An office building (center) at 1740 Broadway in New York, United States, Sunday, February 11, 2024. Commercial real estate transactions are beginning to pick up in the United States at steep discounts, forcing lenders around the world to brace for bad loans. (Photo by Michael Nagle/Bloomberg via Getty Images)
“Overall, the banking system remains healthy and resilient,” Federal Reserve Vice Chairman for Supervision Michael Barr said in congressional testimony on May 15.
“The banking industry as a whole needs to be prepared to absorb any loan losses that may materialize and continue to fulfill its vital role of providing credit to households and businesses,” Barr said.
A closer look at the data suggests that the widely expected wave of commercial real estate loan defaults could trigger enough bank failures to overwhelm the federal deposit insurance safety net. Commercial real estate loan concentrations and banks' reduced capacity to absorb capital losses make a sequel to the savings and loan crisis of the 1980s likely.
The banking system had $2.1 trillion in total regulatory capital to provide the capacity to support losses on about $23.7 trillion in reported assets, according to regulatory data at the end of 2023. Many of the bank assets have fixed interest rates and long maturities and were purchased before the Federal Reserve raised interest rates.
My estimates suggest that banks' unrealized market capitalization losses on fixed-rate loans, leases, and securities would be $1.7 trillion at the end of 2023, when the 10-year Treasury yield was about 3.9%. With the 10-year Treasury yield now at over 4.4%, banks' intermarket losses would probably be closer to $1.4 trillion.
In any event, at least half of the banking system’s tier 1 capital loss-absorbing capacity has already been consumed by unrealized interest losses on assets, and many banks in the banking system are not prepared to absorb additional losses from commercial real estate loan defaults.
December regulatory data shows that the expected wave of commercial real estate loan defaults has not yet impacted the banking system. While there is some evidence of bank “extend and pretend” behavior in some commercial real estate loan categories — primarily non-owner-occupied, non-agricultural, non-mortgage loans by some larger banks, and “other acquisition, development and construction” loans by many smaller banks — there is no evidence of widespread commercial real estate loan defaults.
The banking system's commercial real estate loan concentrations and loan performance in December 2023 are roughly equivalent to the banking system's commercial real estate profile in December 2019, long before COVID-19 lockdowns emptied office buildings and shopping centers and accelerated remote work trends.
Demand for some commercial real estate has been hit by a real and perceived surge in urban crime caused by criminal justice “reform” pushed by liberal district attorneys and some public officials, as well as higher post-COVID costs for commuting and eating out.
Rising interest rates will affect both the demand for and the ability of banks to refinance commercial real estate loans. Interest rates are now significantly higher than when many existing bank commercial real estate loans were signed.
Commercial real estate cash flows may not justify refinancing some properties at new, higher interest rates, as banks typically require minimum interest ratios to qualify for a loan. In some cases, banks and borrowers may choose to modify loan terms in a troubled debt restructuring, but it is widely expected that in many cases default will be the preferred option.
Banking regulators measure a bank's commercial real estate loan concentration as the ratio of the bank's total commercial real estate loans to the sum of the bank's Tier 1 regulatory capital and loan loss reserves. Regulatory guidelines state that a commercial real estate concentration above three may be excessive and warrants additional examiner scrutiny.
Using this regulatory measure, there were 1,763 banks with commercial real estate concentration ratios above 3 as of the end of 2023, including 274 banks with concentration ratios above 5 and 77 banks with concentration ratios above 6. Most of these were small banks, but two banks had more than $50 billion in assets and supervisory commercial real estate concentration ratios above 5.
A more realistic measure of a bank's ability to withstand commercial real estate losses and survive is the ratio of the bank's total commercial real estate loans to its total Tier 1 capital adjusted for unrecognized interest losses and total loan loss reserves. Recent bank failures such as Silicon Valley Bank, First Republic Bank, and Signature Bank demonstrate that regardless of reported regulatory capital adequacy, banks that are insolvent or near insolvent on a mark-to-market basis are at risk of depositor runs and failure.
If we use our estimate of market-value Tier 1 capital instead of regulatory Tier 1 capital, the number of banks with commercial real estate concentration ratios above 3 at the end of 2023 increases to 2,667. These 2,667 banks control 27% of the total assets of the entire banking system and include 231 banks with zero or negative market-value adjusted Tier 1 capital.
By my estimates, losses of just 10 percent of commercial real estate loans could lead to the insolvency of more than 700 banks, representing more than 6.5 percent of the market capitalization of the banking system's total assets. Large commercial real estate loan losses would deal a major blow to the banking system.
If the widely expected wave of defaults on banks' commercial real estate loans were to materialize, the federal deposit insurance safety net could easily be overwhelmed. The FDIC's deposit insurance fund balance of $121.8 billion represents just 0.51% of the banking system's total assets.
The FDIC cannot handle hundreds of bank failures happening at the same time. If zombie banks continue to operate while the FDIC spreads bank failures over years, as happened after the Great Financial Crisis and as the Federal Savings and Loan Insurance Corporation did during the Savings and Loan Crisis of the 1980s, losses will mount and economic growth will stagnate.
Commercial real estate concentrations and unrecognized bank interest losses have created systemic risks in the banking system that are visible and hidden in plain sight.
Paul Kupiec is an economist and senior fellow at the American Enterprise Institute.