Researcher Helps Banks Predict Losses in Lending

Tim Yeager, an associate professor of finance

In response to federal banking regulators’ concern about community banks’ increased participation in commercial real-estate lending, a researcher has developed a system that allows banks to perform stress tests on their commercial real-estate portfolios.

Tim Yeager, an associate professor of finance, modeled how large losses within categories of commercial real-estate loans would affect a bank’s overall losses, earnings and capital. His spreadsheet-based simulation tracked the effects of significant losses, or “shocks,” in eight categories, including retail, industry and construction and land development.

“Nationwide, commercial real-estate loans at community banks have exploded from 23 percent of total loans in 1990 to 47 percent in 2005,” said Yeager. “It is not surprising, therefore, that bank supervisors have expressed concern at the growing concentration.”

Participant banks had an average of $144.7 million in commercial real-estate loans, of which 45 percent was in construction and land development. A 20 percent shock — or rate of loss — to this category relative to the other loan types produced the largest negative effect due to its dominant proportion of the banks’ loan portfolios. This worst-case scenario reduced average capital ratios by 3 percentage points in the first year.

The capital ratio is a bank’s equity divided by assets. High capital ratios protect a bank from
insolvency because shareholder equity absorbs the first losses, Yeager said. Typical capital ratios for banks run between 7 and 9 percent. A capital ratio of 2 percent is the threshold that bank regulators use to close a bank.

As a tool for any community bank, Yeager’s simulation method allows users to “shock” each loan category separately and provides a five-year forecast of balance-sheet and income-statement effects. Results of the simulation estimate the effects of a large loss to banks’ commercial real-estate portfolios.

“To prepare banks and provide the most useful information, our results are skewed toward a reasonable, worst-case scenario,” Yeager said.