Nestled in the vibrant Nashville suburb of Franklin, Tennessee, Cumberland Bank is a $900-million-asset community bank with a $620 million loan portfolio, which is largely allocated to real estate loans. Franklin is centered in affluent Williamson County, which ranks 11th in the U.S. in per capita income ($39,150) and 15th in median family income ($90,087). The area also shows strong population growth, with some cities having doubled in population in just the past few years.
High income and rapid growth, coupled with a lending staff whose experience is largely in real estate lending, led to Cumberland Bank's unsurprising classification by its regulators as a real-estate-concentration bank and thus subject to the December 2006 interagency guidelines. This is the story of how Cumberland met the challenge of the guidelines with a program that its examiner from the FDIC deemed a model for other banks.
During the latter half of 2005, Cumberland Bank's credit team learned that guidance on managing real estate concentrations might be released in early 2006. Regulators had labeled a number of institutions in the Southeast as real-estate-concentration banks, and their examinations were geared toward evaluation of CRE risk management processes. Cumberland's CRE concentration was approximately 435% of Tier One capital plus the ALLL, and construction and development loans were approximately 215%. The criteria for classification as a CRE concentration bank in the final draft of the guidelines are as follows:
1. Total loans for construction, land development, and other land represent 100% or more of total capital; and
2. Total commercial real estate loans represent 300% or more of total capital, and the outstanding balance of the CRE portfolio has increased 50% or more during the past 36 months. Cumberland met both tests for determining a real-estate-concentration bank, so it was no surprise when it was labeled as such.
Loans where the real estate is a secondary source of repayment, or taken as collateral through an abundance of caution, are excluded from the test. For example, a loan would not be considered CRE if it was earmarked to build an owner-occupied manufacturing facility where the cash flow of the company is the primary source of repayment and the real estate is the secondary source.
As is true for many community banks, Cumberland's bread and butter--and expertise--is real estate lending. We did not possess the infrastructure necessary to manage C&I risk, so it would have been counterproductive to reduce the real estate loan composition in favor of C&I lending just to avoid the classification as a real-estate-concentration bank. The best strategy for the long run was to implement sound risk management processes for real estate, so we decided to focus on tackling the new guidelines.
Finding the Concentrations
Management decided to dedicate an experienced senior employee to lead this mission. It was clear that we should manage not only the risk of the individual loans but also that of the overall portfolio, although not everyone shared this opinion. Some failed to see the need to manage the portfolio risk if the bank was managing the transaction risk. Several members of the organization, including members of the board, had to be convinced that transaction risk and portfolio risk are two separate issues. However, we knew that having a full-time person dedicated to this area could add value to the bank and the board.
With the upper levels of management on board, the first major objective was to determine what type of portfolio the bank currently had. Figure 1 shows a report to identify concentrations that we created based in part on information from the regulators.
Our next step was to expand the loan accounting system as well as the loan approval documents so they could capture the more detailed information we needed. This …