From HVCRE to HVADC: What Community Banks Need to Know

On October 27, the federal banking agencies published a joint notice of proposed rulemaking (the “Proposal”) in the Federal Register that intends to simplify and clarify certain aspects of the Basel III capital rule. Among other things, the Proposal would replace the High Volatility Commercial Real Estate exposure category (“HVCRE”) with a new category called High Volatility Acquisition, Development, or Construction (“HVADC”). Notably, HVADC would apply on a going forward basis, while HVCRE would continue to apply to loans that are outstanding or committed prior to the effective date of the final rule.

Under current regulations, an HVCRE exposure generally means any credit facility, other than a permanent loan, that finances or has financed the acquisition, development, or construction (“ADC”) of real property. There are exceptions to HVCRE treatment for ADC facilities that finance certain residential, agricultural, or community development projects or that meet certain so-called “contributed capital” criteria. For purposes of a bank’s risk-based capital ratios, HVCRE exposures are subject to a 150 percent risk weight instead of the 100 percent risk weight that applies to many commercial loans. To avoid the higher HVCRE risk weight, banks have worked to fit their ADC loans into one of the HVCRE exceptions to the extent possible.

Banks of all sizes have struggled to comply with the HVCRE rule. In particular, banks have had difficulty interpreting and applying the contributed capital exception and determining what constitutes a permanent loan. The Proposal aims to address these concerns and to otherwise simplify the capital treatment of ADC loans.

The Move to HVADC 

HVADC would be conceptually similar to HVCRE but different in several important ways. This article summarizes the following differences: (1) HVADC would exclude the contributed capital exception, (2) banks would apply a 130 percent risk weight to HVADC credit facilities, (3) HVADC would define “permanent loan,” and (4) HVADC would apply only to credit facilities that “primarily finance or refinance” ADC activities.

Exclusion of Contributed Capital Exception. The HVCRE contributed capital exception has generated numerous comments and questions from banking organizations, with many banks asserting that the exception is unclear, complex, and burdensome to implement. Borrowers utilizing credit facilities under this exception are contractually obligated to keep both their contributed capital and internal returns on that capital in the ADC project throughout the life of the project. This restriction makes equity more expensive for borrowers and ultimately leads to fewer feasible loans for banks. In order to simplify the capital rule, the Proposal’s HVADC definition does not include a contributed capital exception.

Lower Risk Weight. Although the contributed capital exception to HVCRE is complex, it gives banks the ability to assign a 100 percent risk weight to qualifying loans that otherwise would be considered HVCRE and risk-weighted at 150 percent. As a result, the Proposal’s exclusion of the contributed capital exception is likely to disappoint banks that have worked hard to make loans that qualify for the exception. To offset the impact of the exclusion, the Proposal would assign a 130 percent risk weight to HVADC loans, instead of the 150 percent risk weight currently assigned to HVCRE loans. Banks should evaluate how this change would alter their capital planning and lending programs.

Clarification of “Permanent Loan.” HVADC would bring some clarity to the permanent loan concept by defining the term “permanent loan.” Under the Proposal, a permanent loan would be a “prudently underwritten loan” that has a “clearly identified” and “ongoing source” of repayment that is “sufficient to service amortizing principal and interest payments aside from the sale of the property.” The Proposal expands on this text with several explanations. First, the loan payments themselves would not need to be amortizing in order for the loan to qualify as a permanent loan. As a result, an interest-only loan could constitute a permanent loan for HVADC purposes as long as the source of repayment is sufficient to service an amortizing payment. Second, for an owner-occupied ADC project, the owner may have sufficient capacity at origination to repay the loan from ongoing operations without relying on proceeds from the sale or lease of the property. In that case, the agencies would consider the loan to be a permanent loan. Third, as an ADC property begins to generate revenue, a credit facility that was not considered a permanent loan at origination could begin to meet the permanent loan criteria and become exempt from HVADC treatment. Fourth, bridge loans generally would not qualify as permanent loans, because the underlying property typically could not generate sufficient revenue to make amortizing principal and interest payments.

“Primary” Purpose. The Proposal would define an HVADC exposure as any credit facility that “primarily finances or refinances” ADC activities. The Proposal clarifies that a credit facility would meet this standard if more than 50 percent of the funds would be used to finance ADC activities. Thus, a loan under which 51 percent of the funds would be used for equipment and 49 percent would be used for construction would not meet this standard and would not be subject to HVADC treatment. A bank seeking to escape HVADC treatment under this provision would have to keep records that carefully document how its borrower would use the funds.

Conclusion

If the Proposal becomes final, community banks going forward should enjoy a somewhat simpler approach to ADC risk-weighting, as well as a lower risk weight of 130 percent for many ADC loans. At the same time, community banks stand to lose the “contributed capital” exception that currently keeps a number of ADC loans out of HVCRE treatment. Each community bank should consider the pros and cons of the Proposal and its likely effect on the bank’s capital planning and lending programs.

Republished with permission. This article first appeared in the November/December 2017 issue of Board Briefs.