Regulators are increasingly worried about a lending practice that allows real-estate developers to delay paying construction-loan interest but can mask problems at the banks that made the loans.

Small banks, which are more exposed relative to bigger banks, have $280 billion of outstanding construction loans overall, mostly to condominium developers and home builders. When the loans were made, the banks calculated the interest that would be paid and put that money aside in "interest reserves." In essence, the banks pay themselves until the loan becomes due or the property generates cash flow.

Ingo Fast

Regulators fear this practice can be abused to keep recording loans as performing even though the underlying real-estate projects are failing.

This month, the Federal Deposit Insurance Corp. alerted its bank supervisors to be on the lookout for banks that haven't come clean about potentially problem loans. "You don't want to have a false sense of security because the interest reserve is paying the loan," Steve Fritts, the FDIC's associate director for risk management and exam oversight, said in an interview. "You need to look to the credit fundamentals of the project."

As an indication of regulators' concerns about construction lending, the FDIC in recent months has hit some banks -- including Towne Bank of Arizona, HomeTown Bank, of Villa Rica, Ga., and Integrity Bank, of Alpharetta, Ga., -- with cease-and-desist orders requiring, among other things, that they overhaul how they use interest reserves. Analysts have warned that some 150 small banks could fail in the next few years because of their big bets on construction loans.

"Regulators want you to set aside money for credit losses at the moment you know there is a problem with the loan," said Donald Isken, a real-estate attorney at Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Del. "They don't want you to stick your head in the sand and just wait for the problem to blow up."

There are indications that potential interest-reserve problems aren't limited to a few banks. Matthew Anderson, a partner at research firm Foresight Analytics, said he has seen a surge in the number of banks that have a possible sign of trouble: They are hit with a sharp increase in loans that are expected to go bad after going for months without showing a high level of delinquencies.

The issue is gaining attention because the housing slump means many of the projects funded by construction loans either will never be completed, or won't get sold or rented. That means banks likely will see a sudden jump in the number of dud construction loans as interest reserves deplete.

A warning that interest reserves might have disguised loan problems can pop up when a bank shows a relatively low percentage of delinquent construction loans in one quarter followed by a big jump in nonaccruing loans the following quarter. While there can be other reasons for this shift, one possible explanation is that interest reserves kept delinquencies low. However, once the well ran dry, troubled projects were immediately moved to the nonaccrual category, said Mr. Anderson.

One bank that fit this description, ANB Financial, of Bentonville, Ark., has failed, although not every bank that meets this pattern is in danger of going belly-up.

Meridian Bank in Phoenix is among the banks where nonaccrual rates have outpaced delinquencies. Only 6.4% of Meridian Bank's construction loans were delinquent in the fourth quarter of 2007, but its nonaccruing loans jumped to 30% in this year's first quarter. That jump was among the largest of banks with a sizable proportion of construction loans, according to FDIC data on more than 8,000 banks analyzed by The Wall Street Journal.

"What's been going on...is that interest reserves are running out before the projects are being delivered," said Doug Hile, chief executive of Meridian Bank. He said many troubled borrowers are asking for banks to add extra interest reserves to keep their loans current. "But we're not doing it," Mr. Hile said. "We don't view that as a sound banking practice." He said Meridian Bank, with $2.5 billion in total assets, is in no danger of failing because it is "very well capitalized."

The biggest worry about interest reserves mainly has involved small banks because of their heavy concentration in construction lending. These loans normally ranged from $1 million to $10 million to home builders, land investors and developers of commercial properties such as shopping malls and office buildings. At the end of the first quarter, the $280 billion that small banks had outstanding in construction loans represented about 45% of all such loans, according to Foresight Analytics.

More banks are starting to change how they use interest reserves. Integrity Bank has stopped using interest reserves on loans used only for purchasing land without immediate plans for construction and loans on projects that have been delayed or abandoned. David Edwards, who joined Integrity in December as chief credit officer as part of a management shake-up at the bank late last year, said: "There is nothing wrong with the use of interest reserves. It depends on whether the borrower has hard cash [put up front], and whether the project is active or not."

Towne Bank, of Mesa, Ariz., has eliminated funding interest reserves. "Realistically, you never know whether a borrower can keep the loan current if you are the one who's making the payment," Patrick Patrick, who became chief executive of the bank in February.

HomeTown Bank, also ordered to change interest-reserves practices early this year, now is part of SunTrust Banks Inc., of Atlanta. A spokesman declined to comment.

--Jennifer S. Forsyth and Tom McGinty contributed to this article.

Write to Lingling Wei at lingling.wei@dowjones.com

Norms for Housing Loans by Coop Banks Relaxed: RBI

Home Loans may become Costlier as RBI raises Repo Rate

Local Banks Regain Mortgage Business

Banks Toughen Terms on Loans

Real-Estate Woes of Banks Mount