While mitigating factors are supporting banks’ large mortgage portfolios for now, their smaller commercial real estate exposures appear to be more vulnerable.
That’s one of the conclusions of the European Central Bank (ECB) in a paper written by nine people and published as part of its Financial Stability Review this week.
The ECB has made no secret of its worries that banks might have dangerous exposure to real estate after years of low interest rates stoking the market followed by the recent plunge in values precipitated by rapid hikes in interest rates.
In its paper entitled “Real estate markets in an environment of high financing costs”, the ECB has set out concerns, but they do not seem to be exaggerating them in order to scare institutions into changing behaviour.
Rather, it suggests things could get uglier if certain conditions materialise.
It said: ‘Both commercial real estate (CRE) and residential real estate (RRE) markets are in a downturn and existing borrowers are faced with higher debt service costs amid high interest rates.’
‘While mortgage borrowers’ debt servicing capacity is currently supported by robust labour markets, CRE borrowers face declining profitability. This exposes CRE portfolios to a higher likelihood of facing debt servicing challenges.’
The ECB has been busy making a clear distinction between residential and commercial property. Banks’ RRE exposures are large, with residential mortgages accounting in aggregate for almost 30% of euro area banks’ total loans. By contrast, banks have around 10% of loans exposed to CRE. But that does not mean they are to be ignored.
Says the ECB: ‘While the relatively limited size of bank CRE portfolios implies that they are unlikely on their own to lead to a systemic crisis, they could play a significant amplifying role in the event of broader market stress.’
The ECB report states that for bank loans to real estate firms, the recent rise in financing costs may cause the share of loans extended to loss-making firms to double to as much as 26%.
If tighter financing conditions persisted for two years and firms were required to roll over all maturing loans, this number would increase to 30%. Finally, 53% of loans in the sample would be to loss-making firms if firms simultaneously experienced a 20% drop in turnover.
CRE can amplify problems
The ECB therefore believes CRE market outcomes have the ‘potential’ to significantly amplify an adverse scenario, increasing the likelihood of systemically relevant losses being incurred in the banking system.
Moreover, a negative outcome of this type would drive large losses in other parts of the financial system which are significantly exposed to CRE, such as investment funds and insurers.
And yet, it does not see countries dealing with this threat of commercial real estate loans via policy.
It says that almost all euro areas had implemented macroprudential measures to address residential real estate vulnerabilities. By contrast ‘very few’ measures had been taken for commercial real estate.
‘Most all euro area countries have implemented macroprudential measures to address RRE vulnerabilities, but policy action targeting CRE has been much more contained.’
In residential real estate, measures have come in the form of increased macroprudential capital buffers or implemented borrower-based measures in response to increasing RRE vulnerabilities after the pandemic subsided.
By mid-2023, 15 of the 20 euro area countries had put borrower-based measures in place, ten had implemented targeted capital-based measures (sectoral systemic risk buffers or measures to increase risk weights), and several had increased broad countercyclical capital buffers (among others) in response to the high level of accumulated RRE vulnerabilities.
‘By contrast, very few measures in euro area countries target CRE vulnerabilities, as the complexity of CRE markets and the high number of diverse players make a policy response more difficult to design.’
Policy measures?
Without what could be termed a real and present danger, the ECB seems to hope banks and non-banks will use a combination of the right tools and risk management.
The report states: ‘While the range of tools applicable at the level of banks is, in principle, identical to that of the RRE toolkit, measures available to investment funds or insurance corporations are scarce.’
‘In addition, data gaps are more substantial than they are for RRE and hinder risk assessment. All in all, a comprehensive policy response for CRE markets would require multiple measures to be implemented to target all exposed actors and avoid leakages and would need to take particular care to avoid procyclicality.’
‘Regardless of whether targeted RRE or CRE measures are in place in each country, however, the internal processes of banks and non-banks should ensure that their provisioning practices and capital properly reflect the level of accumulated vulnerabilities.’
