The commercial real estate market has been hit. Normally, such a decline would not pose a threat to the financial system, but the current situation could change that. The Federal Reserve Board already mentioned financial institutions' exposure to commercial real estate debt in its May Financial Stability Report. A Politico.com report from that time also discussed the impact of this exposure on banks' portfolios, especially in light of interest rate increases over the past year. When financial institutions find themselves in such distress, it creates the conditions for banks' behavioral risk to increase significantly.
Another commercial building available for lease (Photo by Howard Schnapp/Newsday RM via Getty) [+] image
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First, foreclosures are surging. Conrad Putzier, writing in the Wall Street Journal, points out that lenders have issued numerous foreclosure notices on high-risk real estate loans this year. In a related article, Peter Grant points out that construction loans have fallen especially hard as capital flows into commercial real estate have dwindled and lenders have scaled back. “Commercial real estate lending has shrunk to historically low levels, threatening to lead to an increase in defaults on past-due loans and a sharp decline in new construction of warehouses, apartments and other properties,” he writes. The content of these two articles shows that commercial banks' commercial real estate loan assets and liabilities are being affected. First, the issuance of foreclosure notices is a bank's response to potential defaults and an economic downturn, essentially an effort to reduce losses before they grow. If these foreclosures exceed normal levels, which seems to be the case based on the evidence presented, this could result in a significant decline in the value of the bank's assets. This would hurt the revenues on these loans and reduce the bank's net income. On the liability side, falling asset values will force banks to either increase their own capital to offset future losses or rely more on external loan funding, both scenarios having a negative impact on banks' capital ratios.
A sign stands outside a foreclosure property in Las Vegas, Nevada. (Photo: Ethan Miller/Getty Images) [+] image
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Second, banks expect risk technology spending to grow by more than 10% annually over the next few quarters. According to Robert Foss, “Millions of dollars in investments are needed to advance data analytics and AI sophistication to improve stress testing and real-time monitoring of risk. Yet, our data shows that less than 30% of bank leaders feel they have the right technology executives to successfully implement these technologies and processes.” He predicts a surge in demand within the banking sector for executives with qualifications in compliance, risk, and technology, as well as directors with audit and risk committee expertise. Amid this industry consolidation, there are concerns that some executives, eager to secure promotion and job stability, may take significant risks to their asset portfolios, especially in the commercial real estate market. This risk is heightened by the growing disruption in the commercial real estate sector. Moreover, as AI-driven tools become increasingly integral to risk monitoring, it is becoming clear that they come with inherent risks, and so does the training of these systems. This includes the introduction of new biases and the perpetuation of various biases. These risks require consistent and careful management. Recognizing these challenges, on December 7, the Office of the Comptroller of the Currency (OCC) announced it would monitor banks’ use of AI, with the OCC warning that widespread adoption of the technology could “pose significant challenges” across a range of risk categories.
The Office of the Comptroller of the Currency (OCC) headquarters in Washington, DC, USA. [+] Photographer: Ting Sheng/Bloomberg
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Finally, in a post-COVID-19 world, changes in the way work, transactions, and even meetings are conducted are also impacting commercial real estate values. Commercial real estate values were in trouble even before interest rates rose due to reduced demand for office space due to remote working. This will require new ways of thinking about managing these bank asset portfolios. This is not a short-term issue, it is a long-term issue. There is no quick fix, as more and better technology will only lead to more remote working, not less.
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These three factors increase the conduct risk of banks. Indeed, (i) broader economic challenges are impacting asset categories previously considered stable and safe, causing asset value and earnings to fall even if inflation falls to 3.1%. And, according to US Treasury Secretary Janet Yellen, the Federal Reserve's “last resort” to return to its 2% target should not be particularly difficult. The specific impact on the banking sector, and especially the commercial real estate sector, will depend on a range of factors: (ii) risks associated with weakened management capabilities and the adoption of new technologies; and (iii) a significant shift in the perception of the commercial real estate market. All of these are drivers for increased risk taking in the hope of higher returns. An independent conduct risk management body that oversees the priorities, criteria and choices of bank asset managers across the board and ensures that risk taking in these challenging times in search of relatively higher returns does not negatively impact the market as a whole may be needed at this point.
Federal Reserve Chair Janet Yellen. (Photo by Chip Somodevilla/Getty Images)
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Professor Srinivas Nippani
Professor Srinivas Nippani
This editorial was co-authored with Professor Srinivas Nippani, Chair Professor of Finance at Texas A&M University-Commerce, who has published over 60 peer-reviewed articles on finance and whose work has been cited in news outlets such as The Washington Post, CNBC.com, Forbes, American Banker, and au.finance.yahoo.com.
Diana Dean
Diana Dean
This op-ed was co-authored with Diana Dean, former Chief Ethics and Conduct Officer and Operational Risk Officer at Bank of the West. She has served as executive leader of risk and compliance at Wells Fargo WFC, JPMC, BNPP, and PricewaterhouseCoopers. Diana currently leads national efforts to strengthen accountability, integrity, and trust in the financial sector and companies in the Americas.