us to use strict historical statistics to evaluate the industry’s current exposure to losses in this loan category.  These standardized rates make even less sense when one considers that certain banks are very experienced and skilled in making certain types of loans, including construction and development loans.

Perhaps the silver lining here is that the new assessment rates will be subject to caps for 1 and 2 rated institutions (as well as floors for 3, 4, and 5 rated institutions.  Therefore, banks with good regulatory standing will have a cap on how much these new rules will affect them.

Again, we applaud the FDIC’s efforts to develop a more serious approach to underwriting deposit insurance.  However, we believe that they should give credit to the industry’s own willingness to evolve in its exposure to credit risk as well.