About 95 percent of the loans issued last year by Butler Bank, a $202 million-asset, FDIC-regulated institution based in Lowell, were related to construction and commercial real estate.

Federal regulators recently turned their attention to commercial lending, eliciting predictably mixed reactions from the banking community.

Commercial real estate is a growing business opportunity, especially for community banks. And banks are one of the most heavily regulated industries in the nation. Given those realities, industry watchers say it was just a matter of time before banking regulators took a harder look at the burgeoning commercial loan arena.

On Dec. 12, three regulatory agencies – the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency – issued “Concentrations in Commercial Real Estate Lending: Sound Risk Management Practices,” a guidance designed to ensure that banks are adequately assessing the risk of the commercial real estate loans they make.

“The agencies have observed that commercial real estate (CRE) concentrations have been rising over the past several years and have reached levels that could create safety and soundness concerns in the event of a significant economic downturn,” the regulators wrote in the Federal Register, a daily printing of federal documents of public interest, when the guidance was issued.

A fourth federal bank regulator, the Office of Thrift Supervision, issued its own guidance under the same name but with some distinctions. Most Massachusetts banks are regulated by the FDIC.

The National Credit Union Administration did not issue regulations governing commercial lending, and state regulators will make use of the guidelines but do not plan to issue their own, according to Massachusetts Division of Banks Chief Operating Officer David Cotney.

Rob Kimmett, senior vice president of marketing and public relations for the Massachusetts Credit Union League, said NCUA likely did not join the other regulators in issuing commercial loan guidance because commercial loans are not available at the extent, dollar volume or variety at credit unions as they are at banks.

Most banks offer commercial loans, but the number and dollar amounts vary widely, as do whether the loans are related to commercial real estate and development or general business lending.

In Massachusetts, levels of commercial real estate lending vary from below 10 percent to more than 90 percent of a bank’s total loan portfolio.

As many as 40 Massachusetts banks exceed the risk-factor threshold the three-agency guidance sets, one industry source said.

A bank might be identified for a second look under the new, three-agency guidance if it has experienced “rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds the following supervisory criteria.”

For example, if a bank’s total reported construction and land development loans represent 100 percent or more of its total capital, or if its total commercial real estate loans represent 300 percent or more of its capital and the outstanding balance of the institution’s commercial real estate loans has increased 50 percent or more in the past three years, it may be subject to further scrutiny.

Generally, banks retain 6 percent to 10 percent of their total assets as capital, which is the positive difference between their assets and liabilities, or money available to lend.

A significant difference between the OTS guidance, which applies federal thrifts, and the other agencies’ guidance is that the OTS uses a different loan-threshold standard.

The OTS enforces the 1933 Home Owners’ Loan Act, the federal law that governs the mortgage activities of federal savings banks, already limits the amount that federal savings banks can invest in commercial real estate loans to 400 percent of capital.

The final OTS guidance states that, “instead of using numerical thresholds to identify institutions with CRE concentrations Â… all institutions actively engaged in CRE lending should assess their own CRE concentration risk.”

CRE loans are defined by both sets of guidance as land development and construction loans, including single- to four-family residential and commercial construction loans, other land loans, and loans secured by multifamily property and non-farm, non-residential property where the primary source of repayment is derived from rental income or the proceeds of the sale or refinancing of the property.

They are loans with risks sensitive to market conditions affecting commercial real estate, such as interest rates, vacancy rates and rents.

Stress Tests
Butler Bank, a $202 million-asset, FDIC-regulated institution based in Lowell, is well known for its construction lending, which accounted for about 95 percent of the loans it issued last year.

“[Butler] has got the highest percentage of construction loans to total loans of any bank in the country. The whole world knows it,” said Ken Ehrlich, a partner and chief of the banking practice at the Boston law firm Nutter, McClennen & Fish.

While the bank is “extraordinarily profitable,” he added, there’s always a fear of a collapse in the commercial real estate sector.

Butler has an application pending to merge holding companies with Marlborough Co-operative Bank, a bank Ehrlich represents that has most of its loans in residential real estate. The affiliation will diversify the loan portfolios of both institutions, he said.

Butler has concentrated in construction lending for projects such as apartment complexes, strip malls and subdivisions “since 1901, when my grandfather opened the bank,” President and Chief Executive Officer John Pearson Jr. said.

The bank already does “stress testing” to make sure the loans can withstand market fluctuations, he said – something the guidance suggests banks implement if they haven’t already.

Pearson said when the new guidance, with its 100/300 percent thresholds, was issued, he was concerned because his bank currently has 800 percent of its capital invested in commercial loans.

“We probably, last year, approved $200 [million] to $300 million in construction versus the rest in car loans and mortgages on single-families – a very small percent,” he said.

Pearson said he checked with the bank’s regulator, the FDIC, which gave him “comforting” answers.

“They said they weren’t concerned [with banks such as Butler that] had been doing construction loans over a long period of time, but in banks that just jumped in and had doubled or quadrupled the amount” of commercial real estate loans they originate, he said.

Natick-based, $3.4 billion-asset Middlesex Savings Bank is closer to the other end of the spectrum, with about 15 percent of its $1.8 billion loans portfolio invested in commercial real estate.

“We are well under the 100 percent/300 percent figures,” said MSB’s Senior Credit Officer and Senior Vice President David Keller. “We are pretty well diversified.”

Some banks, such as $1 billion South Shore Savings Bank – whose new president and chief executive officer, John Boucher, could not be reached for comment – have increased commercial lending dramatically in recent years.

SSSB’s total commercial lending has risen from zero to 50 percent of its total loans since 2001, Boucher noted in a B&T profile last week.

Leader Bank President and Chief Executive Officer Sushil Tuli said his $200 million-asset Arlington bank has about 30 percent of its portfolio in commercial lending, and most of that is real estate-related. Tuli said there’s no question that small community banks have been jumping on the commercial real estate lending bandwagon in greater numbers in recent years.

“That’s where the [profitability] margins are,” he said. While a bank can get an interest rate return of about 5.7 percent on a typical adjustable-rate residential mortgage these days, he said, those taking out commercial loans pay at least 7 percent for the privilege.

Mark Tenhundfeld, director of the American Bankers Association Office of Regulatory Policy and author of the ABA’s 103-page guide to the new commercial real estate loan regulatory rules, said smaller, locally based banks excel at commercial lending because they’re in the same market area as the developers and property owners.

“When you’re talking about CRE, size doesn’t matter but location matters because you need to understand the market and the business model of the borrower,” he said. “Smaller banks are seeing this as a way they can compete with bigger banks.”

ABA did not develop a guide to another recently released federal agency guidance covering non-traditional residential mortgages, he said, because it found banks had much greater concerns and more questions about the commercial real estate guidance.

Massachusetts bankers and industry representatives say they see the new guidelines, in general, as simply reiterating sound lending practices.

“A lot of these are prudent risk-management practices already in use in the industry,” said Keller, who said he doesn’t consider the guidance “overbearing,” although he said some smaller banks may have to put new market-sensitivity analysis procedures in place because of it.

Massachusetts Bankers Association Director of Federal Regulatory and Legislative Policy Jon Skarin agreed with Keller that “generally there’s not a ton of new stuff in [the commercial real estate guidance].”

He said regulators have stated publicly and in conversations with MBA officials that the northeastern United States “was never really the focus of concern” because there has been less speculative lending here, in recent years, than in the Southeast and Southwest.

One of Massachusetts’ most powerful federal-government voices in the financial industry is U.S. Rep. Barney Frank, a Democrat from Newton who chairs the House Financial Services Committee.

In a statement released shortly after the guidance documents were released, he said he was “very disappointed” in the agencies’ decisions to issue them.

“Our committee’s hearing on this topic [in fall 2006] showed that there was no real basis for the approach they are taking, which we believe may unduly discourage lending, including multifamily lending that plays an important social role,” he said.