Our nation’s banking system is at a critical time. The recent fragility and collapse of several high-profile banks is most likely not an isolated phenomenon. In the near term, a damaging combination of rapidly rising interest rates, major changes in work patterns and the potential for a recession could lead to a credit crunch not seen since the 2008 financial crisis.
Back then, in the midst of a housing bubble, lenders made subprime loans to people with bad credit or insufficient income to pay for a home. When the market crashed, so did many of the banks that made these loans, sparking the Great Recession. The epicenter this time is different, but the result may be the same: recession, job losses, and widespread financial pain.
In the past few months alone, Silicon Valley Bank, Signature Bank, and First Republic Bank have all failed. Their combined assets exceeded those of the 25 banks (when adjusted for inflation) that collapsed at the height of the financial crisis. While some experts and lawmakers believe that Monday’s First Republic Bank resolution signals that the turbulence in the industry is coming to an end, I think this may be premature. Adverse conditions have significantly weakened the ability of many banks to withstand another credit shock, and it is clear that a big one may already be on the way.
Rapidly rising interest rates create dangerous conditions for banks due to a basic principle: the longer the duration of an investment, the more sensitive it is to changes in interest rates. When interest rates rise, the assets that banks hold to generate a return on their investment lose value. And because banks’ liabilities, such as their deposits, which customers can withdraw at any time, generally have shorter durations, they shrink less. Therefore, increases in interest rates can deplete a bank’s equity and risk leaving it with more liabilities than assets. So it is not surprising that the market value of the assets of the US banking system is about $2 trillion less than suggested by its book value. When looking at the full set of approximately 4,800 banks in the United States, the decline in capital value is most prominent for small and medium-sized banks, reflecting their greater commitment to long-term assets.
The collapse of Silicon Valley Bank and the First Republic also vividly demonstrates the vulnerability of banks to bank runs. Uninsured depositors, or those with more than $250,000 in a bank, can get nervous at the first sign of trouble and trigger a sudden tsunami of withdrawals.
And there’s another area of looming concern that could spark such a panic: commercial real estate.
Commercial real estate loans, worth $2.7 trillion in the United States, account for about a quarter of the average bank’s assets. Many of these loans expire in the next few years, and refinancing them at higher rates naturally increases the risk of default. Rising interest rates also depress the value of commercial properties, especially those with long-term leases and limited rent escalation clauses, which also increases the likelihood of owner default. In the Great Recession, for example, default rates increased to about 9 percent, from about 1 percent, as interest rates rose.
This time, the damage to the sector threatens to be much greater. The Covid-19 pandemic caused a huge leap in remote work, with more than 40 percent of the US workforce working remotely by May 2020. The return to in-person office work has been slow, with only about half workers in the nation’s 10 largest cities working in the office as of last month, compared to pre-pandemic levels. The resulting decline in demand for commercial property, particularly in the office sector, has been exacerbated by recent tech layoffs and the possibility of a recession.
Signs of distress are already visible, particularly in offices. By the end of March, the value of stocks in real estate holding companies, or REITs, focused on the office sector had declined by nearly 55 percent since the start of the pandemic, according to my and my coauthors’ calculations. a recent study. This decrease translates into a 33 percent reduction in the value of office buildings held by these companies. While the overall commercial mortgage delinquency rate was relatively low in March, at 2.61 percent, it has been rising rapidly.
To assess the ability of banks to withstand the difficulties that the commercial real estate sector could cause, we can look at a variety of scenarios. An increase in the commercial real estate default rate of between 10 and 20 percent, at the low end of the range seen during the Great Recession, would result in about $80 billion to $160 billion of additional bank losses. Such losses could have significant implications, especially for hundreds of small and midsize regional banks that have already been weakened by higher interest rates and may have greater exposure to these types of loans.
The 2008 financial crisis spread from the housing sector to the rest of the economy as big banks with exposure to housing took huge losses. Currently, only a few banks with substantial exposure to commercial real estate lending anticipate significant housing sector stress. If there are spillover effects on the rest of the economy, other banks could also be affected. And yet the banking industry is not sufficiently prepared for another perilous moment. To prepare for these potential challenges, regulators and managers should consider bolstering banks’ equity capital in the coming months.
Once we get past the commercial real estate crisis, there is also a longer-term risk. After the collapse of Silicon Valley Bank and Signature Bank, the government took substantial steps, including guaranteeing all deposits, regardless of size, to restore confidence in the banking system. These steps, as necessary as they are at the moment, create moral hazard, evoking the question: What incentive do bank executives have not to take greater risks with depositors’ money if they believe that the government will protect their clients from any inconvenience? Memories are short, and over time, government support could incentivize reckless behavior dating back to the savings and loan crisis of the 1980s and 1990s.
While the government’s efforts have stabilized the situation somewhat for now by taking over and selling First Republic, it’s too early to declare victory. Small and medium-sized banks play a key role in lending to local businesses, and their insolvency could lead to a severe credit crunch with adverse effects on the real economy, especially in regions with lower household incomes. At the same time, moral hazard risks lurk in the shadows. A real danger is looming and we must be prepared for it.
Amit Seru is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.
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