Will US commercial real estate cause the next banking crisis?

US small- and mid-sized banks are vital to credit formation as they collectively represent 80 percent of commercial real estate lending

With fears of contagion following the failure of Silicon Valley Bank and others in the US and the Credit Suisse saga in Europe have ebbed over the last week, there remains an area of concern in the world’s largest economy that could cause the next banking crisis there.

Depositors are said to be shifting their monies from smaller US lenders to larger ones as well as to money market funds, crimping the capability of such banks to lend more.

US small- and mid-sized banks are vital to credit formation as they collectively represent 80 percent of commercial real estate lending, according to Brett Nelson, head of the tactical asset allocation for the Asset & Wealth Management Investment Strategy Group at Goldman Sachs.

Moreover, as these lenders tighten their lending standards, that could represent something on the order of a half a percentage point drag on gross domestic product growth this year, and the equivalent of about 25 to 50 basis points of Federal Reserve rate hikes, according to Goldman Sachs research.

The tightening in lending standards among those institutions is expected to reduce economic growth this year, Goldman Sachs Research said.

“While the macroeconomic impact of a pullback in lending is highly uncertain until the extent of the stress on the banking system becomes clear, economists in Goldman Sachs Research lowered their forecast for U.S. fourth-quarter GDP growth (year-over-year) by 0.3 percentage point to 1.2 percent,” it added.

Goldman Sachs economists expect lending standards will tighten more to a degree that’s greater than during the dot-com crisis, but less than during the financial crisis or the height of the pandemic.

Meanwhile, property commercial real estate prices in the US have fallen by 4-5 percent from their peak in mid-2022 and Capital Economics expects a further 18-20 percent fall from here.

Also read: Will the collapse of Silicon Valley Bank in the US impact Mumbai’s office leasing market?

The smaller banks are experiencing pressure on their deposit base amid concerns about the health of these lenders in the wake of the collapse of SVB and worry about uninsured deposits in excess of the federally-insured limit of $250,000.

“But this has obscured a broader problem, which is that higher interest rates are causing a shift out of bank deposits and into money market funds as interest rates on short-dated securities rise faster than those on commercial bank deposits,” according to Capital Economics.

This has left the banks in a bind: either they would need to raise deposit rates in line with money markets and try to maintain profits by increasing rates on loans that are due to refinance, or they would need to shrink the asset side of their balance sheet in order to accommodate a smaller deposit base.

Either way, the fact that smaller banks dominate lending to commercial real estate means that financing to the sector is likely to tighten, the brokerage said.

In a worst-case scenario, it is possible that a “doom loop” develops between smaller banks and commercial property, in which concerns about the health of these banks leads to deposit flight, which causes banks to call in commercial real estate loans, which then accelerates a downturn in a sector that forms a key part of its asset base, which intensifies concerns about the health of the banks and thus completes the vicious cycle, Capital Economics said.

“Likewise, it’s possible that concerns about commercial real estate expose other vulnerabilities in the financial system, such as maturity mismatches within open-ended funds,” it added.

The distribution of dollar liquidity needs to shift to stabilize conditions in the financial system, according to Eugene Leow, Senior Rates Strategist - G3 & Asia at DBS.

While, on the whole, liquidity appears flush in the US, a closer look at the distribution of liquidity presents a problem for the Federal Reserve.

“First the failure of regional banks has worried depositors. As a result, deposits in larger banks have increased to the detriment of smaller banks,” Low said. “This shift is problematic if a liquidity crunch (from deposit flight) results in banks being forced to sell their assets.”

Moreover, not all the monies from smaller banks have shifted to the larger banks, with a large proportion also moving into money market funds.

“This also means that the banking system is losing deposits in this era of very high risk-free rates,” Low said. “This is not sustainable in the long run.”

Fed policymakers’ goal for the year will be to keep demand growth below potential in order to keep the rebalancing of supply and demand on track, according to Goldman Sachs economists.

Tighter bank lending standards help to limit demand growth, sharing the burden with monetary policy tightening.

As such, Goldman Sachs has penciled in a pause in Fed hikes for the March 21-22 meeting. It expects a peak funds rate of 5.25-5.50 percent, but notes the sharply increased uncertainty around the path.