The coronavirus could send hundreds of small banks to the ICU

The Federal Reserve Board recently announced the results of its mandatory Dodd-Frank stress test for the 34 largest banking institutions. The Fed estimates that these institutions could post losses in the range of $560-$700 billion under continued stress conditions. While the Fed assures us that these banks are well-positioned to weather the coronavirus, as a safeguard, they prohibited these banks from repurchasing shares and capped on their ability to pay dividends. While the Fed’s stress test results are reassuring, the press attention they garner overshadows the problems facing hundreds of small community banks from the COVID-19 damage impacting their commercial real estate loans.

Since the financial crisis, the largest banking institutions
have been required to raise capital and maintain minimum capital ratios that far
exceed those required for smaller depository institutions. The rational for
higher capital requirements for the largest banks is that very large banks
engage in riskier business activities than smaller banks, and the failure of a
very large bank can create systemic problems that damage the wider economy.

The singular focus on the safety and soundness of the
largest institutions ignores the contribution of small banks that provide
critical services to their communities. Unfortunately, community banks’ focus
on local lending often creates concentrations that put these banks and their
local economies at significant risk when business conditions deteriorate.

Commercial real estate (CRE) lending is a key business line
for many community banks. It is not uncommon for community banks to provide
loans collateralized by real estate to support local construction and
development projects and to finance apartments, hotels, restaurants, and retail

Source: FDIC regulatory report data.

Relative to their size, community banks are far more exposed
to a deterioration in business conditions through their CRE loan portfolios
than are the largest banks. There are only two banks larger than $100 billion
in assets that have total CRE exposures that exceed three times their bank’s
tangible equity capital. In contrast, there are more than 2000 community banks
that have invested more than five times their tangible equity capital in CRE
loans and nearly 150 banks with more than 10 times their tangible equity invested
in CRE.

CRE concentrations are not a problem when times are good,
but they can prove fatal when business conditions deteriorate. CRE loan
concentration has been identified as prime cause of bank failures in the last
two banking crisis. Should the COVID-19 recession linger, CRE concentrations
could again prove fatal for a large number of community banks.

Pandemic business closures and skyrocketing unemployment have led to significant increases in missed rent and lease payments. One survey reports that 32 percent of renters failed to make their full payment in June, and recent data from consumer rating agencies show record increases in the number of consumer accounts in forbearance. While conditions will improve somewhat as the economy reopens, businesses will continue to face revenue pressures from social distancing constraints in restaurants and retail establishments and from weak demand in the travel and lodging industry. These and other factors like the waning support from CARES Act programs portend continuing problems for commercial real estate loan portfolios.  

Facing diminished rent and lease receipts, CRE borrowers are increasingly failing to satisfy their debt payment obligations. At the end of December 2019, bank regulatory data indicate that nearly $3.7 billion of bank CRE loans were 30-89 days past due. By the end of March 2020, while the economy was still in the earliest days of the COVID-19 lockdown, past-due loans had increased by $2 billion. Data from the closely related market for securitized commercial real estate loans is available at a higher frequency. This market posted the largest on-record jump in the delinquency rate in May. The available evidence suggests that the volume of CRE bank loans past due are likely to surge when the June regulatory data are made public.

While the Federal Reserve may believe that the largest banking institutions in America have sufficient capital and liquidity to weather a prolonged COVID-19 recession, the forecast for community banks is more pernicious. Unless there is a sharp and speedy recovery, CRE loan concentrations could again lead to the downfall of hundreds of community banks.

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