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For release on delivery
10:Q0 a.m. EOT
July 30, 1992

Testimony by

John P. LaWare

Member, Board of Governors of the Federal Reserve System

before the

Committee on Banking, Finance and Urban Affairs

United States House of Representatives

July 30, 1992

Mr. Chairman and members of the Committee, I am pleased
to have this opportunity to discuss the Federal Reserve's
supervision of bank lending on commercial real estate and the
international coordination of supervisory efforts, in general.
As requested, I will also provide an assessment of commercial
real estate markets around the country and describe steps we have
taken to alert examiners about potential risks.
In brief, conditions within the U.S. banking system
generally appear to be improving and, for some institutions,
improving in significant ways.

This progress flows from a number

of sources, including a general stabilizing of commercial real
estate markets, albeit at a relatively depressed level in all too
many cases.

Nevertheless, problem real estate credits remain a

principal concern to major bank lenders throughout the country
and also, of course, to the supervisory agencies.

It is

important to learn from past events, and steps are being taken by
both banks and the agencies to prevent the recurrence of problems
of the scope we have experienced in recent years.

Importance of Commercial Real Estate Lending

While always important to U.S. commercial banks, real
estate lending became even more critical to the industry during
the past decade, as all loans secured by real estate increased
from 14.5 percent of total commercial bank assets at the end of


1980 to nearly one-quarter of the industry's assets at the end of
last year.

Currently, loans secured by real estate represent the

largest asset class held by banks today and at $850 billion
exceed the volume of commercial and industrial loans by more than
$330 billion.

In absolute terms, real estate loans have

accounted for more than one-half of the industry's loan growth
since 1980.
This growth in real estate lending includes substantial
increases in home mortgages as well as commercial real estate
loans, but it is the latter, of course, that has mainly presented
the problems to the banking industry.

Commercial real estate

lending has also been the fastest growing real estate segment,
with loans outstanding nearly quadrupling during the 1980s.


lending, combined with that provided by thrift institutions,
fueled a dramatic expansion in commercial real estate building
nationwide that has left markets in most cities around the
country significantly overbuilt.
To understand conditions today, it is helpful to
consider views commonly held during much of the 1980s when most
of the excess construction occurred.

Over that period,

contractors and lenders alike seemed to believe that nearly all
real estate projects would prove profitable, and for a long
period of time.

That view was supported by experiences in which

properties were generally worth more by the time they were
completed than all the costs included in their construction.
Even banks that held problem REIT loans in the mid-1970s had seen


those problems largely disappear with rising inflation rates that
gave real estate values a boost.

Although inflation rates had

declined since then, many developers and lenders still felt that
real estate values would continue to increase.
These expectations, as well as favorable tax treatment
accorded by 1982 legislation and the general ebullience of the
economy encouraged many builders to expand their activities.


the same time, thrifts looking for added revenues to offset other
problems, banks experiencing a loss of customers to other lenders
and to the open market, and foreign banks seeking to expand their
presence in the United States, all decided to lend aggressively
in the real estate sector.
A principal result of this intense competition was that
many institutions liberalized their terms of lending.


particular, they became more willing to finance land acquisition
and construction projects and also to provide so-called "miniperm" loans to carry projects several years beyond construction.
That financing allowed developers and other real estate borrowers
to undertake projects without the permanent take-out financing
traditionally provided by long-term investors.

During their

first few years of operation the projects were to become fully,
or at least mostly, leased and permanent financing obtained.
Clearly, though, as commercial real estate markets deteriorated
in the face of excessive capacity, many properties failed to
lease up and relatively few long-term lenders have stepped


Thus, banks have been unable to extricate themselves

from many of these credits.
As the Committee knows, the resulting exposure from
mini-perms and from other commercial real estate lending has
placed substantial stress on the banking industry, has been a
main contributor to the failure of a number of large banking
institutions, and has led to the merger or acquisition of others.
At the end of March, 1992, U.S. commercial banks held more than
$26 billion of nonperforming commercial real estate loans and
another $21 billion of foreclosed commercial properties.


high levels remain despite the large charge-offs the industry has
taken in recent years.

The main positive note is that the

increase in problem real estate loans has slowed sharply from the
explosive pace of 1990 and, even including foreclosed assets, has
virtually stopped since the middle of last year.

Supervisory Procedures for Real Estate Credits
With that background, I would like to discuss the
Federal Reserve's procedures for reviewing real estate loans and
assessing the lending activities of state member banks.


procedures are contained in our Commercial Bank Examination
Manual and in other supplementary documents that provide guidance
on the supervision of real estate lending that the Federal
Reserve has followed for many years.
An assessment of real estate lending activities rests
heavily on the payment performance of each borrower, the value of

the collateral supporting individual loans, and a review of the
bank's own operating policies and procedures.

Examiners also

determine whether the bank has complied with applicable laws and
regulations and whether its portfolio is consistent with general
principles of diversity.

Where weaknesses are found, examiners

are instructed to ensure that corrective measures are adopted.
Lending policies are reviewed to see that they are well
documented and complete and that they cover relevant aspects of a
sound lending activity.

Examiners also consider whether, for

example, they define the geographic limits within which the bank
will lend, the types of properties acceptable to the bank, the
required internal authorizations, the type and frequency of
information to be required from the borrower and the appraiser,
maximum acceptable exposures, and standards for documentation.
In addition to determining whether the policies and stated
procedures are adequate, our examiners also undertake to confirm
that the policies are being followed by reviewing loan portfolios
and credit files.
Traditionally, in assessing individual loans and loan
portfolios, examiners have been advised to consider the
borrower's fundamental ability to meet his or her obligations and
not place undue reliance on the collateral value of a loan.
Therefore, if the collateral's value declines but other factors
remain sound, a loan is not automatically classified or

The wisdom of that approach has been demonstrated by

recent experience, as the value of many commercial real estate

properties declined below previously appraised values.
Nevertheless, when a credit does become troubled and the borrower
is unable to meet an obligation, the role of the collateral
increases in importance.

It is critical, therefore, that banks

have sound appraisal policies and standards in place.
There are a number of ways to estimate a property's
value that are accepted by appraisers, bankers, and the
regulatory agencies.

They typically consider a variety of

factors including historical cost less appropriate depreciation,
current market comparisons, and the capitalized value of revenues
that the property is reasonably expected to provide.


appraisals are considered to be out-of-date or otherwise
deficient, examiners replace inaccurate or outdated assumptions
and generally follow procedures similar to those used in the

Since commercial real estate loans of banks are

often on relatively new properties, examiners generally consider
estimated stabilized income streams when making their

They also look for indications of troubled loans

such as rent concessions, declining market prices, or payment

Consideration is also given to the unique

characteristics of real estate properties, which can be either
beneficial or harmful to their underlying value.
Following their review, examiners assign a specific
rating to each problem loan.

Those rated substandard are likely

to produce losses to the lender, unless deficiencies are

Doubtful loans are those for which collection in full


is highly questionable and improbable, while assets rated loss
are considered uncollectible and not appropriate to report as
bankable assets.

In addition to assigning ratings, examiners

should attempt to determine what amount of a loan should properly
be charged off or reserved and then classify the remainder, as
Not yet mentioned are other possible supervisory
standards for real estate lending that have been recently
proposed as a result of requirements of the Federal Deposit
Insurance Corporation Improvement Act (FDICIA). Earlier this
month the Board issued for public comment its proposal regarding
Section 304 of FDICIA, a section that requires the agencies to
adopt uniform regulations prescribing standards for real estate

If adopted, the proposal would reimpose a concept of

regulatory maximum loan-to-value (LTV) ratios for real estate
lending that was repealed for national banks by Congress in the
early 1980s.
Tentatively, the ratios would serve as guidelines for a
variety of different types of real estate loans.

Under one

alternative method, lenders would individually establish LTV
ratio limits within or below a range of supervisory limits
prescribed in uniform regulations and subject to supervisory

The low end of the range would be considered as a

benchmark ratio for that category of loan.

Institutions would be

able to select a higher maximum ratio (within the specified
range) on the basis of demonstrated expertise in that particular

type of lending and other factors.

Under the second alternative,

the agencies would prescribe maximum LTV ratio standards in their
regulations that institutions could not exceed.
There are a number of proposed exemptions to these
standards, such as for loans guaranteed or insured by the U.S.
government, and there is a provision allowing for a limited
amount of nonconforming loans.

The agencies are also considering

exemptions for loans to organizations or projects promoting the
economic rehabilitation and development of low-income areas.


final details of the standard will depend upon the comments
received and any further agency reviews.

Uniform régulations are

required to be adopted by March, 1993.
In hindsight, more stringent standards and more
vigorous supervision may have helped to prevent many of the
problems we have seen.

Examiners did not insist on conservative

practices as much as they should have.

But in boom times, it is

hard to argue with success.
It is important to emphasize, in this connection, that
examiners do not dictate that bankers extend or not extend credit
in specific cases.

That responsibility properly belongs to the

The examiner, rather, should review procedures for

safety and soundness and help to ensure that the bank's financial
statements reasonably reflect the condition of the bank.
Provided bank policies and procedures are reasonable, appraisals
appear sound, and the credit is performing as agreed, it is
difficult and inappropriate for examiners to criticize loans or


to override the banker's judgement about the outlook for future
market conditions.
However, as asset quality deteriorates and it becomes
clear that conditions have changed and that management's strategy
has not worked as planned, the bank's activities may begin to
threaten the safety net.

At that point, the examiner and other

supervisors obviously have a more important voice in the approach
management takes in resolving its problems and more forcefully
impose their views.

Corrective measures required of the bank may

take a number of forms, including capital plans, restrictions on
lending, and thé development of stronger credit standards.


necessary, supervisory demands can be backed by cease and desist
orders and can involve the removal of key officers and directors
and, ultimately, seizure of the bank.

Recent initiatives
Concerns about excessive tightening of credit standards
by many banks and the inability of apparently creditworthy
borrowers to obtain or renew bank financing in the wake of
examiner criticisms of commercial real estate credits led the
agencies to undertake an extensive review of their examination
practices throughout much of last year.

In recognition that

banks had shifted markedly in their willingness to lend, the
agencies undertook special efforts to coordinate and clarify
their supervisory policies.


Much of the reduced willingness to lend was
understandable given weak economic conditions, the level of
excess capacity in commercial real estate markets, and the asset
quality problems of many banks.

Moreover, some strengthening of

credit standards was needed in much of the industry, and those
changes would necessarily affect the lending policies of many

Nevertheless, the agencies felt that banks might be

tightening unduly because of concerns about supervisory actions.
We wanted to ensure that banks did not misunderstand our
supervisory policies or believe that examiners would
automatically criticize all new loans to troubled industries or
Accordingly, building on earlier initiatives, in^March,
1991 the agencies issued a joint statement to address this

That statement sought to encourage banks to lend to

sound borrowers and to work constructively with borrowers
experiencing temporary financial difficulties, provided they did
so in a manner consistent with safe and sound banking practices.
The statement also indicated that failing to loan to sound
borrowers can frustrate bank efforts to improve the quality and
diversity of their loan portfolios.


institutions and those with real estate or other asset
concentrations were expected to submit plans to improve their
positions, but they could continue sound lending activities
provided the lending was consistent with programs that addressed
their underlying problems.


At other times during the year, and particularly in
early November, the agencies expanded on that March statement and
issued further guidance regarding the review and classification
of commercial real estate loans.

The intent was to ensure that

examiners reviewed loans in a consistent, prudent, and balanced

This second statement emphasized that evaluation of

real estate loans should be based not only on the liquidation
value of collateral, but also on a review of the borrower's
willingness and ability to repay and on the income-producing
capacity of the properties.
Finally, in December, in order to assure that these
policies were properly understood by examiners and to promote
uniformity, the agencies held a joint meeting in Baltimore of
senior examiners from throughout the country in one more effort
to achieve the objectives just described.

Once again, the

principal message was to convey the importance of balance.
Examiners were not to overlook problems, but neither were they to
assume that weak or illiquid markets would remain that way
indefinitely when they evaluated commercial real estate credits.
I would stress that the regulatory agencies took great
care to indicate that these initiatives did not represent an
exercise in forbearance.

Indeed, they were compatible with the

long-standing supervisory procedures described earlier.

International coordination

The Committee also asked about efforts to coordinate
bank supervision on an international basis, so I will offer a few
remarks on that topic.

As you know, the Basel Committee on

Banking Supervision was established as a permanent body by the
governors of the Bank for International Settlements to provide a
forum for exchanging views and information on bank supervisory

It is currently chaired by President Corrigan of the

Federal Reserve Bank of New York.
Regular meetings of the Committee include a tour de
table, during which representatives from all countries comment on
areas of concern.

When appropriate, topics would include

commercial real estate markets and overall bank exposure to that
market in countries experiencing a problem with commercial real

During these meetings, there is also ample opportunity

for an informal exchange of views, experiences and problems, and
for open and frank discussions.
In the vast majority of cases, credit problems in the
commercial real estate industry tend to be uniquely national in
nature, but where they are not, informal conversations are held
with other regulators.

This is particularly true when foreign

branches and subsidiaries of U.S. banks have significant
exposures in foreign markets that are experiencing problems in a
particular sector such as commercial real estate.

One example

would be the situation several years ago in Australia where
commercial real estate problems in that country had a major

effect on the asset quality of several U.S. bank holding
companies with a banking presence in Australia.
From time to time, a major cross-border problem will
arise, the most recent and most serious being the credit and
liquidity problems of Olympia and York Developments Ltd.

In that

particular situation, there were extensive and informal
discussions with central banks and supervisory authorities in the
United Kingdom and Canada, as well as with major creditor banks
in the United States.

Finally, there was a discussion at the

April meeting of the G-10 central bank governors at the Bank for
International Settlements.

This meeting occurred just after the

initial intensive press coverage of the Olympia and York

Chairman Greenspan and Secretary Brady were kept

appraised of major developments as they occurred.

Assessment of U.S. Real Estate Markets

As noted in my opening comments, the worst seems to be
behind us in terms of declining commercial real estate markets in
most sections of the country, but only because the decline has
stopped or at least slowed markedly.

There remains little real

improvement to be seen in any major market nationwide, and
conditions in Southern California continue to be a concern.
Basically, the volume of excess real estate capacity will take
years for the nation to absorb and for the banking industry to

That said, the industry's performance during recent

quarters offers encouragement that banks will generate sufficient

revenues to resolve their problems more quickly than many have
Although the initial and, hopefully, worst revaluation
phase appears over, further write-downs undoubtedly lie ahead.
Metropolitan office vacancy rates, which reflect both downtown
and suburban experiences, remain around 19 percent nationwide,
about where they have been for several years.

Some communities,

such as Dallas, Ft. Lauderdale, and Stamford, have vacancy rates
exceeding 25 percent.

Such conditions will continue to place

pressure on commercial real estate values and dampen earnings of
some banks for at least the near future.

Olympia and York

One of the largest and most recent commercial real
estate problems involves the Olympia and York (O&Y) group, which
has substantial properties in Canada, the United States, and the
United Kingdom.

As the Committee may know, in late May, the

company sought bankruptcy protection in the British courts for
Canary Wharf, following similar filings earlier in the month for
its Canadian companies.

O&Y's U.S. companies have not sought

bankruptcy, and the parent has stated publicly that it has not
planned any filings for them.
The bulk of O&Y loans appears to be financed primarily
by foreign banks, insurance companies, and public debt holders.
Although some U.S. banks— a half dozen or so— also have sizable
claims on O&Y, their exposures constitute a relatively small

share of overall O&Y debt and do not appear to be unmanagable or
to pose a threat to the lending institutions.

Loans to Canary

Wharf, in turn, are a small portion of U.S. bank claims on O&Y.
Although O&Y is not a major problem in itself for any
U.S. bank, the conditions that produced problems for the company
continue to depress real estate markets and are made worse by the
weakness of this exceptionally large developer.

That broader

issue, which is the principal focus of these hearings, is the
more serious concern.

Recent Examiner Advice
As indicated, examiners have received a significant
amount of guidance from the agencies during the past year or so
about the assessment of commercial real estate loans and about
conditions in that market.

In addition, their recent personal

experiences evaluating these loans have sensitized them to the
risks in this area, not only in the United States, but also in
other countries where real estate values have declined.
Beyond statements already described, the Federal
Reserve has through various Federal Reserve System meetings
discussed risks in other aspects of the economy and bank lending.
These discussions occur at meetings of members of the Board and
Reserve Bank Presidents, at various conferences and seminars of
senior examiners and other supervisory officials, during weekly
conference calls involving the heads of supervision at the Board
and at each Reserve Bank, and through other internal activities.

The Federal Financial Institutions Examination Council
also provides a forum for discussing supervisory issues and
developing advisories or policy statements for bankers and bank
examiners on an interagency basis.

One statement issued early

this year dealt with investment practices of banks, especially
those involving instruments whose values were exceptionally
sensitive to changing interest rates.

In short, this statement

defines such "high risk" instruments and requires depository
institutions that hold them to be able to demonstrate clearly
that they serve to reduce the overall exposure of their
investments to market rate changes.

In closing, the outlook for domestic commercial real
estate markets and for most of its major bank lenders is more
encouraging now than it was a year ago.

The excess capacity in

the commercial sector of the market, however, will take years to

While both the industry and the bank supervisory

agencies must learn from this experience, from a regulatory
perspective, solutions may be difficult to find.
FDICIA contains numerous provisions that urge bankers
to take greater care, including those involving prompt corrective
action, and regulators have had more responsibilities handed to

Requirements such as annual examinations should help

supervisors to identify problems earlier and hold down the FDIC's

We must be careful, however, in turning constantly to


barriers, prohibitions, and controls when something goes wrong.
Too many restrictions will unduly restrain risk-taking and
curtail economic growth.

We cannot have examiners making

decisions that are the responsibility of bankers in our private
enterprise system.
While many changes were needed, the Congress should
consider the more fundamental causes of the problems and not
address merely the unwanted symptoms we see.
and banking laws need to change, too.

Times have changed,

U.S. banks must have the

legal authority to manage their businesses efficiently and pursue
opportunities that arise.

Without the ability to branch

interstate and to expand into related financial businesses, I
fear that many U.S. banks will continue to operate under profit
pressures, a situation not conducive to a healthy banking system.