In this third article of a four-part series, Connect CRE reached out to economic experts for information about lenders and banks. The first two articles, “Economic Recap and Federal Reserve Actions” and “Understanding the Mixed Signals: Analyzing the Economics of Labor and Spending,” are live.

In early 2023, widespread alarm ensued when Silicon Valley Bank and Signature Bank shut their doors. A year later, in April 2024, the Pennsylvania Department of Banking and Security seized Republic First Bancorp, with Fulton Financial acquiring its debts and deposits.

One reason for Republic First’s collapse was higher interest rates, which impacted the bank’s commercial real estate portfolio – which made up about 45% of its loan book.

Unlike what was predicted in early 2023, the bank failures (and the more recent Republic First seizure) haven’t led to a downslide in the banking industry. Economic experts told Connect CRE that overall bank strength remains robust, even if such institutions aren’t opening their coffers to commercial real estate investments as often.

“Very seldom do the banking system bloodlettings that many envision come to fruition,” observed Ryan Severino, chief economist and U.S. research head of BGO. “We didn’t think that would be the case last year, and we don’t believe that will be the case this year.”

The Pinpricks

The Federal Reserve’s Dodd-Frank Act Stress Test 2024 reported that the larger banks could “experience substantial losses under the severely adverse scenario” (as in a severe economic downturn), even while the banks would maintain their common equity tier 1 capital ratios “above the required minimum regulatory levels.”

The report also expressed concerns about the 2.8% decline in aggregate CET1 capital, which is due to a shift toward riskier loans and a growth in credit card balances (and delinquencies). Then there is the growth in commercial and industrial loans, which the Fed said made up over 60% of balances.

Jonathan O’Kane, vice president of Chandan Economics, delved deeper, explaining that commercial real estate debt on financial institution balance sheets increased from about $1.2 trillion in 2014 to approximately $3.0 trillion through the end of 2023. “With Trepp estimating that roughly 30% of outstanding debt is expected to mature by 2026, it’s unsurprising that real estate and banking-sector stress were listed as the third and fourth most salient risks to the U.S. financial system in the Fed’s latest report,” O’Kane explained.

Nor was Trepp, Inc.’s Research Director Stephen Buschenbom much more optimistic, commenting that as interest rates remain elevated, “there’s going to be still more pain to come from deteriorating loan performance, particularly for commercial real estate.”

Certainly, banks with more than $100 billion in assets have increased their loan-loss provisions. These are cash reserves set to cover potential losses from default loans. The smaller regional and community banks? Not so much.

“The question is whether community and regional banks have safer loan portfolios or if there’s a risk that these banks will end up being under-provisioned for future loan losses if CRE loan defaults should increase,” Buschenbom said.

Perhaps unsurprising, the office sector continues to generate much concern over loan maturities and defaults. Eric Enloe, Partner Valuation Advisors’ Senior Managing Director, acknowledged that banking exposure to office assets is more diverse these days. Still, “we haven’t really started to address the pain in the office sector that’s unfortunately unlikely to reverse itself even with an easing of interest rates,” he said. “The office sector’s value degradation is a result of a complete shift in demand dynamics over the last five years.”

What to Expect

The banking crystal ball is murky. While there’s little danger of an all-out banking collapse and frozen liquidity (a la The Great Financial Crisis), the experts indicated multiple industry challenges.

For one, the Perryman Group’s President Ray Perryman isn’t anticipating a widespread meltdown despite interest-rate exposure and debt maturities. “A few banks are facing vulnerabilities on their real estate portfolios, but most have sufficiently diversified their risk profiles,” he noted.

O’Kane wasn’t quite so optimistic, noting that conditions are present for industry distress. “Whether they’ll be sufficient to trigger another crisis is tougher to gauge,” he added.

And while the larger banks have set aside enough to cover potential loan losses, Severino pointed out that the smaller and regional banks are the ones that struggle with problematic loans on balance sheets, as well as what he called a “negative selection bias phenomenon.” This, in turn, has led to less portfolio diversification and lower-quality collateral. Still, “the reforms implemented in the banking system last year have held up pretty well,” Severino noted.

Omar Eltorai, director of research with the Altus Group, also anticipated that the smaller banks will likely experience the most significant changes over the next one to three years, leading to corporate consolidations. “These consolidations will stem from a “challenging operating environment, combined with trapped capital in their loan portfolios,” Eltorai said.