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Proposed Regulatory Updates Will Require Increased Analysis of New Loans to Determine if Different Risk Weight Exposures Apply

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On September 27, 2017, the principal federal banking agencies, the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, released a Notice of Proposed Rulemaking (the “Proposed Rule”) which proposed changes to the current treatment of High Volatility Commercial Real Estate Exposures (“HVCRE”) for banks and financial institutions subject to the standardized approach. The proposed rules would not apply to any existing HVCRE exposures that are outstanding prior to the final rules implementation.

 Currently, HVCRE exposures are governed by the Dodd-Frank Wall Street Reform and Consumer Protection Act which follows the directives from the Basel III regulatory framework. Under these regulations, HVCRE exposures arise from loans associated with the acquisition, development, and construction of real estate prior to permanent financing and are subject to a higher risk weight (150%) than other commercial real estate loans (100%). This requires banks making HVCRE loans to hold significantly more capital in reserve to support these loans. 

The Proposed Rule contains a number of different modifications to existing regulations with the stated intent of simplifying and reducing the compliance burden on community banks and financial institutions using the standardized approach. Notably, the Proposed Rule clarifies the types of loans that are subject to higher risk weighting, eliminates some of the current exemptions, reduces the capital burdens on banks by lowering the risk weight from 150% to 130%, and broadens the scope of loans subject to these higher risk weight percentages through the creation of a new category of High Volatility Acquisition, Development, or Construction exposures (“HVADC”). These proposed changes and their potential impact on community bankers and financial institutions are discussed in more detail below.

The Proposed Rule replaces the current HVCRE framework with a new category known as HVADC.  Under the Proposed Rule, HVADC exposures would apply to a credit facility that primarily finances or refinances the: (i) acquisition of vacant or developed land; (ii) the development of land to prepare to erect new structures, including, but not limited to, the laying of sewers or water pipes and demolishing existing structures; or (iii) the construction of buildings or dwellings or other improvements, including additions or alterations to existing structures.

The “primarily finance or refinances” requirement will likely broaden the scope of this exposure category and will require banks to spend additional time analyzing these types of loans to determine if they are subject to a higher risk weight. Primary finance, in this context, means a loan in which more than 50% of the funds would be used for acquisition, development, or construction activities. The proposed rule balances this increased application of the heightened exposure category by reducing the risk weight from 150% to 130%.

The Proposed Rule’s primary finance test will likely require increased analysis of each loan to determine whether it is subject to the higher risk weight exposure. Certain exposures, for example a multipurpose facility with 50% or more of the funds going towards the purchase of equipment or other non-acquisition, development, or construction activities, will not be subject to the higher risk weight. The removal of certain exemptions and the broad scope of the Proposed Rule will likely lead to an increase in the number of exposures that are subject to the higher HVADC risk weight. The reduction from a 150% to 130% risk weight will mitigate, in part, the burdens associated with this broader category of exposures under the proposed HVADC categorization.                                   

The federal banking agencies will open up the Proposed Rule to public comments for 60 days after the Notice of Proposed Rulemaking is officially published in the Federal Register. This notice has not, as of the writing of this article, been published.  Steptoe & Johnson’s Banking and Regulatory attorneys will continue to monitor the progress of this proposed change.  Please feel free to contact the author directly should you have questions concerning this, or other banking matters.

 

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