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IPFS News Link • Central Banks/Banking

The Commercial Real Estate-Small Bank Nexus

• https://www.zerohedge.com, By Philip Marey

Although large banks recently passed the Fed's stress test for a recession with a 40% decline in commercial real estate prices, 80% of commercial real estate loans made by banks are concentrated in smaller banks that fall outside the scope of the Fed's stress tests.

While commercial real estate lending by large banks has been stable, there has been a credit boom in commercial real estate loans provided by small banks, more than doubling the amount since 2006. The exposure to commercial real estate loans for smaller banks is also much higher than for large banks.

The commercial real estate-small bank nexus exposes the US economy to a vulnerability that may threaten financial stability and could contribute to a recession.

Introduction

During the COVID-19 pandemic the occurrence of remote work jumped, out of sheer necessity. The technology was already available, but the pandemic accelerated its adoption and bypassed the hesitation of employers to allow people working from home. In many cases, remote work has been successful and therefore seems to have become a permanent feature, often in hybrid form. For employers, it has become an employee benefit to attract people in a tight labor market and it saves on office space costs. The flipside of the latter is that demand for office space has seen a structural downward shift. It is estimated that the underlying value of office space in New York City has permanently declined by 39%. This suggests that at current prices, there is a bubble in commercial real estate. In this special we are particularly interested in the implications for financial stability and the economic outlook. First we take a look at the development of commercial real estate prices and commercial real estate lending. Then we discuss the Fed's recent stress test on large banks that included a large decline in commercial real estate prices. In contrast to the Fed's exercise, we show that distinguishing between large and small banks provides a sharper picture of the vulnerabilities in the US economy. In particular, the connection between commercial real estate and small banks, through commercial real estate lending, could pose a threat to financial stability and make a recession worse.


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