In recent years, bank regulators increasingly have focused on the growth in commercial real estate (CRE) concentrations and the perceived risk that such concentrations create in relation to earnings and capital.  This concern was highlighted in December 2015, when the Fed, the FDIC and the OCC jointly issued a statement to “remind financial institutions of existing regulatory guidance on prudent risk management practices for [CRE] lending activity through economic cycles.”  In addition, the OCC moved CRE concentration risk management “from a monitoring status to an area of additional emphasis” in its Spring 2016 Semiannual Risk Perspective.  Regulators generally pay close attention to institutions with CRE concentrations that exceed 300% of total risk-based capital.

The American Banker (sub. required) recently reported that CRE concentrations could significantly shape bankers’ strategies in 2017, and specifically “influence M&A and loan diversification in 2017.” We agree. In fact, the American Banker is perhaps understating the potential impact of CRE concentrations in 2017 given the impact that CRE concentrations already had on M&A activity in 2016.

One important way that CRE concentrations affect M&A activity is by encouraging banks with high CRE concentrations to seek mergers with banks with lower CRE concentrations, because banks with high CRE concentrations are under regulatory scrutiny and may be limited in their ability to grow their balance sheets  organically.  Thus, one solution is to merge with a bank with a different mix of assets resulting in a lower CRE to total risk-based capital ratio.  One example is Independent Bank Group, Inc.’s acquisition of Carlile Bancshares, Inc.  On both the earnings call and in the transaction’s investor presentation, management cited reducing Independent Bank Group’s ratio of CRE to total risk-based capital as a strategic rationale for the transaction.

Similarly, banks with CRE concentrations above the regulators’ targets may have limited interest in engaging in any M&A activity that does not decrease such CRE concentrations.  For example, Suffolk Bancorp disclosed in its proxy statement filed in connection with its pending sale to People’s United Financial, that it declined to engage with certain bidders who had high CRE concentration levels, because such bidders presented a risk that regulators would not approve the deal.

We see CRE concentrations continuing to play a meaningful role in 2017, both driving deals between banks with high and low CRE concentrations, and also presenting hurdles to transactions between banks which both have CRE concentrations above regulatory targets.