The newspapers and business media have stories about the problem in Commercial Real Estate and Banking with what is currently occurring with Mortgage Financing and Loan Defaults.
This article provides background on what today’s “Friendly Bankers” and those that rely on the “Capital Markets” are worried about.
Banks are in the business of lending money and earning interest on those loans. When they lend to commercial real estate projects, they expect the borrowers to repay the loans from the rental income or sell the properties at a profit.
However, when a borrower defaults and a bank is forced to take back a commercial property, it can create severe liquidity and solvency issues. Here’s why:
- Illiquidity of Real Estate Assets: Commercial properties are not readily convertible into cash. Unlike other assets such as Treasury bonds or cash reserves, selling a commercial property can take considerable time and often at a discount to the market value, particularly in a distressed situation.
- Loss of Income: The bank loses the expected stream of loan repayments, which reduces its cash inflow. If the bank has to step in and manage the property, the rental income (if any) might need to be increased to cover the shortfall.
- Operational Cost: Running a commercial property is not a bank’s core competence. It might involve significant operational costs, eroding the bank’s profits and cash reserves.
- Capital Adequacy: Regulatory standards like Basel III ( the 2009 international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision, and risk management within the global banking sector) require banks to maintain a certain level of capital compared to their risk-weighted assets. If the property loses value or can’t be sold, the bank might need to raise money to meet these regulatory requirements. In an extreme situation, failure to do so could result in regulatory sanctions, including the bank being declared insolvent.
- Asset Devaluation: If the real estate market is doing poorly, the bank may need to write down the property’s value on its balance sheet, decreasing its overall net worth.
- Risk Concentration: Regional banks are often more exposed to local market conditions than larger, more diversified banks. If a regional bank has a high concentration of commercial property loans in its portfolio, a downturn in the local real estate market could hit the bank particularly hard, potentially leading to insolvency.
The combination of these factors can strain the bank’s liquidity – its ability to meet short-term obligations, and potentially also its solvency – its ability to continue operations in the long term. While regulatory bodies and central banks have systems in place to prevent bank failures and their potential impact on the broader economy, the insolvency of a bank due to exposure to bad commercial real estate loans can still have significant economic consequences. This is particularly true if the failing bank is a major lender in its region or if many banks face similar issues simultaneously.