High interest rates and a sluggish commercial real estate market are weighing on the economy, and the pressure on local banks could become even greater when short-term federal lending programs expire on March 11.
“A lot of what's happened up until now is people didn't want to acknowledge the severity of the problem, and now it's becoming pretty obvious,” said Desmond Luckman, an economist at the American Enterprise Institute.
Community banks hold more than two-thirds of the roughly $2.8 trillion in outstanding commercial real estate loans in the U.S. And vacancy rates are expected to remain at record lows through 2023 but aren't expected to recover anytime soon, according to the National Association of Realtors.
Tomasz Piskorski, a professor at Columbia Business School, noted that “everyone was in a wait-and-see position” and expected interest rates to fall soon, but with the latest Consumer Price Index report showing inflation still above 3%, he said the Fed is unlikely to approve a rate cut in March and will likely remain at its current 5.25% to 5.5% range.
High interest rates have already wiped out about $2 trillion in the value of banks' assets, according to Piskorski. He wrote a paper called “Monetary Tightening, Commercial Real Estate Distress, and U.S. Banking Vulnerability,” which looked into the number of properties with outstanding debts exceeding their list price. His research shows that about 14% of commercial real estate loans and 44% of office loans are currently at risk of default, and if the default rate reached 20%, more than 380 banks would be at risk of failure.
All of this comes after the Federal Reserve announced it would not extend the Bank Term Funding Program, a short-term liquidity option for banks established in March 2023 in the wake of the Silicon Valley banking crisis.
“A lot of what they've tried to do since SVB went under is to create the impression that they're going to support the banking system to some degree,” Piskorski said. “At the end of the day, this is a trust game.”
That trust is what keeps the system stable, both Messrs. Lachman and Piskorski said: Community bank customers aren't making large withdrawals of their savings, unlike many did last year.
“They acted too late”
Lachman added that the one-year BTFP program wasn't perfect, but he said he was surprised the program ended completely without being renewed or amended, given the current economic climate, in part because some local banks were taking out low-interest BTFP loans to earn higher interest elsewhere. Piskorski said he's not too worried about the federal program expiring because borrowers still have plenty of time to repay their loans.
But both experts agree that the main issue is interest rates, both in terms of their direct impact on banks and the pressure they are putting on the commercial real estate sector. Lachman said the Fed has placed too much emphasis on inflation at the expense of financial stability. Piscorchi added that federal regulators are still too focused on the big banks and not enough on regional banks that could benefit from higher minimum capital requirements.
Fed supervisors are trying to make sure banks are managing their risks, including those related to interest rates, with a particular focus on commercial real estate loans, Michael Barr, the Fed's vice chairman for supervision, said last week at a Columbia Law School banking conference.
“The Federal Reserve's supervisors did not identify problems quickly enough,” Barr acknowledged, “and when they did identify risks, it was too late to act forcefully enough to change management's behavior.”
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