On June 24, 2024, Eric Gerding, Director of the Division of Corporation Finance (the Division) of the U.S. Securities and Exchange Commission (SEC), published a statement regarding certain areas of focus within the Division's Disclosure Review Program. While Director Gerding discussed areas applicable to all industries, his statement put banking registrants on alert regarding disclosures of risks related to their commercial real estate (CRE) exposure and the use of artificial intelligence (AI). This Advisory reviews Director Gerding's statements regarding such disclosures by banking registrants and offers key takeaways for banking registrants to consider in response.
Banks' CRE and AI Disclosures
Disclosures for CRE Exposure
Director Gerding set the table — banks with significant
CRE exposure are subject to several risks, and as a result, the
Division has been considering how banks are disclosing their loan
portfolio characteristics and the disaggregation thereof, risk
concentrations, loan-to-value ratios, loan modifications,
nonaccrual loan policies, policies around timing, frequency and
sources of appraisals, and risk management.
To this end, the Office of the Comptroller of the Currency (OCC)
also observed in its Spring 2024 Semiannual Risk Perspective that
some sectors of CRE continue to experience stress due to increased
expenses and a limited ability to increase rents to offset rising
costs. The OCC added that elevated interest rates could adversely
affect borrower cash flow, and that while inflationary pressures
are subsiding, many economists predict that interest rates will
remain elevated over the next two years. While CRE loan growth
slowed, the OCC noted that concentrations in CRE exposure continue
to present heightened risk.1
The Federal Deposit Insurance Corporation (FDIC) also observed in
its updated advisory Managing Commercial Real Estate Concentrations in
a Challenging Economic Environment (published in December 2023)
that the CRE market and lending conditions have been significantly
influenced by governmental and societal responses to the COVID-19
pandemic, interest rates, and the prolonged inverted yield curve
— including that investment property capitalization rates
have not kept pace with the increases in long-term interest rates.
The FDIC also noted higher CRE vacancy rates across both office and
multi-family sectors and acknowledged the challenges of refinancing
office and multi-family loans in an environment of pressured rent
growth, higher interest rates, and lower property
values.2 Further, the Board of Governors of the
Federal Reserve System also took note of the increased risks to CRE
exposure, issuing a Policy Statement on Prudent Commercial Real Estate
Loan Accommodations and Workouts to update and supersede
supervisory guidance to assist financial institutions' efforts
to modify CRE loans.3
Investors and analysts have honed in on CRE risks in the first
half of 2024, during which time higher interest rates and hybrid
working trends, in part, negatively affected many banks' first
quarter earnings results. In addition to disproportionate increases
in nonperforming loans, charge-offs, and provisions for credit
losses in connection with CRE loans, some banks are also decreasing
their CRE exposure altogether.4 Further,
according to Fitch Ratings, smaller banks (i.e., less than US$100
billion in assets) are more likely to be negatively affected by CRE
exposure because CRE loans are more likely to be a concentration of
risk compared to larger banks.5
Accordingly, Director Gerding stated that banks should consider
areas of disclosure where they can provide more granular
information to improve investors' understanding of the material
risks inherent in their CRE or other loan portfolios and any
mitigating steps taken to address such risks.
Disclosure of AI
Director Gerding observed that as companies incorporate AI into
their business operations, their exposure to operational and
regulatory risks increases, which may require disclosure under the
SEC's existing disclosure rules as to how they use AI and the
risks related to such use.
While Director Gerding did not specifically mention banks when
discussing AI, U.S. banks are increasingly turning to AI to
increase operational efficiency, enhance products and services, and
improve overall customer experience. As the OCC observed in its Fall 2023 Semiannual Risk Perspective,
examples of how banks use AI include customer chatbots, fraud
detection, and credit scoring. However, there is currently no
AI-specific legislation for banks that expressly protects consumers
from AI risks or automated decision-making (ADM) systems, adding
complexity to the regulatory environment for banks which multiple
agencies already govern. Supervisory agencies and banks are still
working through potential issues and risks related to AI and ADM,
but issues to date have included potential discrimination in
automated underwriting processes, reduced availability and accuracy
of information for consumers, and inadequately managing risk for AI
tools developed or implemented by third
parties.6 The OCC has specifically identified
the lack of explainability, reliance on large volumes of data,
potential bias, privacy concerns, third-party risk, cybersecurity
risk, consumer protection concerns, and inaccurate responses from
the use of generative AI as relevant AI risks for
banks.7 In addition, the SEC will scrutinize
statements made by banks in how they are deploying AI and the
associated risks, especially banks with a broker-dealer or
investment adviser arm. Any potential materially misleading
statements or omissions may come under scrutiny by the SEC's
Division of Enforcement, as discussed in our March 2024 Advisory.
Director Gerding stated that the Division will consider how
companies describe the opportunities and risks associated with AI;
tailor disclosures about material AI risks and their impact on
business and financial results; focus on the specific current or
proposed uses of AI; and determine whether there is a reasonable
basis for disclosures made.
Key Takeaways
Director Gerding's recent statement regarding areas of focus for the Division put banking registrants on notice as to which disclosures the Division expects in the near-term, particularly with respect to CRE exposure and the use of AI. Accordingly, banking entities should consider the following measures as early as the current quarterly reporting cycle:
- Examine the completeness of disclosures made of risks related to CRE exposure.
- Assess whether the current level of disclosure related to CRE exposure is sufficient for investors' understanding of the material risks.
- Compare the role of AI in business operations to prior disclosures (if any), and determine whether such disclosures are appropriately tailored, including as to the bank's performance.
- Evaluate legal and corporate governance risks of AI used considering the current regulatory environment and consider whether such risks are appropriately described.
- Consider where AI use should be described (e.g., board oversight, risk factors, management's discussion and analysis, and accompanying financial statements) and confirm that such description is tailored to the bank and accurate.
- Ensure disclosure controls take into account AI discussions, whether in an annual report or other public documents, on a website, on earnings calls, or in statements or speeches by bank executives. The SEC has brought standalone cases based solely on the lack of disclosure controls.
- Begin internal discussions about changes to disclosures for the upcoming annual reporting season and in accordance with relevant disclosure controls and procedures.
Footnotes
1. See OCC Semiannual Risk Perspective (Spring 2024),
page 25.
2. See Managing Commercial Real Estate Concentrations in a Challenging Economic Environment (Issued December 18, 2023), page 2.
3. See Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts (Issued June 30, 2023), page 2.
4. See CRE Credit Quality Cracks Show in U.S. Banks' Q1 Earnings Results (S&P Global).
5. See Small U.S. Banks with High CRE Concentrations More Vulnerable to Losses.
6. See Policing Bot Bankers: U.S. Regulation of AI in Financial Services.
7. See OCC Semiannual Risk Perspective (Fall 2023), page 23.
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