Our nation’s banking system is at a critical juncture. The recent fragility and collapse of several high-profile banks are most likely not an isolated phenomenon. In the near term, a damaging combination of fast-rising interest rates, major changes in work patterns and the potential of a recession could prompt a credit crunch not seen since the 2008 financial crisis.
Back then, amid a housing market bubble, lenders had handed out high-risk loans to people with poor credit histories or insufficient income to afford homes. When the market collapsed, so did many of the banks that made these loans, causing the Great Recession. The epicenter this time is different, but the result may be the same: recession, lost jobs and widespread financial pain.
Just in the past few months, Silicon Valley Bank, Signature Bank and First Republic Bank have failed. Their combined assets surpassed those held by the 25 banks (when adjusted for inflation) that collapsed at the height of the financial crisis. While some experts and policymakers believe that the resolution of First Republic Bank on Monday indicates the turbulence in the industry is coming to an end, I believe this may be premature. Adverse conditions have significantly weakened the ability of many banks to withstand another credit shock — and it’s clear that a big one may already be on its way.
Rapidly rising interest rates create perilous conditions for banks because of 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 fall in value. And because the banks’ liabilities — like its deposits, which customers can withdraw at any time — usually are shorter in duration, they fall by less. Thus, increases in interest rates can deplete a bank’s equity and risk leaving it with more liabilities than assets. So it’s no surprise that the U.S. banking system’s market value of assets is around $2 trillion lower than suggested by their book value. When the entire set of approximately 4,800 banks in the United States is examined, the decline in the value of equity is most prominent for midsize and smaller banks, reflecting their heavier bet on long-term assets.
The collapse of Silicon Valley Bank and First Republic also vividly demonstrates the vulnerability of banks to bank runs. Uninsured depositors, or those who have over $250,000 in a bank, can get nervous at the first sign of trouble and set off a sudden tsunami of withdrawals.
And there’s another looming area of concern that could spark such panic: the commercial real estate sector.
Commercial real estate loans, worth $2.7 trillion in the United States, make up around a quarter of an average bank’s assets. Many of these loans are coming due 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 rose to about 9 percent, up from around 1 percent, as interest rates rose.
This time, the damage to the sector threatens to be far greater. The Covid-19 pandemic led to a huge jump in remote working, with over 40 percent of the U.S. labor force working remotely by May 2020. The return to in-person office work has been slow, with only about half of workers in the nation’s 10 largest cities working in the office as of last month, compared with prepandemic levels. The resulting decline in demand for commercial properties, 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 equity value of real estate holding companies, or REITs, focused on the office sector had declined by nearly 55 percent since the beginning of the pandemic, according to calculations by me and my co-authors of a recent study. This decline translates to a 33 percent reduction in the value of office buildings held by these companies. While the overall delinquency rate on commercial mortgages was relatively low as of March, at 2.61 percent, it has been rising fast.
To assess the banks’ ability to withstand the distress that could be caused by the commercial real estate sector, we can look at a range of scenarios. An increase in the default rate on commercial real estate to between 10 and 20 percent, at the lower 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 smaller and midsize regional banks that have already been weakened by higher interest rates and that may have higher exposure to these kinds of loans.
The 2008 financial crisis spread from the housing sector to the rest of the economy as large banks with exposure in housing undertook tremendous losses. Currently, only a few banks with substantial exposure to commercial real estate loans are anticipating significant stress from the housing sector. If there are spillovers to the rest of the economy, other banks might be impacted, too. And yet the banking industry is insufficiently prepared for another perilous moment. To brace 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 a longer-term risk as well. After the collapse of Silicon Valley Bank and Signature Bank, the government took substantial actions, including guaranteeing all deposits regardless of size, to restore trust in the banking system. These steps, however needed in the moment, create a moral hazard, evoking the question: What incentive do bank executives have to not take bigger risks with depositors’ money if they believe the government will protect their customers from any downside? Memories are short, and over time, government support could incentivize reckless behavior that harkens back to the savings and loan crisis of the 1980s and ’90s.
While the government’s efforts have stabilized the situation somewhat for now by seizing and selling First Republic, it is far too early to declare victory. Midsize and small banks play a vital role in lending to local businesses, and their insolvency could lead to a severe credit crunch with adverse effects on the real economy, particularly in regions with lower household incomes. At the same time, the risks of moral hazard lurk in the shadows. Real danger is looming, and we need to be ready 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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