Commercial real estate (CRE) lending is a risky activity that still dominates the business model of many modestly capitalized small and medium-sized banks. Bank supervisory and regulatory reforms recently enacted have reflected some of the lessons from the Great Financial Crisis of 2008 (GFC), but still underplay the importance of CRE lending and instead focus on bank size and nontraditional banking activities. My analysis (see Commercial Real Estate: How Vulnerable Are U.S. Banks?) shows that although banks have adapted their CRE lending practices, CRE loans have grown substantially among many small and medium-sized banks, defined here as those with total assets less than $100 billion. CRE loans now account for more than a quarter of small and medium-sized banks’ aggregate balance sheets; the only time this share has been larger was the period from mid-2007 to mid-2009.

Banks’ heightened exposures to CRE may foreshadow vulnerabilities that warrant supervisory and regulatory attention. Even small and medium-sized banks can be a source of localized or widespread financial instability. Moreover, CRE lending is inherently risky and can play a key role in propagating shocks. During the GFC and ensuing recession, a bank’s concentration in CRE lending proved to be the single best predictor of whether or not the bank would fail.

Small and medium-sized banks have been, and remain, the main players in CRE lending. Of the roughly $2.1 trillion of CRE loans on banks’ balance sheets as of March 31, 2018, small and medium-sized banks  hold 62 percent, even though they account for less than a third of the banking system’s assets. Following the GFC and the Dodd-Frank legislation that tightened bank regulations, this group’s CRE loans as a share of its total assets fell from an all-time peak of 28.7 percent at the end of 2008 to 22.7 percent at the end of 2012. This decrease in CRE exposure was likely the result of a number of factors, including a collapse in demand, a rash of bank failures concentrated among the banks with the greatest CRE exposures, and an increase in the risk weight assigned to construction loans in capital adequacy calculations. But, since then, the group’s CRE exposures have risen significantly and now make up 27.4 percent of its assets. Furthermore, banks with the highest exposures to CRE tend to be concentrated in certain cities and regions (my paper shows this in detail), and thus may represent significant potential vectors of financial contagion in those places.

Banks in general are  better capitalized and have stronger liquidity positions than a decade ago, and post-GFC bank regulation has reduced or shifted some of their riskier activities to nonbanks. However, in reforming bank regulation, we must bear in mind how crises spread through the financial system and the economy and factors that can slow the recovery. Regardless of the causes of the next recession, it is a safe bet that induced bank failures will have a feedback effect that worsens job losses and slows growth further. Inevitably, bank failures adversely affect local economies. This was the case in the Panic of 1907, the Great Depression, the s&l and banking crises of the 1980s and early 1990s, and the GFC. Such effects will likely be most apparent in smaller towns that are dependent on their local banks for financing a broad array of economic activities.

Although banks taken as a whole are now better capitalized, in the last five years the capital positions of medium-sized banks (with total assets between $10 billion and $100 billion) deteriorated relative to those of their peers. While capital ratios for most large and small banks tended to remain elevated—with the median standing at 14.3 percent and 16 percent of risk-weighted assets, respectively, as of early 2018—the median capital ratio for medium-sized banks fell to 13.2 percent from 14.9 percent five years earlier.

Just as legislators are rolling back regulatory requirements for small and medium-sized banks, many of these banks are increasing their exposure to CRE, which is highly cyclical and historically has been the strongest predictor of bank failure. At the same time, these banks are becoming more leveraged and more vulnerable to economic shocks. There are many good reasons to reduce the excessive post-crisis regulatory burden placed on small and medium-sized banks. However, heightened vigilance on their CRE lending, in combination with their capital ratios, liquidity positions, and other traditional risk management measures, remains warranted and necessary.

This post comes to us from Jonathon Adams-Kane, an economist at the Milken Institute. It is based on his recent paper, “Commercial Real Estate: How Vulnerable Are U.S. Banks?” available here. The views expressed in the post are the author’s and do not necessarily represent those of the Milken Institute or its affiliates.