Commercial Real Estate Lending and the State of the Banks
Carl Gaines Jan. 9, 2013, 7:30 a.m.
By almost every observable metric, the American banking system will enter 2013 with its strongest balance sheet position since before the financial crisis. Marginally higher revenues and shrinking loss provisions have pushed industry-wide net income to its best levels in six years. The improvement is significantly attributable to gains on the sales of assets and a general rise in non-interest income. It is also broad-based. More than half of all institutions reported higher net income in the third quarter while only one in 10 reported a net loss, the smallest share since early 2007.
The banking system’s balance sheet is growing, albeit slowly. As loan demand has picked up among well-qualified borrowers, net lending activity has increased. Progress is necessarily slow going. In keeping with a mixed economic picture and the formidable regulatory environment, underwriting standards are easing slowly. Not every commercial or individual borrower who merits credit can obtain financing, but the magnitude of this inefficiency is moderating with some consistency across large markets.
While quarterly statistics on bank failure still garner fleeting attention, the systemic relevance of recently shuttered institutions has diminished over the last two years. The tally of banks on the FDIC watch list remains elevated, but the 694 problem institutions identified as of the third quarter account for less than 2 percent of assets in the banking system. For large markets like New York, the failure of 51 banks nationally in 2012 has been immaterial to the direct availability of credit in support of large commercial real estate transactions. Only one of the failed banks had more than $1 billion in assets; not one was headquartered in New York.
So is the crisis over for domestic banking? For many lenders, including smaller regional and community banks, income growth is lagging the headline trend. Saddled with small-balance loans backed by assets that have been slower to recover lost value, and with a high rate of recidivism on modified loans, these institutions face a much longer road to normalcy.
The same market characteristics that have weighed on the recovery of their legacy balance sheets are limiting opportunities for new lending activity. For some community banks, the productivity of their capital will not rise fast enough to offset higher reserve requirements. Banks’ regulatory uncertainty will increasingly give way to explicit regulatory requirements in 2013, with the result that the drivers of consolidation among the smallest institutions will shift away from unmanageable distress and toward changing cost structures. In some tertiary markets, that augurs diminished access to consumer banking services, a deleterious consequence of otherwise well-intentioned policymaking.
Across institutions of all sizes, factors external to the banking system continue to pose a substantial threat. The drawdown in loan losses that has contributed to rising incomes depends on an improving economy and rising asset values. As the fiscal cliff debate has demonstrated, we may be our own worst enemies in this regard. Whether as a result of Washington’s impishness in addressing the budget imbalance or global shocks stemming from sovereign indebtedness and recession in Europe, the economy still faces unpredictable headwinds.
For some larger banks, this year’s most serious challenges will result from their own staggering breaches of trust. The Libor scandal has been of large banks’ own making, and it hints at systematic failures in accountability that policymakers may prove eager to address. Well in excess of $1 billion in fines has deservedly been levied against high-profile international institutions thus far. Some banks have cut bonuses and bolstered reserves in anticipation of sanctions that will rival the residential foreclosure abuse settlement.
Renewed calls for active regulation—both abroad and in the Senate’s reconstituted and re-energized Banking Committee—may well lead to much higher long-term costs for financial intermediaries large and small. This year will see the Consumer Financial Protection Bureau come to life as it moves from last year’s study phase to active engagement. Well-funded, and with a broad mandate to interpret its protective function, its implications for the banking sector loom large.
The potential for seismic shifts in 2013 will play out alongside other cyclical and secular changes, ranging from a new Consumer Complaints Database to the anticipated expiry of unlimited insurance coverage. Against a backdrop of modest economics and large financial institutions’ tarnished public perceptions, the adoption of consumer technologies that obviate visits to the teller and may erode the value of incumbent payment networks will become increasingly relevant. For small and large banks, interest rate risks assumed in an environment of artificially low rates and pressure on net interest margins will only begin coming into focus. Beginning the new year on sounder footing, banks will have to work hard to keep their balance.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at firstname.lastname@example.org.