Why this economist thinks a major commercial real estate crash could bring down the FDIC
Meta-explanation: A leading economist warns that the FDIC could be overwhelmed if the commercial real estate crisis leads to the failure of multiple regional banks.
The Federal Reserve's latest stress tests showed that the nation's largest banks could withstand a major commercial real estate crash, but economist Paul Kupiec sees greater danger still lurking in the banking sector. Kupiec told Money Talk News he believes a surge in commercial loan defaults could lead to a wave of community bank closures in a short period of time, potentially overwhelming the Federal Deposit Insurance Corporation (FDIC).
The FDIC was established to insure bank customers' deposits up to a certain amount as a backstop against bank failures. Its main purpose is to increase consumer confidence in the American banking industry by preventing “runs” on banks — a situation in which enough bank customers, fearful that the bank might fail, rush to withdraw their deposits all at once.
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Bank runs were common in the run-up to the Great Depression, when underfunded and over-indebted banks across the country failed almost daily. The biggest problem with a run is that it can be a fatal blow to a bank already suffering losses: if too many customers simultaneously demand their money back, the bank can easily be forced into insolvency.
Perhaps the most famous recent example of this was the collapse of First Republic Bank in early 2023. Customers, frightened by potential unrealized losses on First Republic's commercial loan portfolio, began to withdraw funds en masse, bringing First Republic to the brink of bankruptcy until it was acquired by Chase Bank. Had First Republic failed, the FDIC would have been liable for losses on consumer deposits up to its $250,000 coverage limit.
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And that's where Kupiec sees the problem: The FDIC insures consumer deposits up to $250,000 per bank account, but there's no cash to cover a wave of massive bank failures happening simultaneously across the country. Kupiec estimates that the 2,667 banks account for almost 30 percent of the banking system's total assets. He also believes banks are overly exposed to risks in the commercial loan sector.
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Much of that exposure is in the commercial office market, a sector that has been hit hard since the coronavirus crisis by factors including lower occupancy rates due to working from home and high interest rates that prevent borrowers from refinancing. Kupiec believes that a 10% decline in the banking system's total exposure to commercial loans could lead to the failure of up to 700 banks.
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If hundreds of banks were to fail simultaneously or nearly simultaneously, Kupiec believes the FDIC's roughly $121 billion in reserves would not be enough to cover consumer claims. He worries that as economic growth slows, losses could grow exponentially, making it very hard for the FDIC to meet its obligations. This nightmare scenario would essentially be a repeat of the savings and loan crisis of the 1980s.
During that crisis, savings and loan banks relied primarily on mortgage lending to make money. As interest rates rose, savings and loan banks had to offer higher yields to depositors to continue to attract customers. Unfortunately, the mortgages that banks relied on to make their yields were fixed at lower interest rates, which eventually led to the collapse of the entire industry and hundreds of banks failing.
As a result, the Federal Savings and Loan Insurance Corporation (FSLIC) did not have sufficient resources to cover the losses of consumer deposits at failed banks. This led to the biggest banking crisis since the Great Depression, costing taxpayers an estimated $124 billion in bailouts. Kupiec believes this scenario could be repeated with the FDIC. Needless to say, the U.S. banking industry is hoping he's wrong.
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This article, “Why This Economist Thinks a Major Commercial Real Estate Collapse Could Bring Down the FDIC,” originally appeared on Benzinga.com.
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