Why Commercial Real Estate Could Cause The Next Bank Failures

The collapse and federal takeover of Silicon Valley Bank (SVB
VB
) and Signature Bank is generating worries about where the next bank failures might occur. Will they hit smaller banks with high commercial real estate (CRE) exposure, as the CRE sector faces persistent economic challenges? And why do we continue seeing periodic financial sector crises?

Concerns over small bank risks gained a lot of attention recently, when Goldman Sachs’ Richard Ramsden, the firm’s leader of the Financial Group in Global Investment Research, wrote a widely quoted cautionary note. Ramsden said he expects banks to “pull back on commercial real estate commitments” as they become “more focused on liquidity.”

Ramsden’s worries are especially striking because he was positive on U.S. banks last year, saying in a Bloomberg interview that the “fundamentals within the US banking system today, they’re actually remarkably good.”

So why the alarm now? It’s smaller banks’ exposure to CRE—specifically commercial offices, which continue lagging financially due to high and perhaps permanent new levels of working from home.

As downtown offices remain empty or underutilized, office building values are falling. And many smaller banks have a large share of those assets. The Fitch Ratings agency says the biggest banks only have about 6% of their assets in CRE compared to around 33% for many smaller banks. Fitch’s Julie Solar says “commercial real estate has always been the domain of small banks, and it’s why small banks fail.”

A recent Goldman Sachs report underscores the pressures on these small banks and the attendant risks to the economy. Banks are under increased pressure to tighten credit standards while also managing their declining CRE portfolios. The Goldman report estimates tightening credit standards resulting in less lending “would have the same impact on growth as roughly 25-50 basis points of (interest) rate hikes” by the Fed.

And the Fed’s relentless interest rate increases raise additional worries. CRE leases often are long term, so the decline in office occupancy hasn’t fully hit the sector yet. But many CRE loans are coming due in the next few months, so new lending and refinancing will be challenged both by reduced rental revenues and also higher interest rates for borrowing and refinancing.

The even bigger worry is how these risks might hurt the entire economy. Economists get guidance here from the late Hyman Minsky, whose work emphasized how “financial fragility” in a capitalist economy threatens not only financial firms and sectors, but potentially the entire economy.

For Minsky, investors (especially financial agents) become overly optimistic during growth periods, taking on increasing risks. These can spread through financial markets and also infect the real economy of goods and services through a process of “contagion” where other firms join in the speculative boom, increasing the risks to the entire economy.

Periodic financial subsector crises spread through contagion to other sectors, sometimes causing deep pain across the economy. In our time, we’ve seen crises erupt from savings and loans, developing country debt, energy finance speculation, Japanese asset bubbles in the 1980s, the “dot-com” bubble that burst in 2000, and of course the mortgage and securities crisis of 2008 that threatened not only financial decline but a global depression.

Minsky saw these recurrent risks as endemic to the system. He memorably said “stability leads to instability,” as financial “innovators” seeking high profits will “always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring.”

So we might be in for another “Minsky moment”—a financially driven crash tied to risky lending and contagion—driven this time by small banks and CRE lending. The FDIC can handle individual bank failures. The worry is that we’ll see system-wide contagion revealing risks in other parts of finance that aren’t apparent now. (Remember that no one seemed to think SVB presented risks to the overall financial system until suddenly it looked like it might.)

SVB and the growing concerns about smaller banks show we need tighter regulation and supervision of all financial institutions, including smaller and regional ones. Systemic financial and economic risks don’t just come from the biggest banks.

We probably can’t prevent individual firm or even sectoral financial risks; they’re built into the system. But we need to be much more alert to their destructive potential, acting quickly and aggressively when the next bubble pops up somewhere—as it could in smaller banks and commercial real estate.